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    March 17, 2023
    Financial Brigadoon: Silicon Valley Whack-a-Mole

    Given the recent upset with both Silicon Valley, and closer to home Signature Bank, I’ve spent a little time looking at balance sheets of a number of banks. It looks to me as if there really is a systemic risk here. It would seem the first class you get in banking, would be to make sure that your asset and liability maturities are in line. Well, many of these banks have violated that rule. A substantial portion of their assets are longer dated maturity bonds. Of course, the bulk of their liabilities are next day available deposits. What I see in looking at Silicon Valley (and a number of the other banks mentioned) is that they really are highly leveraged bond funds.

    Silicon Valley’s long dated bonds totaled $120 billion. That compares with $16 billion of equity. And that’s $16 billion of equity based on stated, book value, not reduced for $15 billion of bond losses as of year-end 2022. So, if you mark the bond portfolio to market, there’s no equity. That’s what happens when you lever equity 8 to 1 and mismatch the asset and liability maturities.

    Of course there’s the argument that the reason you don’t mark to market on the healthy maturity bonds is that you’ve had a “temporary decline.“ That’s the crux of the question. Is the bond portfolio that many of these banks hold a temporary decline or a response to higher inflation, and therefore higher yields to compensate. What I see is a fixed income market that hasn’t fully adjusted to yields appropriate for the current level of inflation.

    Today the bond market is priced off the HOPE that inflation moderates back down to the 2% level or so. That is a risky proposition. That creates significantly more risk to that bond portfolio that inflation stays where it is and the bonds go down another 10 or 15%. That creates a huge hole in the capital of these otherwise seemingly well capitalized banks.

    It seems to me, the only way to eliminate this risk is to substantially sell down that long bond portfolio. The question becomes, can you afford to crystallize that mark to market loss as you eliminate that continuing interest rate exposure and, in the process, pick up higher yields that you can get from short-term maturities. It’s a good solution if you can pay the exit price. The problem is that exit price blows a hole in potentially a large portion of your capital. Of course, the second question would be what’s the maturity profile on that held to maturity portfolio to get a sense as to the interest rate risk associated with those investments.

    Another systemic issue is if banks start to make that adjustment process, selling down those bond portfolios to shorten the maturities. Then the question becomes, who is the buyer of those long bonds. It would seem, the FDIC will begin the process for the banks that they’ve seized. To not do that, would put them at risk of accepting that huge, levered interest rate risky portfolio.

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