In a matter of days, the bear market took a dramatic turn as the 16th-largest bank in the United States suddenly collapsed. The Department of Treasury, the Fed and the Federal Deposit Insurance Corp. (FDIC) moved quickly to ensure that depositors would have access to all their funds, but a second bank already has gone under and there are growing concerns about how widespread the problems that hit Silicon Valley Bank and its parent, SVB Financial Group (SIVB) , might be.
The cause of these tremendous difficulties is higher interest rates. For months there has been discussion that it would take months for the impact of the Fed's hawkish monetary policy to be felt, but it has been having an immediate impact on bonds held by SIVB.
During the Covid crisis, SIVB saw a flood of cash pour into the bank. The bank is not a traditional lender like most other banks and had to invest that cash to produce a return. Billions were used to purchase very safe Treasury bonds that had extremely low yields at the time.
As interest rates increased due to Fed policy, these bonds declined in value. Eventually, SIVB was sitting on billions in unrealized losses on its balance sheet. That would not be a huge problem if the bank held the bonds until they matured, but many depositors were unhappy with the low interest rates that SIVB was paying and there were growing concerns about the bank's balance sheet.
Customers started withdrawing cash, which caused a liquidity crisis for SIVB and forced it to start liquidating the bonds it had planned to hold until maturity. The unrealized losses were now realized, and the bank was insolvent.
The Fed's quickly stepped up to backstop the deposits. If it had not done so, there was a huge risk that other banks with large unrealized losses on their bond portfolio would suffer the same fate. One other bank-Signature Bank (SBNY) -- has already gone under.
The market avoided a panic open on Monday morning thanks to the quick action to protect depositors, but there are now a host of other issues it is dealing with as the market has no choice but to recognize the damage inflation and higher interest rates are producing.
The market and various bank indexes initially traded higher overnight after the news of the SIVB bailout, but they have reversed and are now mixed. The SPDR S&P Regional Banking ETF (KRE) , which holds SIVB stock, was down more than 16% last week and is down another 5% here on Monday morning.
If the FDIC had not acted, the situation would be far worse, but now the market needs to recognize that the entire banking sector faces problems because it is not paying sufficient interest on deposits and may be forced to recognize large unrealized gains on bonds that were intended to be held until maturity.
The bank drama is also going to have an impact on Fed policy. The Fed is now in the difficult position of wrestling with inflation while trying to stop the damage that higher interest rates are inflicting on the financial system.
The most dramatic fallout of these events is that the chances of a 50-basis-point rate hike at the Fed meeting on March 22 have gone from 80% at one point last week to zero this morning. The market now believes that there is no chance of a 50-basis-point hike.
That doesn't mean inflationary pressures suddenly have cooled off. There are very important Consumer Price Index (CPI) and Producer Price Index (PPI) reports this week, which will reignite the focus on inflation, but the Fed now must worry about protecting banks in the short term and can't risk more immediate rate hikes.
The good news is that all this drama is going to change the trajectory of Fed policy and the bear market. The Fed has broken something in the financial system and the full fallout of its hawkish policy is starting to be felt. The market is now in a better position to fully discount the problems that are being uncovered.
The action will be macro-driven as these events are digested, but that may create exceptional opportunities in individual stocks. I'll be looking for new buys as the price action develops but I will be moving slowly and incrementally.
