How the Fed’s Inflation Fight and Rising Interest Rates Triggered SVB’s Collapse


One of the unintended consequences of the Federal Reserve’s long battle with inflation is the current turmoil in the financial system that has led to the biggest bank failure since the Great Recession.

The collapse of Silicon Valley Bank, the Signature Bank as well as the last-minute bailout of the First Republic’s private sector all have their roots in the Fed’s decision to raise interest rates sharply to stem the surge in inflation. Although there are many complaints.

This puts the Fed in a very difficult position this week as officials meet to determine what level of interest rate hikes can continue to lower inflation without destroying the banking system. They must manage a double threat to the economy: inflation and banking stability.

After the Silicon Valley Bank collapse, Washington asks: Is it to blame?

How did we get here exactly? Here, in seven charts, is a look at how the Fed’s fight against high prices helped trigger instability in the banking sector.

1. Prices started to rise at the start of the pandemic – and have continued.

The economy came to a virtual standstill when covid took hold in March 2020. Over 20 million workers lost their jobs. Schools, restaurants, gyms and countless other businesses have closed. Everyone has been ordered to stay home.

As a result, the economy plunged into a deep recession.

By the time things reopened – and people started spending again, armed with fresh stimulus money – there were major shortages, supply chain issues and production hiccups that fueled inflation. . Demand for goods soared, while supply remained depressed. The result: higher prices.

But the Fed did not act. Policymakers, including the president, were adamant that inflation was temporary and would subside once pandemic-related shocks subsided.

It wasn’t until December 2021, when inflation hit a 40-year high of 6.8%, that Fed officials started talking about raising interest rates. They finally did — by a modest quarter of a percentage point — in March 2022. By then, prices were up 9% from a year earlier.

Timeline: US Policymakers Misjudged the Inflation Threat Until It Was Too Late

2. The Fed tried to catch up by aggressively raising interest rates.

Since then, the central bank has raised interest rates seven more times, in an effort to slow the economy enough to curb inflation.

But a number of new complications — including the war in Ukraine, which has driven up gas and energy costs — have forced the Fed to redouble its efforts. Each jump in interest rates shocked the economy, although the end result was not immediately clear.

3. Fed actions drove up borrowing costs.

The central bank controls only one interest rate: the federal funds rate, which is the rate banks use to lend money to each other overnight.

This rate has risen from near zero to around 5% over the past year, the fastest increase on record.

And it doesn’t take long for banks to pass on these higher borrowing costs to customers: mortgages, business loans and other types of loans have all become more expensive over the past year.

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4. The bond market sees the biggest decline ever in 2022

Bonds, which are loans to a company, or in this case the government, generally pay fixed interest rates and are considered safe and reliable investments.

And while the Treasury Department still issues a lot of bonds, it has issued even more over the past 10 years because that’s how the US government funds expensive projects. Trump’s tax cuts. Pentagon budget. Covid-era stimulus programs to support the economy under Trump and Biden.

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But as interest rates rose, investors were more interested in new bonds that promised to pay more, and long-term bonds tied to older, lower rates became less desirable — and therefore less valuable. .

As a result, the bond market took a nosedive last year, registering its biggest decline.

5. This was bad news for banks like SVB, which had invested heavily in fixed rate bonds.

In recent years, banks — newly replete with additional deposits from savings and pandemic-era stimulus — have increased their bonds and other fixed-rate investments like mortgage-backed securities. At SVB, fixed-rate securities accounted for almost 60% of the bank’s assets at the end of 2022.

But as the Fed raised interest rates, those bonds lost value. SVB’s $91 billion portfolio of long-term securities was worth just $76 billion at the end of 2022. That $15 billion gap was far larger than the $1 billion shortfall that the company had reported a year earlier.

In addition, the vast majority of the bank’s deposits – nearly 94% – were uninsured, according to data from S&P Global. The national average is around half, which has left SVB particularly vulnerable to fears of a race that has become self-fulfilling. The bank’s customers withdrew $42 billion in just 24 hours, leaving the bank with a negative balance of $1 billion.

“It’s simple: when interest rates go up, bond values ​​go down,” said Darrell Duffie, professor of management and finance at Stanford University. “Silicon Valley Bank had a lot of bonds – both Treasury and mortgage bonds – so when the Fed raised interest rates to try to reduce inflation, the value of all those bonds went down. “

It wouldn’t have been a big deal if SVB had been able to hold onto their bonds until they matured. But with a rush of depositors demanding to withdraw their money from the bank, SVB had no choice but to sell its securities at a massive loss. The bank quickly collapsed.

“It was a classic bank run,” Duffie said.

The 72-hour scramble to save the United States from a banking crisis

6. Countless other banks are still sitting on billions of devalued Treasury bonds.

The SVB was not alone in its stock of depreciating bonds. US banks are sitting on a staggering $620 billion in unrealized losses, according to the FDIC.

The Federal Reserve stepped in last week with an emergency program that allows banks to exchange devalued bonds for their original cash value. While this offers a temporary fix, economists say there could be other unforeseen problems lurking in the financial sector.

“So far we’ve been able to prevent big ripple effects – the central bank and others have come up with quick fixes to prevent this from metastasizing into a wider banking crisis,” he said. Dana Peterson, chief economist at the Conference Board. “But there could still be more shoes to put down.”

The Fed moved quickly to stem a wider financial crisis, launching a new emergency lending program with generous terms to supplement its existing “discount window” for emergency lending. Measures are gaining ground so far, banks over-the-counter borrowing hit a record high of $153 billion last week.

What is the Fed’s Discount Window and why do banks use it so much?

The whirlwind events of the past week and a half have raised new questions about the Fed’s next move.

The European Central Bank stuck to its aggressive plan to hike interest rates by half a percentage point for the euro zone last week, despite problems at Swiss giant Credit Suisse which forced the bank to borrow up to $54 billion to the Swiss National Bank. .

Many pundits and investors still expect the central bank to hike interest rates another quarter-percentage point when it meets on Wednesday, even as fears grow that the system financial institution is too fragile to withstand the rise in rates.

It’s a sharp turnaround from earlier this month, when Fed Chairman Jerome H. Powell offered to hike interest rates by half a percentage point, citing higher numbers. stronger than expected on inflation and employment. The economy created more than 800,000 jobs in the first two months of this year and inflation remains high, with prices up 6% from last year.

But all of that is now in the rearview mirror as investors worry about the potential cascading effects of bank failures and rising market stress.

“The Fed wants to raise rates a bit more,” said David Donabedian, chief investment officer of CIBC Private Wealth US. “It’s just a question of whether the volatility of the banking system will let them.”

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