This article was originally published by the Santa Barbara News Press on April 1, 2023. You can read the original article HERE.
The banking crisis of the “Great Recession” was a result of poor lending policies and poor investment decisions on Wall Street.
Leading up to the crisis, lenders were approving mortgage loans for any borrower who could breathe! Adding to the easy approval process were “negative amortization loans,” where the borrower paid only a portion of the interest while the unpaid interest portion was added to the loan balance, putting the borrower further and further behind each month.
It wasn’t long before Wall Street got into this “lending fiasco.” The “Wizards of Wall Street” came up with the idea of bundling these loans and selling them as “conservative investments” to institutions and regular retail investors. They were anything but conservative. It didn’t take long for these “collateralized mortgage obligations” to unravel.
Not only did a huge percentage of these mortgages default, but worse yet, the bundled mortgages fell apart as well.
Bear Stearns, a longtime global investment bank, went bankrupt and was sold to JP Morgan Chase for $2 a share in March 2008, down from $170 a share earlier that year.
In addition to Bear Stearns, some of the big corporations that went through bankruptcies during this very difficult time were Lehman Brothers, AIG, Washington Mutual, General Motors, CIT Group, Chrysler and many others. It was the most significant financial crisis since the Great Depression of 1929 -1939.
Our current banking crisis is very different from what we saw in 2008.
The problems the banks are going through today are a result of regulation and investment policies. Several banks, such as Silicon Valley Bank, took in millions of dollars worth of deposits and invested those monies in fixed, long-term government bonds.
Through the COVID years the interest rates were at “zero-point-nothing” (0.01%). Throughout 2022, inflation became a huge concern for the marketplace, economy and the Fed.
The Federal Reserve Board of Governors (the Fed) is charged with overseeing the Federal Reserve Banks and with helping implement the monetary policy of the United States. Raising interest rates is the tool the Fed uses to tame inflation. When interest rates go up, the cost of loaning money rises as well as the cost of financing real estate, and, unfortunately, this causes bond values to decline.
This process reduces business expansion and puts pressure on the housing markets, which in turn will dampen an overheated economy and hopefully will reduce inflation, but at a cost.
2022 was an awful year for U.S. bonds. The 12 months through October ranked as the worst ever recorded for the bond market. The lending market was mostly inactive in 2022 so many companies had to draw down their bank deposits.
As a result, these banks were forced to sell long-term Treasury bonds at a significant loss.
For the past three decades, the bond market has been the “Steady Eddie” of the investment marketplace. Bonds were thought of as boring investments that could be counted on for stability and steady income.
In 2022, however, as inflation and interest rates soared, the bond market has been anything but reliable. The Fed has indicated that interest rates will continue to go up through 2023.
Rising yields may not be a problem if you buy a security for the income it provides and hold until maturity. But if you trade a portfolio of bonds, or hold shares in a bond mutual fund or ETF, falling bond prices bring significant risk.
When Silicon Valley Bank reported a big loss on its Treasury and mortgage holdings, the market and many of SVB depositors removed funds from the bank. Withdrawals took place in anticipation of SVB not being able to make good on deposits, since FDIC insurance covered only up to $250,000. This led to a bank run and forced SVB into receivership.
It later became known that SVB did not adequately manage its interest rate risk, hoping to ride out higher rates and simply wait for their fixed income securities to mature. This resulted in their unrealized losses swamping the available capital, putting far below adequate levels of capitalization compared to its peers. SVB also had a far greater percentage of deposits beyond $250,000 (uninsured by FDIC), making it more vulnerable to a bank run.
The SVB investment management team should have invested in such a way as to mitigate interest rate risk. Shorter term debt and “floating rate” investments would have been much more appropriate.
And bank regulators should have been well aware of the significant risk of the SVB long-term fixed bond portfolio. Hopefully … lessons learned!
Regardless of what this market and economy may bring, remember just how important it is to stay the course!
Tim Tremblay is president of Tremblay Financial Services in Santa Barbara (www.tremblayfinancial.com).