This Week In the Mayonnaise Clinic: Who Likes High Interest Rates?

High rates were supposed to be good for banks. Oops. Plus: NHL Pride Nights.

Dear readers,

Welcome to the Mayonnaise Clinic. This week, we’re talking about interest rates and the collapse of Silicon Valley Bank.

That’s because Tracie asks:

Who can and does benefit from higher interest rates?

An ironic thing, given the events of recent weeks, is that a standard answer to this question is “banks.” Banks are in the business of borrowing money at low rates and lending it back out at higher rates. The difference between these rates is called “net interest margin.” When interest rates rise, banks pay more to borrow money and earn more by lending it out. But the changes are not equal: Interest rates on bank deposits tend to rise (and fall) only by a fraction of the extent to which interest rates on credit cards and government bonds and other instruments move. Therefore, higher rates mean higher net interest margin and higher bank profits.

But there is a catch. While higher interest rates make it more profitable to lend in the future, they also — as we have seen in recent weeks — reduce the value of fixed-rate debt that’s already been issued. If a bank has a balance sheet full of government bonds that pay 1% or 2% interest, it won’t be able to sell those bonds for their face value today, because the government is issuing new bonds right now that are more attractive because they pay higher rates. Those old bonds have to sell at a discount. If the term of the bonds is long, the discount will have to be substantial.

As we have seen, banks are highly leveraged, and if they haven’t managed their interest-rate risk properly (as Silicon Valley Bank especially did not) then they may end up owing more money to their depositors than they have in assets — that is, they may become insolvent, despite the prospect of being able to make more profitable loans in the new, high-interest-rate environment.

Insolvency means the bank could not be liquidated in a way that pays off the bank’s liabilities (mostly deposits) in full. But there’s this sort of paradoxical situation where a bank can have a negative liquidation value but still stay in business because the value of its enterprise — the present value of its future profits — remains positive.

As Matt Levine wrote earlier this month:

The basic lessons of the Silicon Valley Bank failure might be:

1. Some number of US regional banks are apparently insolvent, if you compare the market values of their assets (lots of fixed-rate loans and bonds that lost value as interest rates rose) with their liabilities (deposits, etc.).

2. Mostly this is a weird uncomfortable fact of life in banking in a rate-hiking cycle, and everyone politely ignores it.

3. Sometimes people notice and that’s bad.

The reason it can be possible for a bank to soldier on like this is that it might have some assets that are valuable, but not liquidatable. Roughly, these assets are its brand and its customer relationships.

Dall-E image generation for “soaring interest, impressionist painting”

SVB had valuable customer relationships that it could expect to turn into future business. Not only could it expect customers to keep low-interest deposits there, it could expect future lending and other business with those customers. Those prospects are a reason that, before the crash, SVB’s stock was trading well above the book value you’d find in its accounting statements — investors believed the company was worth more than its liquidation value because it would keep doing profitable business in the future.

The value embedded in SVB's deposit base was particularly important. In theory, deposits mature immediately — your customer can come to you at any time and demand his or her money. But in practice, most deposits stick around most of the time. They are a cheap source of funding for a bank — some of SVB’s deposits paid no interest at all — and if the bank can expect those deposits to stick around, then the true burden of its deposit liabilities is lower than they would appear by looking at its balance sheet. In fact, as interest rates rose, the cost profile of SVB's deposit base should have been growing more attractive.

But when SVB depositors started showing up en masse at the bank and demanding their money back, that all went to hell.

The run didn’t just create a liquidity problem, where it was hard for the bank to quickly come up with all the money it needed to pay those depositors. It also made SVB’s liabilities more expensive — the bank had to replace the fleeing low-interest deposits with other sources of financing, like borrowings from the Federal Reserve, on which it had to pay higher interest rates — and it wrecked the intangible value of the SVB franchise, because the prospect of future business from existing customers became much dimmer.

This was damaging to the bank’s future profit outlook and therefore to its present value — and the relevant answer to “what is SVB worth?” changed from being about the future profitability of the SVB business to being about the present liquidation value of its financial assets. That liquidation value wasn’t enough to cover what it owed to depositors.

It was possible to imagine a scenario where, after the government closed SVB on March 10, a megabank like JP Morgan came to the rescue, buying the entire business over the weekend for $1 or some other nominal price. JP Morgan’s rock-solid balance sheet and too-big-to-fail status might have persuaded the vast majority of depositors to stop worrying about the safety of their deposits and even move money back into their accounts. Goodwill toward JP Morgan for saving the day, along with the continuity of employee-customer relationships that could have been achieved with a quick acquisition, might have meant that JPM’s hold on future client business in Silicon Valley looked as good as SVB’s once had. In other words, maybe you could have reconstructed all that intangible value at a stronger successor institution, and maybe the prospect of doing so would have bolstered an acquiring bank’s willingness to take on all of SVB’s liabilities.

But for whatever reason, such a bid did not materialize. (JP Morgan CEO Jamie Dimon, in particular, seems chagrined about how these emergency acquisitions have worked out for his bank in the past; it’s not obvious that any of the megabanks would have bid a positive price for SVB even if government regulators were not skeptical of allowing those banks to grow.) Instead, the FDIC took several weeks to find a buyer, and the one they did find, First Citizens, is acquiring most of the SVB business for an effective purchase price of about negative $20 billion — a price that likely needed to be so low in part because of the extremely unsure prospect of First Citizens actually managing to obtain the future business that SVB had expected.

So, who benefits from higher interest rates? Maybe some banks in the long run — especially the ones that didn't have too much long-term fixed rate debt, and which are financially strong enough to attract customers in an environment of greater uncertainty about the banking system. Stock prices for the largest banks have held up well in recent weeks compared to their mid-size peers, and they are gaining deposits as smaller banks lose them. But for now, there’s a lot of pain to go around from the decline in asset values and the turmoil it’s caused in the financial system.

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Zach asks:

What's your take on the NHL's Pride Night controversy?

For those who have not followed this news: In recent years, the NHL has made a significant, public push related to inclusion in hockey — a push that has not been solely about LGBT inclusion, but has prominently featured it, including “Pride Night” observances by teams across the league, which have often included players wearing special jerseys with rainbow theming during warm-ups or in games.

This year, some NHL teams have been pulling back on their “Pride Night” plans, and some individual players have declined to participate in team observances. Some players have cited their personal religious views as a reason for opting out. News outlets have also reported that some franchises are concerned about legal repercussions that Russian players could face given new Russian laws prohibiting certain pro-LGBT expression (approximately 5% of NHL players are Russian).