Borrowing Short and Lending Long//The Hold To Maturity Fallacy and SVB
Borrowing Short and Lending Long//The Hold To Maturity Fallacy and SVB
The big problem all?deposit based banks face is that they tend to borrow short term and lend long term.
Pre money market funds and pre internet this was not a bad business: pay 3% on deposits (including the pittance you pay your employees for counting the nickels and dimes; lend the money out again at a 3 point margin to anyone moderately able to pay it back; be on the golf course by 3 p.m.
Pre Depression era these mortgage assets were usually of a fairly intermediate term, often renewable every three years. Thus the average mortgage investment's interest rate could be repriced, or the invested money reinvested, at worst every three years.
Worst case here was that if deposit costs rose during those three years the bank would make less money, but unless rates rose 3% or more during the three years they would still make money.
Post depression the industry to 25 and 30 year durations giving the borrower the sole option to prepay, but the owner of the mortgage no way to avoid long term rate risk.
Since both borrowing and deposits were until 25 years ago very localized, this meant essentially that a local bank was. taking money from its community and lending it back in the same community, essentially to the same group of people., with little short term rate risk, but real long term rate risk.
That long term rate risk was, for the depositors at least, if not the owners of the bank, absorbed by FDIC mortgage insurance
If one community had an excess of money and another a shortage of money, two distant bankers would get together and essentially partner (correspond) to do a deal at even higher spreads, generally sharing the long term rate risk.
The first thing that happened was that Fannie Mae and somewhat later Freddie Mac started to bundle up conventional home mortgages and sell them to wall street.?This enabled local bankers to SELL OFF loans that they originated but did not really want to have their own portfolio money invested in.
With the sale went long term rate risk and sometime even the cost of servicing the loan.?The originating bank got a chunk of cash, often on day one, for its anticipated long term interest profit.
The big advantage was that insurance companies and pension plans which essentially do not pay taxes on interest income liked to buy these long term loans because the rate risk was offset by predictable premium income and loss experience. The average prepay period (the biggest damper to long term interest rate risk) was seven (7). or eight (8) years and insurance companies liked to put their money out at fixed rates for twelve (12) years anyway, but did not want to service the small mortgage loans. Ditto pension plans with somewhat the same guaranteed cash flow numbers
Insurance companies and pension plans were mathematically fairly certain to be able to hold these assets to maturity and without much risk.
Competition for bank deposits was unknown until the 1970's.?If you could not physically visit a bank branch you probably would not want to deposit your cash there.
Unless protected by its relationships with individual depositors (think credit unions etc.), good branch or ATM structure became more important than interest paid on savings.
All that changed with the advent of electronic banking.
Precise cash management became available to everyone with a computer.
Equally importantly, every bank was able to get all the deposits it needed by just offering higher rates to depositors.
The problem was that these deposits were worth much less than deposits were historically worth since depositors could now take their money back in a few seconds by just pressing a few buttons. THE INDUSTRY AND REGULATORS GENERALLY HAVE BEEN OBLIVIOUS TO THAT RISK
Silicon Valley Bank was build on a business plan certain to explode:?large short term deposits from high net worth very well connected depositors built on relationships used to invest in relatively long term obligations with volatile interest rate risk.
Increasing cost of deposits and inadequate return fo long term investments was not SVB;s problem.?SVB's problem was essentially just the almost immediate loss of all of its demand deposits.?NO BANK IN THE WORLD CAN SURVIVE THAT., no matter how good the yield to maturity of its long term portfolio.
In a certain sense the cost of demand deposits is now always going to exceed the rate at which they can be reinvested unless the bank run risk can be?insured against.
PL Goduti