The failure of Silicon Valley Bank (SVB) – as well as that of Signature Bank and many others seemingly on the brink of collapse – gets attributed to social media-driven fear in the minds of depositors and investors. In other words, some might argue that there is no cause for concern: the financial sector – while not perfect – is quite robust.
In actuality, a vicious cycle of risky business activities interplaying with government actions in recent times exacerbated and laid bare the shaky foundations of the financial services sector. An important key to understanding this is to examine how U.S. government debt issuances are consumed by the financial giants of the world.
Why Treasuries Are Key For Banks’ Market Activity
Ordinarily, banks use cash from customers’ deposits to provide loans to businesses and individuals. The interest payments on these loans ensure that the customers’ deposits used effectively earn a (modest) amount as interest, along with the banks earning a (sometimes substantial) profit as well. Over the course of the pandemic and its associated lockdowns, borrowers wound down borrowing for business purposes while massive disbursements made by the government under various schemes resulted in borrowers often paying down their debts. For instance, commercial real estate developers and car dealerships declined to borrow to expand their businesses while high-interest-rate credit card holders paid their debts off with government stimulus packages. If debts are paid off, there is no interest receivable – which means that there is no cash stream to fund the interest payments on deposits or – for that matter – profits for the banks.
This is when the banks began to buy large chunks of what had lately been the least attractive asset to own: government bonds. After all, a yield that is slightly better than zero at no risk is better than no yield. The Federal Reserve had been inactive on the issue of creeping inflation for years by now and had been propping up the U.S. government’s ever-increasing debt issuances by holding it, thereby effectively acting as a “market maker” of sorts. By all means it sounded like a best choice under the circumstances.
Theoretically, US Treasuries are supposed to be held to maturity wherein the holder gets paid. After all, a Treasury Bond is a loan undertaken by the U.S. government, which pays it off by the end of the specified period. However, the Basel III reforms enacted to regulate banks’ investment activities added another form of utility: non-cash collateral. The Basel III framework demanded that banks set aside even more “additional capital” against the cash they set aside for trading (and risk-taking) than they had before. The rules effectively penalized banks if they were to fund themselves with short-term unsecured deposits to invest in longer-term assets. A cash deposit made in a customer account that can be withdrawn at a moment’s notice therefore cannot necessarily be considered “safe cash” set aside to cover cash used in trading. Banks were required to access high-quality liquid assets (“HQLA”) in a significantly greater volume than before to cushion their investment activities. Naturally, U.S. Treasuries proved to be a beneficiary of this demand.
It wasn’t necessary that only an investment bank would hold U.S. Treasuries; a smaller regional bank could lend U.S. Treasuries from their vault to another party – a large investment bank, for example – for a fee. After all, banks are in the business of making loans. When markets are booming, U.S. Treasuries remained in demand as non-cash collateral all over the world.
Things Take a Turn
When the Federal Reserve couldn’t ignore rising costs hurting citizens any more, it finally began to raise rates – which was arguably long overdue. The U.S. government’s debt issuances, thus, came with a higher yield than the several trillions in debt already in circulation. This began to affect the balance sheets of banks awash in U.S. Treasuries. At the end of 2022, Bank of America held $3 trillion worth of debt securities, which was represented at a value of $862 billion. While accounting rules specify that banks don’t have to record losses due to change in value of these securities unless they were sold, the bank recorded $114 billion as “unrealized losses” for its bond portfolio. Wells Fargo recorded $41 billion; JP Morgan recorded $36 billion and so forth.
It bears remembering that this is an entirely voluntary disclosure. At the time when regulators were seizing Silicon Valley Bank, unrealized losses of $15 billion were estimated on a bond portfolio of just $91 billion. The bank had tangible capital amounting to a total of just $16 billion. Silicon Valley also specialized in “venture debt” wherein the company made unsecured loans on new tech companies and start-ups who also maintained deposits in that bank. When the rate hikes made their debt more expensive, they pulled their deposits. When deposits were pulled, the bank had to liquidate its assets. It started with an attempt to sell a portion of its U.S. Treasury portfolio. After several attempts, the bank managed to sell its bond portfolio with a book value of $23.97 billion at a $1.8 billion loss to Goldman Sachs.
One reason a loss had to be booked when selling U.S. debt is that the market had shrunk to a handful of participants. Chief among them are foreign central banks who buy U.S. debt issuances as policy tools. Given that these issuances guarantee delivery of the U.S. dollar, it could be considered as a proxy of the U.S. dollar to balance the books of trade. However, the highs of the U.S. dollar have created the need for foreign central banks to defend their currencies. The U.S. central bank’s Foreign and International Monetary Authorities (FIMA) repurchase agreement facility, established in March 2020 to enable foreign central banks to post their US Treasury holdings as collateral in exchange for U.S. dollars, recorded the fastest liquidation of U.S. Treasury holdings in nine years after $60 billion in cash was pulled.
Only about 30% of the U.S. government’s debt is held by foreign entities. The rest of it is owned domestically. One such holder is the Federal Reserve itself with over $7 trillion. Recently, it has estimated an unrealized loss of over one trillion dollars.
