Banks group their holdings into a few buckets
Available-for-Sale vs. Held-for-Trading vs. Held-to-Maturity Securities
Banks have the ability to group their holdings, stocks, treasuries, and mortgages into a few different buckets. There are three classifications of securities— held-for-trading, held-to-maturity, and available-for-sale.
Held-for-trading means you buy and sell the investment quickly to make a profit. Held-to-maturity means keeping the investment until it matures, like a certificate of deposit (CD). Available for sale is the middle option – you keep it for a while, but may also choose to sell it.
The way banks classify these portfolio investments affects whether gains or losses appear on their balance sheets or income statements. So the banking sector has a lot of leeway on how they classify those.
The banks also used these accounting conventions to make profits and help them manage stock market risk, which seems like the root of today’s banking crisis.
How Did We Arrive at a Banking Crisis?
When the Federal Reserve was pumping money into the markets there was all this cash running around. People had money in their pockets, and they deposited it in banks. But even though people had excess cash, there was not any increasing loan demand.
During this time frame, banks accumulated a significant amount of cash and high-volume deposits on their balance sheets, exceeding both their ability and desire to make loans, as well as the demand for loans.
So they had all this excess cash and they needed to put their money to work for a profit. All banks including your community bank on the corner, all the way up to JP Morgan Chase, took those profits and excess deposits, that excess cash, and bought treasuries and mortgage-backed Securities (MBS).
No Loan Demand Leads to Risk-Taking
Banks took the cash gains they were sitting on from deposits and started buying federal debt (treasuries and MBS). Their timing was terrible. They bought treasuries before the Federal Reserve started hiking rates. So banks bought the 10-year for less than 1%, right, they bought mortgages when mortgages were between two and 3%. These banks are buying high and some are now selling low.
So, again, all these banks from JP Morgan Chase, all the way down to the bank on the local corner, purchased securities that they were allowed to buy in hopes of making a profit. Without realizing the risk was beyond their level of sophistication.
Held to Maturity Accounting
There’s nothing stopping a regional bank from saying, “Hey, I've got a billion dollars in extra cash, let me make a $500M investment in securities, and call those available for sale and mark them to market. Then I'll buy another $500M and call them held to maturity. I never have to mark those to market, and I can just let them eventually mature 10 years down the line, collect the interests, and collect the principal. I don't have any more risk of loss.”
That's great in a video game, I guess. And all that works until somebody starts draining in deposits, taking deposits out and all of a sudden, you need to raise cash. And all of a sudden, all those held-to-maturity securities are in play, because you need cash, they're not hedged. And you're sort of getting punched in the face through losses. Now they're worth a 10th of what you paid for them. Sure, you can hold them for 30 years, but in the future, you're gonna have to go to finance it at a big loss.
Here's an example:
For example, let's say you bought a 10-year on January 1, 2020. At the 10-year, Treasury rate was probably less than 100 basis points, probably less than 1%. As of last week, that was close to 4%, which represents somewhere around a 20% loss in value. That's not insignificant for investors in any financial institution.
And then it's further complicated by the fact that some of these are mortgages. There are hundreds of mortgages piled together, commonly referred to in trading as a mortgage pool.
You really don't know the maturity of that mortgage bond, sure there are estimates, there are data, there are models and financial research data. But you really don't know what that maturity is, and so when you buy the mortgage, you buy the mortgage-backed security when rates are at 2%-3%.
If you have a financial research model that basically says: if rates stay around XXX, chances are on average, these are going to pay off in six years. So you treat it, like a 6 or 7-year Treasury, from a thought perspective. But then as the interest rate price goes up, I'm less likely to sell my house, right? Because as the price changes, it's going to be harder, I don't want to sell it at a lower price. I'm certainly not going to refinance. So all of a sudden the average maturity of all those mortgages gets extended.
So not only do rates go up but the mortgage-backed security that you thought had an average maturity of 6-7 years all of a sudden has a maturity of 10-12 years. So you get a double whammy. You get one whammy from interest rates going up, inflation, and the value of the mortgage going down. And then you get another whammy because the duration of the mortgage has increased, and it becomes a longer-term debt instrument than when you originally bought it.
Are investors in these banks required to mark their fixed income to market when they're releasing quarterly earnings?
So those bond instruments, such as debt instruments, treasuries, and mortgage-backed securities, that are labeled as available for sale, are marked to market, and the hedges are marked to market. For those mortgages or treasuries that they've classified as held to maturity, they don't mark those to market.
They are held at cost, and basically from an accounting standpoint, the same way you'd accrue a bond. And that seems like that was a big case in this situation where they had to market and they just didn't have any money behind it.
Going to trade an options contract? Be cautious
There is a lot of systemic risk in the market right now in the wake of this bank failure. This market volatility is going to stay until all of this is figured out.
This doesn't happen in isolation
This doesn't happen in isolation, there are others that will fall. And you see it in the stock market, in options trading, and you see it with volatility increasing, but this is why we always want to stay hedged. And know that it's okay to make smaller trades because more volatility is expected, especially in stock options and options contracts.
Ensure your trading account is protected when investing in times of high volatility. As an investor, when events like this occur, expect that underlying stock prices will increase in volatility due to uncertainty of the future.
Banking Sector BS
If a bank has a stress test pending, do they manicure the books just to pass the test?
So, there are absolutely window-dressing kinds of things that go on. If you watch Twitter you'll see, some people make comments that particular moves in equities, or in particular bonds, are because banks are sort of truing things up for the quarter end, for their balance sheets, and for the upcoming stress test. Particularly, for liquidity ratios.
And you'll also see that for large fund managers. If at the end of a quarter when they have to report, and Apple went up 10% and they don't have any Apple in their portfolio because they missed the run-up. These guys will actually buy options and stock in Apple at the end of the quarter, or at the end of the reporting period, to show the markets that they were holding Apple so that somebody doesn't ask them, “how come you don't have any Apple?”
A very common set of procedures and processes that banks and traders have. The challenge is when you start trading options buying illiquid stuff, that stuff will be difficult to value.
The Issue with Silicon Valley Bank
That's part of the issue with Silicone Valley Bank (SVB), because you see all these losses in securities that you can value. The other complicating factor here is that they had a loan book. Who knows what those loans were valued at? Who knew the credit quality?
No one was willing to step up to the plate
It was kind of apparent that no bank was willing to step up to the plate here and essentially buy Silicon Valley Bank. Now, that may have been because it happened too quickly, it may have been because they couldn't get comfortable with the loan portfolio, it could have been because the Federal Reserve, Treasury, or administration said “we're not backstopping and providing any funds like we did in 2008 and 2009.”
The SVB bank failure gets worse…
The other shoe to drop: what's quality, what's the realized value of either Signature Bank's or Silicon Valley Bank's loan portfolio? On top of just the premium fact that SVB would syndicate loans…
Let's say for argument's sake SVB originated a $500M loan, they would keep $250M for their own books, and sell the other, $250M to other, to other banks. So other banks may have some of this loan portfolio on their books at an uncertain value that nobody knows about.
What’s the difference between what's going on now, and what happened in 2008, and 2009?
Two things were really going on in 2008 and 2009. First, there was just an unbelievable amount of leverage by Bear Stearns, JP Morgan Chase, and all the banks across the board.
Rather than having $10 of capital for every $100 in assets, which is pretty much what they're required to do today. During the 2008 financial crisis, they had $10 in capital for $200 worth of assets. So, they were leveraged 20-to-1, 30-to-1, and sometimes higher than that.
With that leverage, there is little margin for error. Extreme volatility in market price and price movements would pose a tremendous risk. They had very little capital standing behind their underlying asset base. So, if something did go south, they didn't have that shock absorber in place.
What triggered the 2008 banking crisis?
The reasons behind the GFC include falling housing prices and the increasing number of people unable to repay their loans. The house price in the US reached its peak about mid 2006, a period which coincides with an increase in new construction in some areas.
The case for the future
Because of all the changes in bank regulations, leverage is really not as much of an issue right now in 2023. Another thing that's not as much of an issue yet, is credit quality.
Credit issues and leverage drove the 2008 crisis
The mortgage is backing all these MBS. What was f***, right? It was loans made to people under circumstances where they either didn't intend to pay or couldn't pay. It was like the Wild West.
So there were two things going on in the past that aren't going on now… Yet.
This leverage issue, and the credit quality issue. That's why I think the Federal Reserve, the Treasury, and the administration were pretty comfortable saying, “hey, let's guarantee all the deposits… it sounds like we're guaranteeing them forever now because this is really a valuation and hedging and duration problem, not leverage and credit quality problems.”
The other challenge here is that some of this is out of A bank's control now so so I could be a bank you know I could be a Regional Bank you know wherever a small Community Bank I could have held my Securities I could have hedged them I could be in perfect shape but if there's a run on my bank- people take deposits out of my bank to go put it in JPMorgan Chase. At the end of the day, there's not a lot I can do to stop that unless, which is going to happen, I actually start paying interest on deposits to keep them from escaping.
Situation Overview (TL;DR)
The banking sector had excess cash due to the lack of loan demand even though the Federal Reserve was pumping money into the markets. The excess cash led the banks to invest in securities such as treasuries and mortgage-backed securities (MBS) hoping to make a profit. Banks classified their portfolio investments into three categories – held-for-trading, held-to-maturity, and available-for-sale. This classification determined whether gains or losses would appear on the balance sheets or income statements.
However, the banks failed to realize that the risk was beyond their level of sophistication. They bought treasuries and MBS before the Federal Reserve started hiking rates, which resulted in banks buying high and selling low. Regional banks invested in held-to-maturity securities and marked them to market, but the risk was that when deposits were drained out, they needed to raise cash, and the held-to-maturity securities were not hedged, leading to losses.
The interest rates going up and the increase in the maturity of mortgages were a double whammy for banks. The investors in these banks are required to mark their fixed income to market when they are releasing quarterly earnings.
Always ensure your trading account is protected when investing in times of high volatility. As an investor, when events like this occur, expect that underlying stock prices will increase in volatility due to the uncertainty of the future.