112: More Thoughts On Banks' HTM Portfolio; Boston Fed Paper
You’re reading the free version of Watchlist Investing on Substack. If you’re not already subscribed, click here to join 2,800 others.
Want more in-depth and focused analysis on good businesses? Check out some sample issues of Watchlist Investing Deep Dives, a separate paid service.
For $20.75 per month, you can join corporate executives, professional money managers, and students of value investing receiving 10-12 issues per year. In addition, you’ll gain access to the archives, now 32 issues and growing!
Boston Fed Paper
The Boston Federal Reserve put out a short white paper on the Silicon Valley Bank crash and the accounting for debt securities known as held-to-maturity or HTM. It’s a nice short read and got me thinking about this issue again, which I examined back in May in Issue #100 (link below). Read the paper here.
The question, which has not definitively resolved itself in academia or policy circles, centers around bank accounting and whether banks should be allowed to value bonds they’re not planning on selling (hence the term held-to-maturity) based on amortized cost. The other option is to value them at market just like other bonds held on the books which are classified as available for sale. This has implications for capital ratios and bank safety and soundness.
The fair value adjustment was large enough in the case of Silicon Valley Bank’s HTM portfolio to wipe out the bank’s equity capital. The market recognized that if the bank had to sell the bonds quickly it would not have the luxury of time and would be forced to sell at less than par, going far beyond wiping out shareholders to possibly negatively impacting depositors.
This logic can also be extended to loans, which, in theory, have values that fluctuate with interest rates. The logic extends further still on the other side of the balance sheet to liabilities, whose values move inversely, including demand deposits. But few go that far even if the logic of it is sound.
Reaffirming My Original Conclusion
In my May 2023 post, I concluded that one could take the side of adjusting or not adjusting the assets to fair value depending on one’s vantage point in the capital stack and your choice of discount rate. An equity investor cares about residual cash flows. If I don’t change my discount rate and the cash flows of the bank remain the same, then what’s changed?
On the other hand, as a depositor or lender to the bank, I care about the liquidating value of the bank. My ultimate safety comes from the bank having enough assets to cover its liabilities plus a margin of safety in the form of equity capital. As a creditor, I should care deeply about changes in asset values.
The Fed paper proposes an alternative that would allow HTM accounting but include the unrealized changes in market value in one version of capital and the resulting capital ratio. I think this makes sense. One of a banker’s primary jobs is to ensure the institution has enough liquidity to meet obligations. Banks that get lazy and expect demand deposits to remain sticky - because they’ve historically behaved a certain way - should reassess their assumptions.
I think it makes sense for banks, bank regulators, and investors to calculate the market liquidating value of the assets and see what this ratio says about the health of the bank. They should also shock their assets in planning sessions to see the effects of changes in asset prices due to changes in interest rates.
It’s a shame that SVB went so long without anyone noticing the hidden risks lurking in plain sight in its debt portfolio. Investors, regulators, and depositors should all learn from SVB’s failure and protect themselves and the financial system in the process.
Stay rational! —Adam