If I buy $1000 worth of bonds at 2% interest rate for 10 years, my expected return is 1000 * .02 * 10 or $200, making the bond worth at maturity $1200. This bond is worth $1000 today and will return $200. If the bond price falls to $.80 on the dollar or $800 and I am forced to sell today to make my depositors whole, now there is a realized loss - $200 from the original price and $200 from the eventual returns.
If I can wait I have $400 more. If I can't and have to sell then I lose $400.
The distinction between insolvency and illiquidity is a red herring. People who have to sell their house in foreclosure will be discovering the exact thing you are describing here.
What's happening here is SVB is big enough that the authorities go "aaaaah, wait a second, this could blow up a bunch of other businesses and we wouldn't want that". And so they are taking the illiquidity interpretation and helping out the depositors, but at least they are not helping the shareholders.
One thing that may be a bit different in the case of a bank is that the general public does not know or consider deposits to be a loan to a bank. Which is what it is, but people don't think of it this way, and the aren't encouraged to either thanks to FDIC and other state level guarantees. If we change that by letting the depositors lose money, there's going to be chaos.
Here’s the thing: when illiquidity leads to temporary insolvency, it’s easy to chalk it up to bad luck. SBF would probably agree. But an Austrian economist would probably argue that no, actually what is happening is that market forces have determined that you made bad long-term investments and they ought to be liquidated sooner rather than later so the economy can shift that capital into more productive uses.
You can't just add up future value and current value of things. The future value is in future dollars, they are different from current dollars. You owe depositors their current dollars.
Yes you owe the depositor in current dollars, and that's why the bank failed. But I was responding to the parent about it not mattering if the bond is held to maturity - it does matter.
The problem SVB had is that there was no market buyer for their bonds at a price they needed today. They deserve to fail for that but that's not the part of the discussion I am responding to.
What I am responding to is the idea that there is a myth about the value of the bond. Here is what might happen, in a very simplified way:
- Depositors need their cash today
- SVB can't sell their assets to meet this need, and so the bank is fails and is dissolved (already happened). Let's make this simple and say SVB owes the depositor $1000, can sell for bonds for $800 today. If they can have wait the bonds will return $1200 later.
- The FDIC steps in with all their capital. They say ok - depositor here is your $1000 today and you are now whole. But we will not sell the SVB bond today to cover that $1000, instead we will hold the bond and wait for it to mature at $1200. Thus the depositor is whole, and over the long term no money is lost.
No regular market participant step in to provide the $1000 because they can get a better return on their money in other ways. But the government can do this because their goal is not maximizing return on capital, but instead stabilizing the system.
The government needs to get its money from somewhere. If it spends the taxpayers' money, that money cannot be spent on other things. So instead of doing things that are useful to society, like maintaining roads, the money is just sitting there until the bond matures. If it creates money out of thin air, the effect is the same, except that now every market participant pays (in the form of increased inflation). So in either case, the losses are socialised.
Of course, you can still argue that stabilising the system is worth it.
$1000 worth of bonds at 2% simple interest rate returns $1200.
The US 10 year treasury interest rate is 3.7% right now. That means you can get $1200 in 10 years with $835 today at 3.7% compounding; 1200 / 1.037^10 = 834.44 and change.
So your $1000 worth of bonds is actually only worth about $835, at best, because that's the market price for a (close as possible to) risk-free investment which matches the return at maturity.
Inflation is the flip-side of this. You can reasonably expect $1200 in 10 years to be worth about what $835 is today. It might be less, it might be more, but it's an estimation with money behind it.
That's what I don't get. Why are bonds considered risk free if their value can drop when interest rates go up? Sure, they may be worth $1200 in 10 years, but they're only worth $835 now, when they were worth $1000 yesterday.
Risk may be lower than buying shares in a company at risk of bankruptcy, but it's hardly risk free. These things can go up and down just like normal share prices.
There’s no default risk, that’s all. “Risk-free” only refers to the risk of default. Every (fixed-rate) debt instrument has unavoidable interest rate risk. And the floating rate ones are just transmuting it into default risk.
You are correct, these are two different kind of risks. The "risk-free" rate refers to counterparty risk (which should be zero when the counterparty has the money printer, or can be bailed out by the money printer.)
In your example, the market's saying that $1200 in 10 years won't have the purchasing power of $1200. And the future purchasing power would be closer to $800 than to $1000. Consider an alternative world where inflation is zero but you paid $1200 for a $1000-par bond.
The important concept here is the time value of money.
The price doesn't fall because the future purchasing power falls, the price falls because there are better alternatives in the market. No one will pay $1000 for a 2% return when they can pay $1000 for a 5% return. Market participants will always maximize their return. Bond prices adjust to be competitive or equivalent.
But the govt. doesn't have this problem. They don't care about maximizing return - they care about containing contagion. So they can pay $1000 for a 2% return and not still not lose money over the long term.
Inflation strongly determines interest rates. You are getting 5% return because inflation expectations are high which caused the Fed to raise interest rates. When you see 5% risk free, you assume high inflation. The price falls because of the risk free rate, which is caused by high inflation, which causes drop in purchasing power.
If I buy $1000 worth of bonds at 2% interest rate for 10 years, my expected return is 1000 * .02 * 10 or $200, making the bond worth at maturity $1200. This bond is worth $1000 today and will return $200. If the bond price falls to $.80 on the dollar or $800 and I am forced to sell today to make my depositors whole, now there is a realized loss - $200 from the original price and $200 from the eventual returns.
If I can wait I have $400 more. If I can't and have to sell then I lose $400.