Silicon Valley Bank's failure is a lesson for depositories with MBS

Silicon Valley Bank's demise highlights a unique risk for financial institutions holding mortgage-backed securities.

While many things played a role in the bank's downfall — including the withdrawal of its niche depositors, a social media post from a newsletter they followed, and the poor timing of its capital raise — its management of MBS did, too.

A lot of the issues stem from the Federal Reserve's rate hikes and the fact that banks "lend long and borrow short."

Tech investments looked attractive when rates were low, but when monetary policymakers concerned about inflation started to raise the cost of financing, the funding tech investors provided to startups got more expensive. As a result, they began withdrawing their funds from SVB.

Meanwhile, SVB had invested deposits it got when rates were low in what are generally considered safe long-term bonds: mortgage-backed securities from government-sponsored enterprises and U.S. Treasuries.

More than 40% of the bank's assets were MBS as opposed to an industry average closer to 10%, according to Federal Deposit Insurance Corp. data analyzed by Chris Whalen, a consultant and NMN columnist in his Institutional Risk Analyst report. SVB also has been ranked as No. 7 on the list of the top 20 bank/thrift holders of MBS by this publication.

"Silicon Valley Bank was an outlier," Whalen said in an interview. but noted that even banks with 10% exposure to similar investments could experience financial pain he describes as "not fatal" but still horrible.

Banks are supposed to make sure they have liquid assets that the market will absorb easily if they have to sell to cover deposits. GSE-backed mortgage bonds and Treasuries generally fill that bill, because they're insulated from the risk that the borrower won't pay, but that wasn't the concern in this case.

"You should have different weightings in your portfolio with different risk tolerances from different market sectors. They didn't do that," David Stevens, CEO of Mountain Lakes Consulting and a veteran of the industry's public and private sectors, said in an interview.

That doesn't necessarily mean investing solely in agency MBS as an asset class is a problem. But not investing in a diverse range of such assets, failing to hedge them properly and mismatching them with liabilities were likely concerns for SVB, according to Stevens' report on the topic.

Properly hedged investors in MBS have financial instruments in place that are generally designed to manage the risk that interest rates will change. 

So while credit wasn't a concern, interest-rate risk was. 

When rates rise, bond prices generally fall and the duration of mortgage-backed securities also extends, so that lower priced bonds stay on the books longer.

To make matters worse, recently the curve between the yields of short and long-term investments has sloped downward instead of upward, which hurts MBS values and challenges banks, Stevens noted.

"The inverted yield curve puts them in a position of having to raise deposit rates for their deposit customers, and when you're paying your depositors more, or the same as what you're earning on your mortgage on your investments, you're at breakeven or underwater. In this case, they were underwater," Stevens said.

An investor's analyzing the mortgage backed securities etf fund
maurice norbert - stock.adobe.co

In addition, the Fed has been letting its large portfolio of MBS and Treasuries — which it originally acquired as a form of monetary stimulus known as quantitative easing — into runoff. In other words, it's not replacing maturing bonds. That "quantitative tightening" slowly shrinks its portfolio and also puts additional downward pressure on MBS prices.

SVB's actions regarding the management of its bonds appear to be encouraged by how the banking system is structured, but officials clearly are looking to hold someone accountable. Stevens said that while it is to some degree a perfect storm, there may be questions about supervision.

"I believe it was the result of just the payday that was going on in 2020 and 2021 and the fact that you didn't have all the things that are occurring right now: the inverted curve, the challenge on liquidity, and the risk of having concentrated MBS with the lack of hedging," Stevens said. 

"It was almost like nobody was watching or mom and dad were watching the kids as they were burning down the house," he added.

The experience revives the question of whether bank sales of MBS in line with declining deposits could add even more downward pressure to bond prices.

MBS researchers have expected a bank retreat as a result of the Fed's rate hikes but haven't anticipated heavy sales and still don't. That's because changing bonds to an available-for-sale categorization as opposed to held-for-investment would force banks to immediately record losses immediately on a mark-to-market basis. 

The bulk of Silicon Valley Bank's MBS and a smaller amount of collateralized mortgage obligations were categorized as held for investment at year-end 2022. (Collateralized mortgage obligations are pooled MBS that get sliced up into different maturities along the yield curve.) All those assets have to be recategorized to be sold. Questions about its categorizations have been raised.

Mortgage-backed securities were struggling in early trading on Monday, experiencing a jolt that was on the order of some of the worst seen in 2022, which was an unusually volatile year, said Walter Schmidt, senior vice president, mortgage strategies, at FHN Financial. 

Prior to last year, the last shock of this magnitude was probably on the order of the 2013 taper tantrum, when the Fed first surprised the market with scaled-back bond-buying.

"Today's move is definitely big," Schmidt said.

All these challenges with MBS investments point to a vulnerability banks have that non-depositories don't, Stevens noted in his report.

"Nonbanks don't retain interest rate risk, other than short-term, pre-funded/pre-sold [loan] pipelines," he said. "It's a minor risk compared to how a string of errors, bad marketing timing and management failures can take down a bank."

For reprint and licensing requests for this article, click here.
Banking Crisis 2023 Secondary markets Risk management Technology
MORE FROM NATIONAL MORTGAGE NEWS