Evening Brief – 04.03.23

The bond losses at Silicon Valley bank totaled $18bn at the end of the year, $15bn of which was kept off the books if the securities were marked “Held-To-Maturity (HTM).” While HTM losses wiped out 98% of SVB’s tangible equity, they are spread throughout the banking system, albeit to a lesser degree. For example, Bank of America would see 53% of its equity vanish under mark-to-market accounting; however, the bank’s bond portfolio was only 26% of total assets.

This is not to suggest the problem is isolated to bond portfolios. Banks’ loan books make provisions for future credit losses, not mark-to-market losses due to rising interest rates. According to Goldman Sachs, 99% of outstanding mortgages originated at levels below today’s market rate.

In other areas of the financial industry, we have mark-to-market accounting with margin calls. Not in banks. Insurance giant AIG went bust in 2008 because they thought they could hold securities to maturity and ignore unrealized losses. Banks are correct that if they only held their securities to maturity, they don’t need to worry about interest rate risk.

But the current crisis shows that this is the wrong way to think about it because you could have a depositor flight. If, instead, there was a threat of margin calls, which is what this is the equivalent of induced by depositors, you have an incentive for good risk management and a disincentive to use excess leverage.

This leaves the Fed in a pickle. Allow interest rates to rise further and jeopardize the fragile banking system or try to push rates lower and price inflation heads higher.