If you haven’t seen The Big Short, I highly recommend it. It’s a great movie based on the best-selling book by Michael Lewis which tells the story of the very few people who saw the 2008 financial and housing crisis coming, and the many who were blinded by what was right in front of their faces. It highlights how the entire system was a house of cards (no pun intended) ready to collapse. And as we all know, it did. Mortgage lending, banking requirements, government regulations all went through a massive overhaul to ensure another crisis wouldn’t happen again.
And with the collapse of Silicon Valley Bank (SVB) and Signature Bank and the emergency rescue plan for First Republic and Credit Suisse, clients, friends, and those within my network were asking if this is 2008 all over again. And in the digital age of instant information at our fingertips, it’s easy to understand how many people can feel that way. But this is different. This is not 2008. And it’s not even close. I think it’s important to not only understand what happened, but to also understand why it happened, and what’s next.
So what happened? To simplify the turmoil amongst the banks mentioned above and the yet to be named banks that I’m sure we’ll hear about in the next couple of weeks, it all boils down to a lack of diversification. Any competent financial advisor will tell you not to put all your eggs into one basket and yet, that’s exactly what these banks did. From some banks being over-exposed in Crypto Currencies to others holding too many Mortgage Backed Securities (MBS) – (more on this in a second), the banks failed to diversify.
To illustrate what I’m talking about, let’s use Silicon Valley Bank (SVB) as our case study. For those who don’t know, SVB was the bank for Start-ups and Venture Capital Investors. Around 50% of all start-ups had money with SVB and when Covid hit, those deposits skyrocketed. Why? Here’s why. Because in March of 2020, when Covid first invaded our vocabulary, the Fed lowered rates to 0% to help an economy that was shut down. Remember that? As a result, it was really cheap for Venture Capitalists (think of people like the Sharks from Shark Tank), to borrow money from banks and lend to or invest in start-ups. These start-ups then took the money and deposited into their bank, SVB. In a two-year period, deposits at SVB went from around $60B to $200B. That type of growth is unprecedented.
Now, stay with me here, you’re doing great. With SVB flushed with cash, they had to put that money to work. Afterall, that’s how banks make, umm, money. So they invested roughly $80B in mortgage backed securities (MBS) and treasuries. And when rates are low, the price is high, but when rates rise, the price goes down. Don’t worry, I’ll explain this further, it’s going to make sense in a second.
Think about it this way. If I own a $100 bond at 3%, that means that bond is paying me $3 every year in interest. And let’s say rates rise to 6%. So now, on the market, a $100 bond is paying $6 a year. Now for the math question that’s going to teleport you back to high school. In a 6% interest rate environment, what would the value of the bond have to be, to get a return of $3 every year? And the answer is $50. Because a $50 bond at 6% will pay $3 of interest every year. So that original bond of $100 at 3%, just lost half of its value. This is akin to owning a home that you bought for $1M and now the market value is $500K. If you’re staying in that home and not selling any time soon, it doesn’t really matter. But if you’re forced to sell, it’s going to be painful.
And SVB was forced to sell these Mortgage Backed Securities (MBS) at major losses. Once investors started to look under the hood and see that SVB was losing a ton of money, they advised any client with money in the bank to pull the money out. And when news started to spread, it created this domino effect of bank withdrawals.
Lastly, to put a bow on this, you might be thinking, why did SVB have to sell these Mortgage Backed Securities (MBS)? If they knew they would be selling them at a loss, why didn’t they just hold onto them? And the reason is because for two years, when these start-up companies needed money, they didn’t go to the bank to pull their money out. No. They went to venture capitalists who were borrowing money at 0%. And when the Fed started raising rates, these Venture Capitalists weren’t so eager to lend or invest anymore. And when that happened, the start-ups withdrew funds from their accounts to fund new projects and make payroll. At this point, more money was coming out then coming in, and to honor these withdrawals, SVB had to sell the securities at losses.
As you can see, there was a lack of diversification here with SVB, and the other banks have similar stories. So where do we go from here? Well, the Fed is in a little bit of a pickle. If they continue to raise rates as they have been, we may hear about more banks going under. If they don’t raise rates, it could signal to the markets that they’re not taking inflation seriously enough.
Here’s what I’m seeing. Inflation is still the number one issue in the economy. If the money you’re earning isn’t going as far as it once did, that’s impacting everyone. The good news is that inflation, by every single economic metric, is coming down. The consumer price index (CPI), the producer price index (PPI), the personal consumption expenditure (PCE) – (don’t worry about what any of this means, I’m just showing off now) and every other report that measures inflation, is showing that it’s on the decline. The rate hikes the Fed has been doing for the past year is working. It takes time for the higher rates to make their way through the economy but it’s certainly happening. And as inflation continues to come down, rates will follow, and if history has taught us anything, it might just be an amazing time to be a buyer.
I should just end it there, that sounded so good in my head, but I need to leave you with this to highlight my last point. Since 1941, home prices have increased 73 years, decreased 7 years and were flat once. Most of the losses were during the housing crisis which inspired The Big Short. At that time, there was an oversupply of homes on the market, mortgages were being handed out to anyone with a pulse, and there was minimal demand. Today’s market isn’t that.
Vice President of Lending
CrossCountry Mortgage, LLC