Market Story - Are we facing another stock market crash?

Yesterday, the financial sector in the US recorded the biggest decline in almost 3 years. The sell-off also affected banks on other global stock exchanges. The turmoil is caused by Silicon Valley Bank, whose shares lost 60% yesterday and similar moves are observed today. What is the reason?

Another Lehman Brothers?

Silicon Valley Bank was forced to sell part of its $21 billion bond portfolio in order to maintain liquidity. As a result, the bank recorded a loss of $1.8 billion.  The bank attempted to raise more than $2 billion in capital to help offset losses on bond sales. However, the market fears that a domino effect may appear if the capital increase is not sufficient, given the worsening financial conditions of many tech start-ups supported by the bank.

What caused such a large loss?

US banks hold significant amounts of US Treasury bonds in their portfolios. As a result of FED interest rate increases, the value of these bonds deteriorated, so the value of bond portfolios also recorded losses. But only "on paper", defined as an unrealized loss. In order for this loss to be realized, the bank must sell its bonds earlier, before their redemption date, which is often caused by liquidity issues. This exactly happened to Silicon Valley Bank. However the potential problem of increasing unrealized losses on bond portfolios applies not only to Silicon Valley Bank, but also to some of the largest US banks. The scale of the phenomenon is illustrated on the chart below. Hero of today's story is highlighted in red.

Source: Bloomberg

Are Wall Street bankers sitting on a powder keg?

As it turns out, the value of unrealized losses in the portfolios of the largest banks on Wall Street is substantial and has increased significantly as a result of interest rate increases.The Federal Deposit Insurance Agency in February reported that U.S. banks' unrealized losses on held-to-maturity securities as of December 31 totaled $620 billion, compared with $8 billion a year earlier, before the Fed started tightening the process. It is worth looking at the amount of unrealized loss on the securities portfolios of the four biggest US banks.

Source: Bloomberg

Will Silicon Valley Bank be the first domino cube?

If Silicon Valley Bank won't be able to raise capital then it will be forced to sell more bonds to maintain liquidity. This may cause panic as markets fear that the 2008 scenario will repeat itself again. The first signs were visible yesterday. The shares of First Republic, a San Francisco-based bank, fell more than 16.5% after hitting their lowest level since October 2020. It was the second largest loss among S&P 500 companies. Zion Bancorp fell more than 12%, and the SPDR S&P regional banking ETF dropped 8% after hitting its lowest level since January 2021.

Major US banks also suffered, with Wells Fargo & Co down 6%, JPMorgan Chase & Co fell 5.4%, Bank of America Corp lost 6% and Citigroup Inc dropped 4%. Following Thursday's crisis more than $80 billion "evaporated" from the stock market. JPMorgan's value decreased by $22 billion.

The voice of common sense

However, it seems that predictions regarding the beginning of another financial crisis should be taken with a pinch of salt.

There are three reasons.

Firstly, the bonds held by banks are largely US Treasury bonds, not toxic bonds "backed" by non-performing mortgages as was the case in 2008.

Secondly, banks will realize losses on the bond portfolio only if they have to sell them earlier, before their fixed redemption date.

Thirdly, if banks do not have problems with current liquidity, they will not have to liquidate their bond portfolios at an earlier time.

In summary, current liquidity conditions of the banking sector is crucial. Investors need to monitor Silicon Valley Bank financial condition and whether share issues will fill the $1.8 billion gap and restore the bank's liquidity.