In March, several banks failed or were in trouble, which prompted central banks to intervene with emergency liquidity injections to prevent further “bank runs.” As a result, interest rates on government bonds saw a significant decline, and some of the excess liquidity flowed into the stock market, which led to a 3.5 percent rally in the S&P 500 index for the month.
The yield on the 10-year Treasury note declined from over 4 percent in early March to 3.39 percent, and the 2-year Treasury yield fell from over 5 percent to 3.76 percent in eleven days.
In the previous report, it was noted that the surge in interest rates resulted in marked-to-market losses of nearly $1 trillion on the bonds held on the Federal Reserve’s balance sheet. However, given the Fed’s ability to create money, those losses were unlikely to have an immediate material impact. As regional banks lack the same capability, significant investment losses can create massive problems, as seen with Bear Stearns and Lehman Brothers in 2008.
Banks invest funds to generate interest to pay a small return on their deposit base, and they usually classify their bonds into two accounting categories: “available for sale” and “held to maturity.” Bonds in the “available for sale” category are marked-to-market, which means their value is based on current market prices. As interest rates increased, the prices of longer-dated bonds decreased in value, resulting in losses for banks holding such bonds.
Bonds categorized as “held to maturity” are not subject to the “marked-to-market” valuation requirements because they are not intended to be sold. However, a crucial exception to this is that if any of the “held to maturity” bonds are sold, the entire portfolio must then be valued at current market prices.
In early March, shares of Silicon Valley Bank (SVB) stock experienced a decline of over 60 percent in a single day following its announcement that it sold $21 billion in bonds and was in search of additional capital. This news indicated that the bank was either insolvent or close to it, which triggered a run on deposits.
According to reports, at year-end SVB had $91 billion in the “held to maturity” category that were worth just $76 billion. The $15 billion “unrealized loss” equated to almost all of SVB’s shareholders equity. This created stress on other banks such as First Republic Bank, PacWest, and Credit Suisse to name a few. Central banks flooded the markets with liquidity and other measures to stave off a panic.