Silicon Valley Bank collapse crushes bond yields
Bank failures are nothing new. Through most of post-war history banks have continued to fail, particularly in the United States where banking has been a fragmented and ultra competitive market.
As we write, Silicon Valley Bank (SIVB) seems to be getting the regulatory support that is in place for situations like this. That is why the US$250k deposit insurance scheme is set up in the first place. Deposit holders will be protected while stockholders and other unsecured creditors take a hair cut.
Our focus isn’t necessarily on SIVB but the implications of the failure on the availability and price of credit. Over the past few months we’ve written that the US Fed will remain on its rate raising course until something breaks. SIVB is totally manageable, other big failures might not be. We don’t know what comes next, but history has taught us that these kinds of events are not immune from each other.
We had a similar situation a few months ago when the UK treasury market almost collapsed, forcing the UK government to step in and buy bonds to contain the fallout. Things are starting to crack, slowly. As Warren Buffett says, when the tide goes out, you find out who has been swimming naked.
What we are watching closely are bond yields and the market pricing of future rate expectations. We saw bond yields fall drastically last week on the SIVB news. These falls came despite hotter than expected US job numbers. Yields will start to rise slightly again as the SIVB problems are addressed this week.
But they will slump again on the next crack, which will come.
Our overall real estate thesis is always built on top of two key factors - 1) The price and availability of credit and 2) The supply pipeline. Bond yields are still too elevated to call a bottom in the residential real estate market, but certain markets such as Australia and Canada are showing signs of a bottoming because of low underlying property supply.
Aussie 2 year bond yields are now trading at around 3.30-35% compared to a cash rate of 3.6%.
In the United States, the SIVB experience will start to reverberate throughout the commercial real estate market which is looking very vulnerable. We don’t know where the next bank collapse will come from, but we do know that there will be one and the US commercial real estate market is likely to wobble as a result.
News out of SIVB suggests that they didn’t properly manage risk of rising rates on their investment portfolio. Given the huge increase in rates over the past two years, there will be many banks and investment firms with similar exposure.
Every 25 or 50 basis point increase would have caused a corresponding % market down on bonds purchased during the ultra low rate environment. Those securities are now starting to be marked down.
As a illustrative example in SIVB’s case, a $120bn bond portfolio with a 5.6 year non-hedged duration means that every 10 bps move higher in 5-year interest rate lost the bank almost $700m.
So we think there will be much more pain to come and the US Fed will be cautious now that SIVB almost took the entire banking system down with it in less than a few days. Once bitten, twice shy.