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  • Writer's pictureJason Tuvia

Bank Closures Could Sway Federal Reserve Decision, Fast Government Response Alleviates Concerns

The collapse of Silicon Valley Bank and Signature Bank sent shock waves through capital markets, but agencies have been quick to counter it from spreading. Expectations for a smaller interest rate hike at the upcoming FOMC meeting has meanwhile been a byproduct of the recent events. The Fed will likely tread more cautiously despite persistent inflation and resilient employment.

Banking turmoil may encourage the Fed to tread carefully. Over the past year, the Federal Reserve has aggressively increased interest rates in a bid to cool inflation, creating challenges for commercial real estate investors and lenders. Messaging from the Fed prior to the recent bank failures implied that they would remain assertive, but the high-profile collapses could encourage a more cautious stance. While the banking sector’s stress rippled across capital markets and prompted many lenders to widen their spreads, the higher probability of more stable rates in the near term could serve as a positive for real estate transactions. Government agencies have also been quick to respond, soothing concerns that a broader contagion will occur.

Regulators seize the nation’s 16th-largest bank. On March 10, California state regulators placed Silicon Valley Bank (SVB) into FDIC receivership, marking the largest banking collapse since 2008. Two days later, New York authorities closed Signature Bank for irregular practices. The bank was also heavily engaged with clients in the beleaguered cryptocurrency sector. While both institutions faced similar underlying troubles, each collapse was independent of the other. The chain of events leading up to these failures extends to the pandemic. Tech companies did very well during that time, leading to heightened inflows of deposits into SVB, which is a prominent financier of the sector. Needing a place to store all this cash amid excess liquidity, the bank allocated a large portion of its capital base to securities and long-term U.S. treasuries. Most of this was done prior to the Federal Reserve’s rapid series of interest rate hikes, thus the value of those government bonds dropped as rates increased, producing paper losses. Those unrealized erosions would not have been problematic, however, if tech-industry specific headwinds did not prompt a wave of firms to withdraw funds, placing immense pressure on SVB.

Tech sector stress put SVB in a difficult position. The technology industry, especially startups that grew at an unsustainable pace during the pandemic, has been among the most visibly impacted in recent quarters. Layoffs have been much more common in the sector relative to other labor segments, while the initial public offerings market and fundraising also slowed down drastically. This coaxed some tech industry firms to withdraw funds from banks like SVB to meet their liquidity needs. As a result, SVB was forced to sell a $21 billion bond portfolio before maturity and incur a $1.8 billion loss to help fund the wave of withdrawals. This activity ignited a powder keg that ultimately led to the bank’s demise.

A spiral of events quickly led to a collapse. Trying to cover the losses from the bond portfolio sale, SVB attempted to sell $2.25 billion of common equity and preferred convertible stock. This announcement backfired, however, spooking additional clients into withdrawing funds. Investors also responded to the news by selling off SVB parent company stock, further hampering the bank. Amid this freefall, SVB unsuccessfully tried to sell itself on March 9, leading additional clients to withdraw funds and sending the stock price even lower. One day later, financial regulators stepped in and shut down the bank. In the following days, the federal government quickly responded to quell fears of a broader financial market contagion event.

The banking sector is more stable than in 2008. Federal agencies have been quick to respond to SVB and Signature Bank’s failures to curtail fears that they will be the first in a series of dominoes to fall, like Bear Stearns, Lehman Brothers, and Washington Mutual in 2008. The circumstances, however, are much different now than they were at the kickoff of the global financial crisis. Both SVB and Signature Bank had heavy exposures to certain industries that are going through challenging times. Most other similarly-sized banks are more diversified, mitigating that risk. Additionally, regulatory reform after the 2008 financial crash has created a more stable banking industry in general. While many other banks with excess liquidity during the pandemic also put funds into U.S. treasuries and bonds when interest rates were historically low, those unrealized losses will not pose a problem unless a wave of depositors rush to withdraw. Federal agencies have taken action to shore up protections in the aftermath of SVB and Signature Bank’s collapse and avoid contagion.

A lending program headlines response measures. Silicon Valley Bank provided financing for a considerable share of venture-backed tech and healthcare firms in the U.S. This idiosyncratic corporate client base meant that more than 85 percent of the bank’s deposits were uninsured, as they exceeded the $250,000 threshold. Following the collapse, the U.S. Treasury used the systemic risk exception to instruct the FDIC to make whole with all depositors, including the uninsured. The support will not come from taxpayer funds but rather from a variety of programs, including a special assessment on all banks and the Federal Reserve’s reverse repo facility. To address problems that could arise in the broader banking sector moving forward, the Fed introduced a Bank Term Lending Program (BTLP). Financial institutions pressured by the drop in bond prices and needing a BTLP loan can use collateral assets at par, instead of being marked to market. This source of liquidity should help banks with similar bond value challenges to SVB avoid facing the same fate.

Some smaller-sized banks still face uncertain futures. The BTLP should alleviate the need for a stressed bank to abruptly sell securities at a loss. Allowing collateral assets at par also means that depreciated bond values should not hinder the amount that a bank can borrow, including from the Fed’s discount window. Still, it is estimated that U.S banks held about $620 billion in unrealized losses at the end of 2022, leaving the near-term outlook uncertain for some institutions with smaller balance sheets. Irrational public fears leading to additional bank runs would put strain on the financial industry. Although the rapid and expansive measures taken since SVB’s collapse should allow most banks to weather some choppy water.

Lenders become slightly more conservative post-SVB collapse. Many banks have already adopted more caution over the past few quarters, and the recent financial sector turmoil may further heighten due diligence. While the SVB and Signature Bank seizures were a consequence of unique circumstances, lenders across the industry will likely heavily scrutinize LTVs and take conservative underwriting and debt service coverage approaches. Reducing their risk profile may be paramount for depository institutions as regulators pay closer attention to balance sheets. Meanwhile, a flight-to-quality has pushed down interest rates on vehicles like treasury bills, but lenders have also widened their spreads. This combination should have a relatively negligible impact for borrowers.

Commercial real estate borrowers face some extra hurdles. As many lenders tighten underwriting in response to the bank seizures and greater regulatory attention, commercial real estate borrowers may have some additional obstacles to combat. Interest rate increases over the past year have made debt service coverage tests a significant constraint on the amount of leverage available for refinancings and new loans. Many lenders will require borrowers to pay down some of their existing loan if they want to refinance. Additionally, most banks will continue to focus on standing relationships rather than growing their books. This is partially due to liquidity constraints enforced by high short-term bond yields, as depositors shift funds to those instruments. These dynamics will sustain real estate transaction hurdles near term and keep buyer-seller expectations separated. Nevertheless, opportunities are still out there for investors who do not need a lot of leverage. Agency lenders like Fannie and Freddie may also serve as a good option for some borrowers, as they have ample liquidity and remain active.

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