The bankruptcy of SVB raises several questions about the reliability of the US financial sector. It was not subprime loans or high alternative books that sunk Silicon Valley Bank, but the accumulation of what were thought to be the safest securities on earth: US Treasury bonds. 

The bonds were bought at a time of extremely low-interest rates. Such Treasury bonds are still susceptible to losing their immediate resale value if rates soar, which is what happened. Having immediate liquidity needs, the bank sold these securities on the market, resulting in a loss of $1.8 billion. 

We are seeing the first effects of the Fed’s aggressive monetary policy. The Federal Reserve has raised rates at the fastest pace in decades to tame inflation, bringing its benchmark rate from near zero to a range of 4.75% to 5%. Treasury prices collapsed as bond prices move in the opposite direction of rates. 

US lenders hold more than $4 trillion in government-backed securities. And last year, Treasury bonds posted their worst losses since at least the early 1970s, with some bonds falling nearly 30%. That’s one reason why fears of banking contagion won’t go away, even after the Treasury Department, the Fed, and the FDIC rushed in to offer emergency protection to all SVB depositors. However, regulators must still confirm whether other lenders will get the same coverage. Consequently, deposits have continued to drop, particularly those of small regional banks. 

The Fed lent billions to banks after the collapse of SVB to ensure their liquidity, including new emergency programs that offer generous terms to borrow against Treasury bonds and other securities that had lost value. But the Fed is also continuing its monetary tightening. The FOMC raised rates another quarter of a percentage point on March 22. Treasury prices have rallied as investors think President Jerome Powell and his colleagues will change course. If they don’t, it could mean more losses for Treasury bonds and more problems for the banks that hold them. 

But rising rates is not the only problem in the $24 trillion Treasury market. Another is a longstanding concern about market liquidity, essentially the ease with which transactions can be made. Fear and uncertainty last month created unprecedented volatility, with the highest yield fluctuations seen in 40 years. Liquidity could become a problem, causing a dramatic rise in interbank rates. 

There are various explanations for the liquidity problem. Treasury debt has ballooned by over $7 trillion since the end of 2019, and there’s a widely held belief that the market size has exceeded financial institutions’ capacity. Regulations imposed on big banks (the “too big to fail”) after the 2008 financial crisis have also limited the ability of banks to hold enough bonds to ensure smooth buying and selling. The Fed and the Treasury have been working on solutions for years, but changes have been slow to come. 

Then there’s the looming debt ceiling impasse or the possibility that politicians won’t reach a compromise on raising the self-imposed borrowing limit. The Treasury is already using extraordinary measures to fund the US economy. But these will run out by the end of the summer. Not renewing the US debt ceiling before the Treasury runs out of means to continue funding public spending could trigger an unprecedented default on US public debt. It could spread to the global financial system where Treasury bonds are massively used as collateral.