What were they thinking?

I still can’t get over the “strategy” devised by the managements of these two failed banks.

A typical bank takes in deposits, which can be withdrawn relatively quickly, in savings or checking accounts or CDs. It makes much longer-term (meaning at least several years) loans to individuals (mortgages, car loans…) and businesses. Larger and longer-term loans loans may be variable rate and typically have protective covenants that allow the bank to change the rate or call the loan under specified conditions–usually if the borrower’s financial condition deteriorates.

For many loans, the bank chooses either to keep them on its own books or charge an origination fee and quickly resell them to another institution that includes them in an aggregate for sale to, say, a pension fund.

From what I’ve read, neither Silicon Valley or First Republic did much of this. Instead, at the most basic level, their specialty was to collect deposits from wealthy individuals, for whom they provided investment or concierge services. The banks avoided the expense of having an extensive loan department by investing these funds in long-dated US government securities. They also decided to pick up a little extra potential return by buying highly illiquid mortgage-backed aggregates created by other financial institutions. The downside of such securities is that their price tends to shift down a lot at the first whiff of selling pressure.

The banks “maximized” their returns in three ways:

–they didn’t have the expense of having big loan departments

–they picked up a few extra basis points in yield by buying illiquid bonds

–they had a very low cost of funds by relying on wealthy individuals (who were exposed to the risks of having deposits only partly insured by the FDIC).

Looked at slightly differently, the two banks seem to have made an all-or-nothing bet that interest rates would remain stable for a long time and that customers would be happy earning next to nothing on their deposits. In other words, both bet that customers would never withdraw their money, so they would never face the daunting prospect of trying to sell illiquid bonds in an unfriendly market.

The two banks put much of this structure in place while rates were at pandemic-induced lows. To put what they did in context, for a good portion of 2020, the 10-year Treasury yield fell considerably below 1%. 2021 wasn’t much better. The 10-year yield didn’t rise above the 2% level until well into 2022. Overnight money was yielding less than 20 basis points.

So the banks were paying out, say, 20 bp to depositors while collecting 2%- from their bonds. What could go wrong?

What did go wrong is this: if we assume the US economy can grow about 1.5% yearly in real terms and we have 2.5% inflation, then nominal yield on the 10-year should be around 4%. Overnight deposits should provide protection against inflation but no real yield. This implies bank deposits should yield 2.5%.

Two big negatives for our two banks:

–a bond yielding 2% has to be trading a lot below par in a 4% world, so they had enormous unrealized losses on their balance sheets, and

–20bp isn’t enough to prevent even the most loyal customers from shifting deposits to higher-earning vehicles like money market funds. These banks couldn’t pay competitive yields because they were getting 2%- (before their administrative costs) in. They also couldn’t meet requests by depositors for their money both because they couldn’t sell their investments and the proceeds wouldn’t be enough to pay all depositors.

What I still can’t wrap my head around is why the two would risk valuable franchises by making this transparently lunatic bet.

Another thing: During the Trump administration, banks like Silicon Valley and First Republic were exempted from the more rigorous federal supervision maintained for larger banks. Some have blamed this legislation for the subsequent failure of smaller banks. I think this is right, but not for the reasons I’ve read given. My (cynical) take is that the path of least resistance for managements and boards of directors of poorly-managed companies is to collect a salary, look the other way and hope for the best. This is much easier to do if there’s no regulator’s stress test that documents the parlous internal state of affairs–and the culpability of management for it.