Prologue: In 1991, the Treasury Department reviewed potential risks to the financial stability of Fannie Mae and Freddie Mac. A government model had concluded that the companies would not face problems due to an increase in interest rates until rates rose to the 24 percent or 28 percent level.
My review of this model found that the model understated interest rate risks for two reasons. First, the model omitted information about annual and lifetime payment caps on Adjustable-Rate Mortgages, which reduce bank revenue when interest rates rise. Second, the model did not fully consider the impact of interest rates on defaults and other outcomes that could exacerbate financial stress when interest rates rose.
A revised version of the government model that I put together concluded an interest rate shock in the 12-14 percent range would lead to financial problems for the two companies. Treasury officials were grateful for this input but were largely unconcerned because interest rates were on a downward trajectory.
The current generation of management at many banks takes extremely low interest rates for granted and understates risk associated, which exist when the duration of their asserts do not match the duration of their liabilities.
The 10-year Treasury interest rate a couple of years prior to the 2008 insolvency of Freddie Mac and Fannie Mae was around 5 percent, far lower than the interest rates that prevailed in most of the 1990s.
The 10-year interest rate at the time of the SVB debacle was around 4.0 percent and is now at 3.7 percent, below its historic average.
Comments
Comment One: Don’t blame the Fed or high interest rates for this debacle. High interest rates did not cause the SVP collapse because interest rates are not high as discussed in the post Should the Fed Pivot?
Comment Two: It is hard to understand why anyone, let alone a sophisticated financial institution with short term obligations, would tie up funds in long-term bonds when the yield on the 10-year government bond was lower than 1.0 percent during the pandemic and remains below the long-term average. More information on the type of investments that lead to this debacle is needed. Note, even short-term bond ETFs invested in inflation protection bonds like VIPSX, VTIP, and STIP, have lost substantial value in the past year. Go herefor a discussion a discussion of use of bond ETFs in a low interest environment. The collapse of a bank due to an interest rate exposure when the 10-year bond yield remained at 4.5 percent could have occurred if the bank’s analysts had grossly miscalculated the impact of interest rates on certain assets.
Bank officials purchasing these bonds and bond funds should have more carefully researched the impact of interest rates on all of their investments and realized there was more downside risk than upside potential from investing in fixed income assets when interest rates were at such a low
Comment Three: SVP may be the canary in the coal mine. The insolvencies of Freddie Mac and Fannie Mae were preceded by insolvencies of some smaller private mortgage insurers. The SVB closure occurred very quickly after the public became aware of the problems at the bank because there was a run for deposits. The First Republic Bank, is now losing deposits. Transparency causes depositors to flee but is necessary to assure better investments.
Comment Four: Regulators need to actively monitor a second potential stress point — crypto Ponzi schemes like the ones at FTX and Silvergate. Did crypto play a role in the SVB debacle? I wonder what impact if any exposure to crypto had on the SVB collapse.
Comment Five: The CEO of SVB sold $3.5 million in stocks prior to the sale of the bank. Federal regulators should move to claw back the proceeds of this gain.
Comment Six: The blame game has started. Republicans are blaming lax fiscal and monetary policy and have conveniently ignored their role. Yes, Jerome Powell should have increased interest rates sooner. However, there is a lot blame to be shared here. The Trump era tax cuts and Trump’s threats to fire Chairman Powell if he did not lower interest rates had a major impact on the nation’s fiscal and monetary condition. Also, Republicans have consistently argued for less regulation, a position that is hard to defend.
Comment Seven: The Fed is now in a tight box. Inflation and the labor market remain robust. A move by the Fed to prevent insolvencies, by lowering the cost of credit or by purchasing some of the long-term bonds owned by SVB, will lead to more inflation. Bill Ackman is making the case that SVB is too big to fail and the Fed should consider some sort of bailout. Dealing with the banking crisis could lead to higher inflation over a prolonged period.