The recent failure of three U.S. banks has raised concerns over the economy and financial system. The situation is still evolving, and there is plenty of speculation about what might come next. One recent development is that government officials from the Treasury, Federal Reserve, and FDIC have announced that depositors will be made whole in an effort to backstop the system and restore confidence.

I'm often one to blame to government quickly, but in this case, I thought they acted decisively and prudently. They didn't bail out the banks. They created a lending mechanism so "Held to Maturity Bonds" (HTM for short, more on these later) could continue to be held, and they ensured no client of these banks was punished through unlimited FDIC coverage. They fired and will hopefully punish the imprudent management of these banks, which were more focused on DEI initiatives than ensuring their job was being fulfilled as stewards and fiduciaries of the bank.

This crisis has created hardship for many companies and individuals as payrolls are disrupted and access to cash is halted. However, when it comes to investing, it's more important than ever to stay levelheaded and focus on the big picture. What should long-term investors know about these bank failures, and what do they reveal about the financial system?

Bank stocks have struggled due to recent failures

The collapse of Silicon Valley Bank (SVB) was the first FDIC-insured bank failure since 2020 and the second largest in history. This was followed two days later by the failure of Signature Bank, the third largest in history. A few weeks earlier, these two publicly traded companies had the 14th and 18th largest market capitalizations among U.S. banks, respectively. Silvergate, a smaller bank active in the crypto industry, also failed the same week but through an orderly liquidation.

From a market and economic perspective, the main question is whether there is a wider systemic risk to the financial system. This episode reveals that these particular banks grew too aggressively and with too little risk management as tech valuations rose and crypto prices rallied over the past several years. While this worked well in a bull market, reversing these trends in 2022 made these banks vulnerable to classic bank runs.

How do bank runs occur? A simplified description of the classic banking model is that customers – both businesses and individuals - deposit funds for safekeeping. Banks then use these deposits to make loans or to buy high-quality investment securities, which they hope can generate profits. This works well as long as these investment assets maintain or grow in value and customers trust that their deposits are safe. If either is not the case, a bank may not have the liquidity to meet its obligations. With this in mind, these recent failures were due to two related problems.

SVB was in a unique situation in that nearly 85% of their deposits were in excess of the FDIC coverage amounts, which currently stands at $250,000 per depositor. This is uncommon in most banks, but when you're serving a single industry almost exclusively, you can see how this can happen, especially one as flush in cash as the tech industry. For example, how many of you have Roku? They currently have $1.9 billion in cash on deposit at different financial institutions. According to a recent SEC filing, nearly $487 million was in SVB. Than means nearly all $487 million was uninsured! Granted, that is a large multinational company, but the point is still valid; SVB was mainly made up of clients like Roku.

Banks accumulated unrealized losses on investment securities as rates spiked

First, rapidly rising interest rates and Fed rate hikes over the past year created financial stresses on bank balance sheets. Bonds had their worst performance in history in 2022, driving unrealized losses on investment assets, including U.S. Treasuries, as shown in the accompanying chart. Whether banks need to book these losses depends on how these securities are accounted for, Held to Maturity ("HTM") or Available For Sale ("AFS"), on their balance sheet. HTM assets can be held on your balance sheet, and you never need to report the losses because they will be held to maturity and should not bear a loss. AFS, on the other hand, because they are used to meet liquidity needs from the depositors of the bank, should that arise, are "marked to the market," and you'll see the current values reflected on the banks' balance sheet.

You might be wondering why they are even given a choice. Bonds are loans that you, an investor, are making to a third party. In the case of most banks, they are forced to buy very high-quality bonds, the largest of which are US Treasuries. US Treasuries are backed by the full faith and credit of the US government; however, the longer-term bond you buy, the more the current value, what you'd get if you sold it today, changes if there is a change in interest rates. For example, you purchase a $10,000 bond today, and it matures in 20 years with a 1.5% interest rate. In 20 years, the US Treasury will pay you back the $10,000, and all the while, you're receiving the interest on that $10,000 at 1.5%. However, if rates were to move higher, as they did last year, that bond would show a current value of something lower, say $9,000, even though it pays its interest on the original value and it's going to mature at the original value of $10,000. The reason for the lower value is a result of the fact that the person buying your bond would need to be compensated for the fact that they're getting 1.5% when new bonds are paying 4.50%, or whatever prevailing interest rates are. The higher rates go, and the longer your bond is for, the more the bond's value will decrease.

Going back to my original question, why are they even given a choice? The HTM book is exactly that, held to maturity. It doesn't matter what the current value is because the bank says we'll hold this to maturity and get back what we put into it, plus our interest. However, if one bond is sold from the HTM book, the entire book must be repriced at current values, meaning you'll take a very large loss if rates spike. So as we think about what happened in 2022 and SVBs bond book......

Their bond book got so large because their deposit base nearly tripled, and there was not much loan demand from these tech startups. They put many excess deposits into bonds. The duration of their portfolio (a way of getting an average of the length of bonds) was around six years. Confusingly, they bought longer-term bonds during a period of historically low-interest rates. Then in 2022, interest rates spiked, while SVB continued to see outflows of their deposits base as these tech startups needed to use their cash since liquidity was getting tight for them. When SVB ran out of deposits that were available to them (AFS) then, they were forced to dip into their held-to-maturity book, which had $16 billion or so of losses that they didn't have to account for unless you sold one bond from that HTM book. Since they did dip into that HTM book, the entire bond portfolio needed to be repriced, therefore creating such a loss that the bank was no longer able to operate safely, and the FDIC was asked to come in and take over.

Second, SVB’s concentration of tech and startup customers made it vulnerable as conditions deteriorated for that sector, just as Silvergate and Signature Bank were exposed to the slowdown in the crypto industry. SVB tried to plug this gap by raising fresh capital, but this backfired since it highlighted the liquidity and solvency issues it faced. Like shouting "fire" in a crowded theater, once there is the perception of solvency problems, a classic bank run can occur swiftly, which can then become a self-fulfilling prophecy. To a large extent, this played out publicly as many in the startup and VC communities urged companies to move their funds.

While government actions are always controversial and subject to political debate, moves by Treasury, the Fed, and the FDIC to backstop customer deposits across these banks will likely help to prevent contagion effects across the system. At the same time, it does not directly address the underlying issue of impaired assets, which depends on the quality of risk and asset/liability management at each bank. However, the risk that unrealized losses become a solvency issue is mitigated for larger, more diversified banks who are less reliant on deposits, have a stronger deposit base, and maintain higher amounts of capital.

These bank failures are the largest since 2008

One reason that investors may be concerned is that there have been few bank failures in recent history, especially since banking legislation such as the Dodd-Frank Act was put into place after the 2008 financial crisis. According to the FDIC, there were only eight bank failures from 2019 to 2022, far below the 322 experienced around the global financial crisis or the hundreds that regularly occurred in the 80s and 90s. That said, SVB is an outlier in that it had total deposits of $175 billion, while the eight from 2019 to 2022 had a combined $628 million.

Naturally, there are also parallels being drawn to 2008 when the last wave of bank failures threatened the global financial system. It's important to keep in mind that, back then, the problem was not just that all banks held significant amounts of mortgage-backed securities and other housing-sensitive assets that ended up being worth only pennies on the dollar. Rather, significant amounts of leverage coupled with new financial instruments such as collateralized debt obligations allowed a housing crisis to turn into a financial meltdown. While it's unclear exactly how this episode will play out, many banks today are much better capitalized and do not primarily rely on tech or crypto deposits. Additionally, any economic spillover has so far been concentrated in the technology and venture capital industries which were already struggling with layoffs and a slowdown in demand.

These developments impact the Fed's upcoming rate decisions since they underscore an unintended consequence of rapid rate hikes. This likely creates a new sense of caution for the Fed as they continue to battle inflation. According to the CME Group, which is the tool I use most frequently to track expected Fed interest rate decisions, there is now a 62% probability that rates will rise 0.25% next week with 1 38% chance there is no rate increase. Then they expect the Fed to hold steady until their July 2023 meeting where the current odds on favorite is a 0.50% rate decrease at that meeting.

Interest rates have also fallen, with the 2-year Treasury yield declining over one percentage point to around 4.1%. These rates were nearing 5% only two weeks ago. While these expectations can change rapidly, they show how much sentiment has shifted in the past week.

The bottom line? While recent bank failures are problematic, parallels to 2008 are premature. Investors ought to stay diversified as the situation stabilizes while focusing on the big picture rather than minute-by-minute speculation.