The “higher for longer” narrative was erased last week in the blink of an eye with the collapse of Silicon Valley Bank (SVB).  Systemic risk to the financial system is one thing that will stop the Federal Reserve’s current rate hike trajectory in its tracks.  It remains to be seen how much SVB’s failure will reverberate through the financial system.  Then on Sunday night New York regulators closed down Signature Bank (SBNY).  Most of our comments below relate to SVB. 

SVB was a big bank with $208 billion in assets before its failure.  So what happened at SVB that led to its collapse and become the second largest bank failure in U.S. history (Washington Mutual was the largest and went bust in 2008)?  After all, SVB didn’t suffer the sort of collapse in loan performance that is the typical source of doom for banks.  And the bank did not rely on heavy leverage.  Rather, the bank was largely a victim of its own success in the era of ZIRP (zero interest rate policy).  Part of the SVB business model was locking in tech employees and founders, providing them with both commercial and personal loans if they agreed to bank with SVB as their primary relationship.  The combination of sharply higher interest rates (lower bond prices) and falling deposits (due to the slowdown in venture tech activity) eventually meant SVB had to sell some of their long-term “held-to-maturity” bonds and book steep losses.  That led to more deposit outflows and, eventually, the failure of the bank.  It is clear that SVB’s management mismanaged risk.

Also announced Sunday night was that all deposits at SVB and SBNY were fully guaranteed under an exception to the $250,000 deposit insurance cap.  Besides making depositors whole, this was done for two other reasons; First, to hopefully prevent a run at other banks, and second, to prevent a mass exodus of depositors at smaller banks in favor of the country’s mega-banks which are perceived to be safer.  With deposits at (all?) U.S. banks having essentially been backstopped by the actions of the Federal government, one could argue that the banking system has become de facto nationalized and the consequences of that are completely unknown.  Once again, private sector risk-taking is being pushed onto the public sector balance sheet.

Do these regional bank failures pose systemic risk in our banking system?  Some analysts say yes.   In fact, some think the Fed should cut short-term rates by 100 bp (1%) by year-end, if not sooner.  Would that be bullish for stock investors?  No, not necessarily for two reasons:  First, it is an admission by the Fed that the financial system may be vulnerable, and second, it would only delay the Federal Reserve’s fight against inflation.  However, we agree that putting the inflation fight on pause may be prudent behavior by the Fed.  Unfortunately, this may cause the bear market to continue for longer than it would otherwise, in our view.

These bank failures are a painful lesson of a credit mania fed by easy money and misguided regulation.  The Fed and Treasury will blame the bankers (which is justified), but they are as much if not more culpable.  The easy money bill came due.  First, as inflation.  Now, as financial panic with unknown economic damage.