About Those 'Safe' SVB Treasurys

"One surprise for investors in the Silicon Valley Bank failure is that it didn't hold exotic derivatives, structured debt products or other horrors that caused so much financial carnage 15 years ago. Far from it. SVB held boring Treasurys and highly rated mortgage-backed securities in large quantities. How could these supposedly safe assets go wrong?

Bad management and negligent oversight from the San Francisco Federal Reserve Bank played a role. But the politicians and regulators who supposedly fixed the financial system after 2008 share responsibility. The banking rules they introduced after 2008 made sovereign bonds such as Treasurys and the mortgage securities of Fannie Mae and Freddie Mac the coin of the realm for bank capital standards.

The rules were agreed to at the Bank for International Settlements and are known as Basel III, after the Swiss city where the BIS is headquartered. Banks, especially the largest, now are required to hold a larger quantity of highly liquid assets to avoid panics, as well as larger capital buffers to prevent insolvency.

Crucially, regulators put sovereign bonds of various durations on the preferred list for each type of buffer. That's because default risk is low -- unless you're Argentina or Russia -- and sovereign bond markets tend to be highly liquid. A buyer can almost always be found if a bank must sell in distress. The helps with credit and liquidity risk.

But what about interest-rate risk? For at least 15 years the Fed and other central banks have downplayed this risk -- through their regulatory policies and their loquacious forward guidance concerning monetary policy. Their promises to suppress interest rates to abnormally low levels for extended periods encouraged banks and others to believe sovereign bonds would hold their market value.

But not forever, it turns out. Rising rates amid high inflation are driving down the value of those "safe" assets and plenty of others too. Unrealized losses for securities held by U.S. banks stood at $620 billion as of December 2022, according to the Federal Deposit Insurance Corp. Other regulators around the world are noticing, too. Germany's financial regulator in January identified this as a significant concern for banks in the eurozone's largest economy, though officials believe banks are sufficiently prepared to absorb the hit for now.

And that's without a panic fire sale. For an example of the worst-case scenario, consider what happened to British pension funds in September. When bad interest-rate bets on hedging instruments forced pension managers to sell down government bonds to meet collateral calls, the mass selling caused yields on British bonds to spike.

Even regulations intended to manage this kind of risk can inadvertently become a danger, as appears to have happened with SVB. U.S. accounting rules allow banks to avoid recognizing losses on assets they declare they're holding to maturity, while they must mark-to-market assets they designate as "available for sale" in case of distress.

That mark-to-market requirement for liquid assets should give banks and regulators a clear view of the value of their liquidity cushions. But it creates an incentive for banks to shift more assets into the hold-to-maturity pool as interest rates rise. SVB was an extreme case in designating an outsized proportion of its assets as hold-to-maturity, meaning it faced crippling penalties if it had to sell bonds to satisfy deposit withdrawals.

This offers a bigger warning about financial regulation, not that anyone in Washington is likely to be interested. No law, rule or regulation can spare the economy from the consequences of bad policies, especially bad monetary policies, which can turn even the safest of assets into a ticking time bomb.

Now taxpayers and depositors must wait nervously to see if any other fuses are burning away in the financial shadows." [1]

1. About Those 'Safe' SVB Treasurys
Wall Street Journal, Eastern edition; New York, N.Y. [New York, N.Y]. 15 Mar 2023: A.16.