Will taxpayers be on the hook for bank bailouts?

Suddenly, no one is all that certain about the financial health of regional banks in the United States. Over the course of the weekend, the collapse of Silicon Valley Bank went from a big financial story to a big national story with potentially far-reaching ramifications for the U.S. economy. 

The collapse of the bank most tied into Silicon Valley’s high-flying world of venture capital comes on the heels of the sudden end of two banks tied into the cryptocurrency industry. The government is also pledging to guarantee the full deposits of New York-based Signature Bank; and last week, San Diego-based Silvergate Bank announced it was winding down operations and liquidating its holdings. 

What do those two latter banks have in common? They were the top two U.S. banks tied into cryptocurrency. 

In Silicon Valley’s giant game of musical chairs, the music just stopped, and everybody’s scrambling to make sure they still have a seat. The Biden administration’s solution is to throw the traditional limit on FDIC guarantees out the window and pledge that the U.S.-government-backed FDIC will make everyone whole again. 

Moral hazard is back, baby.

Financial-Health Scare

If you’re old enough, you’ll remember television commercials for banks ending with the statement, “member, FDIC.” This is referring to the Federal Deposit Insurance Corporation, established in 1933, designed to ensure that if you put your money into a bank and the bank went out of business through bad management, your deposit would be returned to you by the FDIC up to a certain amount. When I was growing up it was $100,000; in 2008, that threshold was raised to $250,000.

For most people, the idea of having more than $250,000 in their bank accounts is a distant dream. But businesses have bank accounts, too, and a lot of businesses and venture-capital firms in Silicon Valley kept their money in the aptly named Silicon Valley Bank. SVB boasted that it provided “banking services to nearly half of all venture-backed technology and life-science companies in the United States, according to its website. Silicon Valley Bank was also a bank to more than 2,500 venture capital firms, including Lightspeed, Bain Capital and Insight Partners. It managed the personal wealth of many tech executives and was a stalwart sponsor of Silicon Valley tech conferences, parties, dinners and media outlets.”

In fact, as of the end of last year, 93 percent of the money in Silicon Valley Bank was above that $250,000 threshold and not covered by the FDIC. Yet the bank had a seemingly sterling reputation. One month ago, SVB ranked 20th in Forbes magazine’s annual America’s Best Banks list. (Note that this is Forbes, not a continuation of the Fortune magazine-cover curse.)

When you put your money in a bank, it rarely just sits there, like in Scrooge McDuck’s Money Bin. The bank takes your money and uses it to make loans with interest, or make investments. One of those potential investments is long-term bonds. Long-term bonds don’t usually have high returns on investment, but they’re considered pretty safe, particularly when the stock market is turbulent or in decline for a period. The interest rate on long-term bonds is low, but considered very reliable — but there’s a problem when the rate of return starts getting really low and the inflation rate starts getting really high. If inflation gets high and stays high, then what you get out of your investment in the bond gets smaller and smaller. As Investopedia summarizes, “Typically, bonds are fixed-rate investments. If inflation is increasing (or rising prices), the return on a bond is reduced in real terms, meaning adjusted for inflation. For example, if a bond pays a 4 percent yield and inflation is 3 percent, the bond’s real rate of return is 1 percent.” As you probably noticed, inflation has been really high for the past two years.

This is the problem Silicon Valley Bank encountered. Moody’s, an investment-research firm, looked at SVB’s numbers and didn’t like what it saw, warning that it was considering downgrading the bank.

Silicon Valley Bank had put way too many of its eggs in the basket of long-term bonds, and once word of its troubles spread, everyone wanted to take their money out of the bank, instead of putting money in.

Part of the bank’s plan to limit the impact of the Moody’s downgrade was to raise liquidity with a sale of assets SVB held on its balance sheet. The bank initially sold more than $20 billion of bonds, but did so at a $1.8 billion loss. The bonds had been purchased in a lower-rate environment; the present higher-rate environment had caused downward pressure on the marketable value of the bonds; and that downward pressure translated to realized losses in this sale. So far, so not good, but certainly not fatal. (Anyone holding bonds purchased at 2 percent yields is underwater on the value, but there is no credit impairment whatsoever and holding to maturity generates a return of par value.)

Needing to raise capital to deal with some funding issues, only to lose depositors at the word of your needing to raise capital, and in turn losing the ability to raise capital at word of losing depositors, is obviously a vicious cycle. It can only be offset by one thing: an antidote that is truthful, not hopeful. In SVB’s case, no such antidote was forthcoming. Its bond portfolio held a larger share of long-dated (therefore, underwater) maturities than expected. Worse, there appears to have been no hedges on the books whatsoever — no interest-rate swaps to hedge that rate risk they were clearly carrying. The duration on the hedged and unhedged portfolio was the same.

On Friday, almost every major depositor in Silicon Valley could smell trouble and attempted to withdraw $42 billion in one day.

Then, Sunday night, the Treasury Department, the Board of Governors of the Federal Reserve System, and the FDIC announced that they were guaranteeing all the deposits of every amount in Silicon Valley Bank, as well as a New York-based bank, Signature Bank. Signature Bank was a big lender in the cryptocurrency sector, which, since the collapse of FTX, has looked a lot less secure and stable. San Diego-based Silvergate Bank, which had been touted as “the go-to bank for the cryptocurrency industry,” announced last week that it was winding down operations and liquidating its holdings. (One of Silvergate’s biggest customers was FTX.) Liquidation is when a bank sells all its assets, pays off all of its creditors, and ceases operations.) But Silvergate, with $11 billion in assets, was much smaller than Signature, with $114 billion in assets.

“Wall Street — not taxpayers — will pay for the SVB and Signature deposit relief plans,” declares CNBC.

Eh, taxpayers may not officially be picking up the tab, but everyone else who uses a bank will pay for this down the road in the form of higher fees with their bank. This remains a system that has concentrated the benefits among a well-connected few and spread out the costs and risks among the rest of us. The executives running Silicon Valley Bank did just fine over the past few years, and surprise, surprise, the CEO sold a bunch of his stock for millions of dollars right before the bad news hit.

That joint statement from the Treasury Department, the Federal Reserve, and the FDIC insisted:

No losses associated with the resolution of Silicon Valley Bank will be borne by the taxpayer. We are also announcing a similar systemic risk exception for Signature Bank, New York, New York, which was closed today by its state chartering authority. All depositors of this institution will be made whole. As with the resolution of Silicon Valley Bank, no losses will be borne by the taxpayer.

But the money to reimburse those depositors — above the standard $250,000 per account — will come from the Deposit Insurance Fund of the FDIC:

While the DIF is backed by the full faith and credit of the United States government, it has two sources of funds: assessments (insurance premiums) on FDIC-insured institutions and interest earned on funds invested in U.S. government obligations. Revenue from assessments and interest on investments add to the DIF balance (or fund net worth), while losses (primarily from bank failures) and operating expenses reduce the balance.

This morning, MIT economist Simon Johnson told the Washington Post’s Jeff Stein: “Disingenuous: that’s the right word to describe anyone (Treasury official or not) who claims the DIF is not ultimately backed by the taxpayer.“

The Deposit Insurance Fund balance was $128.2 billion on December 31, 2022. Silicon Valley Bank said it had $212 billion in assets as of the end of last year; as mentioned above, Signature had $114 billion in assets. Not every asset is a deposit that must be reimbursed by the FDIC, but making the clients of SVB and Signature whole is going to eat up a huge chunk of that Deposit Insurance Fund. The fund will need to be built back up, by charging more for those assessments/insurance premiums on FDIC-insured institutions. When your bank gets a bigger bill from the FDIC, it’s going to look for ways to hike fees on customers — maintenance and service fees, overdraft fees, ATM fees, insufficient-fund fees, etc. So as a taxpayer, no, you’re not paying to help make the SVB and Signature customers whole. But as a person who uses a bank, you’re going to be paying to help make the SVB and Signature customers whole.

President Biden is going to speak about the banking crisis today, and he will insist to high heaven that this is not a bailout of these banks. But it is: The government set up clear rules that the FDIC would only protect the first $250,000 in a deposit. Every depositor, every business, every Silicon Valley venture-capital investor knew the risks, or should have known them. (You could even have $500,000 in a bank and still be protected; the FDIC covers savings accounts and checking accounts separately.) If you have more than $250,000 in an account, you are accepting a small but real risk and might want to think about opening another account in another bank.

And then, once the management of Silicon Valley Bank and Signature screwed up badly enough, the federal government decided, “Never mind. We’re going to protect every amount for every bank customer.” The Biden administration may not like people calling that a bailout, but that is indeed a bailout.

In practice, it has created a huge moral hazard by signaling that the $250,000 FDIC limit on deposit insurance does not exist in practice. The clear signal it sends is that when financial institutions make poor decisions, the government will swoop in to clean up the mess.

As the editors of the Wall Street Journal conclude, “This is a de facto bailout of the banking system, even as regulators and Biden officials have been telling us that the economy is great and there was nothing to worry about.”

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