SVB Collapse Scrambles the Coalitions

It was another regular week in Washington – well a regular budget kick-off week that is. Republicans and Democrats were fighting the usual battles over identity issues (the former with glee, the latter with resigned fury). Arguments over President Biden’s proposed tax increases were heating up. Folks were wondering if the House GOP would ever get around to proposing a budget of its own or simply rely on the Freedom Caucus’ vague demands (which include a hidden cut of $962B in defense spending).

Then, on Friday afternoon, Silicon Valley Bank (SVB) was wound down, and a major economic issue crashed into everybody’s favorite culture wars. I wouldn’t go so far as to say Chaos Ensued, but there was more than a little scrambling of the usual political coalitions.

How We Got Here

Before we get into how Congress, the Treasury Department, and the Fed reacted, let’s take a quick walk down memory lane to see what happened to SVB. This will not discuss the two crypto-heavy banks (Signature and Silvergate) that also went down. Cryptocurrency crashing and burning is not really a surprise. SVB, while having some crypto depositors, had other problems.

SVB’s troubles begin when the Fed went all out with “quantitative easing” in the 2010s – by which I mean all the 2010s. For all the talk about COVID’s effect on the economy, the Fed was lowering interest rates in 2019. For the uninitiated, lower interest rates on U.S. Treasury notes raise the price of the notes themselves (the interest payments stay the same, so the interest rate and the asset price have to move in opposite directions). Thus, the Fed was creating a Treasury note bubble.

Pop Goes the Bubble

Banks that looked to keep their assets ahead of their liabilities are supposed to diversify. SVB … didn’t. They went heavily into the low-yield, high-price bonds. So when the Fed finally got around to raising rates again, SVB was stuck with bonds valued well below their purchase price. They attempted to sell the bonds on the open market … proceeding to make things worse. From RBI: “… a $21bn loss-making bond sale caused a $1.8bn hole in its budget.” Ouch!

SVB couldn’t survive the basket with all its eggs crashing. That suddenly got a lot of California politicians nervous. Talk of bailing out the bank became heard, leaving me in the very uncomfortable position of agreeing with Matt Gaetz (who is vehemently opposed).

Where We Go from Here

As Sunday wore on, talk of a full bailout faded. The Administration did go a bit above and beyond for depositors (WaPo).

The Biden administration announced Sunday night that all depositors at the failed Silicon Valley Bank would have access to all their money on Monday morning, approving an extraordinary intervention aimed at averting a crisis in the financial system.

The decision by Treasury to backstop all deposits at SVB and Signature — not just those up to $250,000 that are insured under federal law — rested on a judgment that it was necessary to avoid a wider “systemic” meltdown. The move will likely ignite a political firestorm over the decision to protect the assets of tech firms, venture capitalists, and other rich people in California.

This one is a little trickier than a simple bailout. In this case, any depositor with more than $250,000 in the bank will still have full liquidity of their funds. On one level, as noted in the quote, it is an abnormal protection for some of the wealthiest in California. On the other hand, we’re not talking about a risky investment whose failure would be a fair warning to others about due diligence. Depositors don’t think of themselves as bank investors, but rather bank customers.

The other action, by the Fed, will likely have far greater economic impact.

Separately, the Federal Reserve announced that it was creating a lending facility for the nation’s banks, designed to buttress them against financial risks caused by Friday’s collapse of SVB.

The new Fed program will enable banks to pledge U.S. Treasuries and other safe government securities as collateral in return for loans of up to one year from the central bank.

The initiative is aimed at resolving one of the problems that led to SVB’s failure: unrealized losses on the bank’s government securities. As the Fed raised interest rates last year, the value of those securities fell.

The central bank will lend up to the security’s original value rather than its depressed market value, thus potentially allowing banks to delay recognizing their losses for up to one year.

In other words, the Fed is trying to alleviate the pain from its loose-money-for-too-long mistakes. Personally, I think this could work. It would give banks with too many bonds the chance to rearrange their portfolios without risking a cash crunch and sparking a bank run. I would even go so far as to opine that had something like this been in place for mortgage-backed securities in 2008, history would have been far less traumatic.

As for the taxpayer, their only role in this so far is a $25B backstop to the new loan program, but that would only be needed if the nation’s banks can’t pay for it themselves. If that’s the case, we have far bigger problems than we realize.

More to the point, this should be a wakeup call to politicians and pundits alike. There’s a lot more to governing than performative virtue signaling.

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