I have heard the term “moral hazard” more than a few times since the Federal Reserve, the US Treasury and the FDIC stepped in on Sunday to collectively address investor jitters following the failures of Silicon Valley Bank (“SIVB”) and Signature Bank. What did the trifecta do in response to these failures?
1. The “now” provision for depositors: The Federal Reserve, the US Treasury and the FDIC announced jointly that insured and uninsured depositors of SIVB and Signature would be paid out in full (see Fed press release here). This addressed fears of clients of both banks about their deposits, which could have otherwise meant that they would have not been able to access vital cash needed to fund their working capital needs, especially payrolls. Longer term, it would have left the fate of uninsured deposits at the mercy of the value and timing of a liquidation of bank assets.
2. The future provision for banks more broadly: The Federal Reserve, with the backing of the US Treasury, established a Bank Term Funding Program (“BTFP”) which will provide one-year loans to banks against high quality collateral like US Treasuries (“USTs”) and agency Mortgage-Backed Securities (“MBS”). The BTFP is described by the Fed in a press release here. Importantly the loan-to-value ratio will be 1:1, and all amounts will be lent at the face value of the securities rather than the then-current market value. This means that even if securities in a bank’s investment portfolio are underwater due to higher interest rates (a la SIVB), the bank can still borrow at 100 cents on the dollar against the face value of the collateral.
These actions, which soothed markets and even shifted expectations regarding the path of monetary tightening by the Fed (towards a more dovish stance), were greeted with enthusiasm, with yields falling (meaning bond prices rising) and stocks clawing back lost ground and initially moving into positive territory. The question that has been raised is “do these actions constitute moral hazard”? In my opinion, the pay out of deposits for SIVB and Signature Bank shareholders is not moral hazard, but the availability of the new Bank Term Funding Program is.
What is moral hazard?
Moral hazard is present when a person alters their behaviour when they believe that bad-decision making is borne by others. The concept arises generally in the context of insurance. For example, when a person buys insurance on their car, it might make them more likely to take risks with the car (since it is insured). In the context of financial markets, it refers to any actions that – similar to obtaining insurance – can alter the behaviour of companies or investors vis-à-vis “normal” behaviour.
With respect to banks specifically, moral hazard is when investors buy stocks or bonds of a bank with an implicit belief that should the bank get in trouble, it would somehow be rescued. Such a rescue typically occurs involving the Fed or the US government. With this in mind, you can probably understand how the rescue of a bank could save equity and bond investors from the inevitable outcome of seeing their position greatly reduced or wiped out completely. Similarly, should a new government regulation alter banks’ perception of risk, it could make the bank more likely to take certain kinds of risk that they would have otherwise not taken.
The decision by the Fed to make good on uninsured deposits for SIVB and Signature
The decision by the Fed to make good on uninsured deposits of SIVB and Signature is rather clever. Although the issue of moral hazard could be debated, this unusual decision by the Federal Reserve prevented wide-spread pain into a borrower base that for the most part did not see this coming. The decision to guarantee uninsured deposits did not protect equity investors, which have been wiped out. Bond investors also face an uncertain future as to whether or not they will recover anything, as they are technically last in line once the assets of the bank are liquidated[1]. As I wrote in my article on SIVB two days ago (article here), a pro forma mark-to-market of SIVB’s investment portfolio would have nearly wiped out shareholders’ equity. Based on SIVB’s asset base at the end of its fiscal year (12/31/22), depositors would have access to an investment portfolio of USTs and MBS (mostly) worth around $105 billion fully marked-to-market, plus cash at year-end of $13.8 billion, plus a loan book of $73.6 billion[2]. Considering only the cash and the liquid investment portfolio, pro forma deposit coverage was around 69% using current UST yields to mark the investment book to market.
The table below shows the 2022 year-end deposits and major assets by category for SIVB, both actual to tie to the 12/31/22 balance sheet and based on three yield scenarios: UST yields at the end of 2022, UST yields on March 8, 2023 (before SIVB was known to be in serious trouble), and UST yields on March 14, 2023, reflecting the rally in bonds since SIVB’s failure and the change in expectations of future rate trajectory.
As the table above illustrates, although depositors would have only been able to recover around 69% of their deposits from cash and the at-market liquidation of investments, they would have almost certainly recovered the rest from the sale or liquidation of the loan book. Hypothetically, the net proceeds from the loan book would need to be around $54 billion to pay out depositors in full, which is 73% of the net book value of the loan book on Dec 31, 2022. Unless the loan underwriting standards of SIVB were horrific, the government should not lose money on the liquidation of SIVB, although it might take time.
In addition, bondholders at the listed holding company (SIVB) might actually realise some recovery on their positions, recognising that SIVB is likely to file bankruptcy itself imminently. The debt outstanding of SIVB is in the table below extracted from the 10-K.
Once depositors are satisfied, the book value of collateral available to settle outstanding debt of $19 billion for the holding company will be around $23 billion to $24 billion, assuming the loan book recovers its full book value. Of course, there will likely be losses on the loan book, although the significance is difficult to gauge. Also, there will be ongoing operating and administration costs associated with the liquidation of the bank (and eventually SIVB), but I would think some of this would be offset by income from the loan book. SIVB’s debt is currently trading around 50 cents on the dollar, which means debtors of SIVB are expecting to receive around $9 billion or so of value.
I have drifted off the topic of moral hazard, so let me return to this topic in light of the Fed’s decision to guarantee all uninsured deposits of the bank. The beneficiaries of this provision are depositors, not shareholders or bondholders. Depositors faced an uncertain recovery because a significant amount (85% to 90%) of SIBB’s deposits were uninsured, meaning that they breached the $250,000 / depositor / bank threshold of FDIC insurance. Shareholders have been wiped out, but bond holders might realise some recovery, although almost certainly less than they would had if SIVB had not failed. I have a difficult time concluding that moral hazard played a role in this situation, aside from potentially rescuing depositors (although this analysis suggests that there is sufficient value in the company).
The Bank Term Funding Program
The new BTFP put in place by the Federal Reserve is designed to avoid runs on banks by giving banks attractive funding against high-tier collateral to meet withdrawals. As we saw in the case of SIVB, depositors all show up at the same time to make withdraws if there are suddenly concerns about a bank potentially failing. In cases like these, the outcome is almost always failure because banks do not keep enough cash and liquid investments on hand to fund a sudden influx of deposit withdraws. The BTFP will buy a bank time to sort itself out, although whether or not it will save a bank under depositor pressure remains to be seen. SIVB was an excellent reminder of how quickly the end can occur for banks in which depositors have lost confidence.
Moral hazard with respect to the BTFP needs to be considered in the context of the bank’s risk taking decisions and in the case of investors in bank equity and debt (bonds). From a bank’s perspective, the availability of this facility arguably does encourage a bank to take more maturity risk on high-tier debt, meaning that banks could more aggressively consider carry trades to improve their net interest margin. Moreover, the availability of this facility can buy a bank time, in some ways encouraging it to take chances on carry trades because – even if they are wrong – they can get financing against the face value of underwater investments.
The BTFP also provides a benefit to bond and equity investors, at least in terms of providing liquidity to a stressed bank to enable it to buy time to address its issues . However, accessing the BTFP requires that a bank have financeable high-tier investment collateral available, and the financing is for a limited amount of time (one year). In addition, the facility provides no assurances against poor performance of a bank’s principal asset – its corporate loan book. Bad corporate loans and poor underwriting standards are in fact the reason that bank runs normally occur. The BTFP does not save a bad bank but it certainly extends the lifeline of a bank that is struggling, providing a form of moral hazard that gives shareholders and bondholders time to assess their position and trade out of it.
Shareholders and bondholders could recover more than they might have otherwise. This is a classic example of moral hazard, not fully protecting investors by any means, but certainly buying investors time.
[1] Note that the shares of the bank, which the FDIC took over, are owned by SIVB, a holding company. The presumption is that SIVB will file bankruptcy imminently since the equity of the bank was its principal asset. Most of the conventional bond debt and various agency loans are at the SIVB level, not at the bank. [2] Of course, it is clear at the time of the bank’s seizure that cash was nil (or near nil) and deposits were reduced by cash withdrawals. But for purposes of this analysis, these offset.