CIO Letter: Past the Easy— Tightening Has Taken Its First Casualties
SVB and Signature Bank Collapses & The Implications from an Investment Perspective
Written as of 7:00 AM on March 17th, 2023, based on what we know so far. This situation is evolving quickly, and many unknowns remain. We will try to provide timely updates as needed.
We have argued for some time that the Federal Reserve made its first policy mistake by leaving rates at near zero for far too long. This allowed inflation to rise much too high and become too entrenched before they came to the revelation that the inflationary pressures were not transitory. By starting so far behind the curve, the Fed was required to tighten at the quickest pace since the 1980s. We have talked about the long and variable lags that monetary policy acts with. At this pace the full impacts of each hike were not realized before the next hike occurred. During previous rate hiking cycles, the Fed has typically tightened until something has broken. Earlier this year we wrote our Quarterly CIO Letter, entitled “Betting on Nirvana”. The market was pricing in a perfect landing where there were no implications for anything that had occurred. We remained genuinely concerned about the mounting risks and that led us to the decision to sideline a sizable portion of our clients’ assets. With short-term Treasuries yielding 4.5-5% it made sense to get paid this yield to wait there until valuations were more accurately discounting the reality we were seeing. In the real-world consequences do exist, something the market seems to be quickly waking up to.
It is just a week into this turmoil and although Treasury markets are back to betting the Fed will cut rates, it is now driven by fear the Fed may need to reverse course to avoid breaking anything else. This is a far cry from a month earlier when markets were pricing in rate cuts on hopes inflation was falling faster than expected.
We have entered a new regime. Inflation is not falling quickly enough, and the Fed’s job is not done. However, now the Fed also needs to weigh the stability of the banking system and the health of the labor markets. In an ideal world they would have had inflation under control before anything broke, giving them cover to loosen policy in the future if necessary. They did not want to get into this situation of having to choose which piece of the mandate to prioritize.
But, to truly squeeze inflation out of the economy and wring out the excesses, lenders need to be nervous enough to tighten standards, loans need to become expensive enough to temper growth, and businesses need to be wary enough about the future to be reluctant to spend. It may not be pleasant, but reckless companies will and should go bankrupt.
What Happened with SVB and Signature Bank?
These banks violated two fundamentals of Finance 101—diversification and risk management. More concentrated and unhedged bets payout better when they work out; but those high returns come with an incredible amount of risk that can wipe a company or investor out if they do not work out. For long-term sustainability of wealth and of businesses, diversification and risk management are key.
Silicon Valley Bank (SVB) was the 16th largest bank in the US, with over $200 billion in assets. It became the second largest US bank failure ever (Washington Mutual in 2008 remains the first) on March 10th after a sudden bank run and capital crisis. SVB was the go-to bank for early-stage, venture-capital sponsored US tech start-ups and saw massive deposit growth from June 2020 to March 2022. SVB funded about half of US venture-backed tech and health care companies. The deposit base was concentrated to one sector and the clients themselves were large.
There were several forces that worked together to cause SVB’s perfect storm.
1. The Federal Reserve aggressive rate hike campaign hurt the interest rate sensitive tech sector more quickly than other sectors, an exceptionally large exposure for SVB.
2. SVB had a major asset-liability mismatch, creating material unrealized losses in the bond portfolio as the Fed raised rates. Higher rates decreased the value of long-term bonds which SVB had outsized exposure to. The influx of deposits during the pandemic, when interest rates were near zero, were put into long-term bonds to get a better return. They took duration risk by reaching for yield.
3. Venture capital funding started drying up which led startups banking with SVB to draw down their deposits as they burned through cash. This cash burn escalated in February. The mountain of unrealized losses had to start being realized to fund the withdrawals and the duration risk they took came back to bite them.[1] On March 8th SVB, in a mid-quarter update, announced it had sold “substantially all of our Available for Sale (AFS) securities portfolio” for a $1.8 billion after-tax loss and that it would need to raise $2.25 billion in new capital to shore up its balance sheet.[2]
4. SVB also had concentration risk among institutional/business accounts and the tech sector. The need to raise funds triggered panic among the venture capital firms who emailed the start-up companies they advise to withdraw their deposits. Because those companies made up such a large part of SVB’s deposit base this was a major problem and became a self-fulfilling prophecy. These larger sums of money made it easier for the bank run to happen, especially in a digital age.
By March 9th, the selloff in the stock took hold and by Friday trading was halted. California regulators stepped in and placed SVB in receivership under the FDIC. The FDIC is returning all money to depositors, even if their account was above the $250,000 threshold. The FDIC has stated the deposits will be made whole by fees banks pay to the FDIC and not by taxpayers.
Why didn’t they hedge against this risk? The short answer, they put profit over the sustainability of the bank. Hedging the risk would have eaten into their profits. However, it is more complicated than that. They did have hedges on in 2021, but by the end of the third quarter 2022 they had unwound them all. This could have been because they needed the boost to income, because they thought rates on the long end were done moving higher, or because they did not have a Chief Risk Officer over that period. Whatever the reason, the risk they incurred did not pay off.
Every lender faces many risks including interest rate risk, credit risk and liquidity risk. What is happening here is centered on interest rate and liquidity risk. Interest rate risk occurs when rates rise quickly over an abbreviated time, raising the yield on debt as well. As yields rise the value of the debt falls quickly, especially on longer-term bonds. If you are going to hold the bond to maturity this doesn’t matter, but if you sell the bond before maturity at a discount to face value the loss is locked in. Liquidity risk is the risk the bank won’t be able to meet obligations without losses. SVB depositors were withdrawing money in larger sums than was available in the cash reserves. SVB had ~7% of its assets in cash and Signature is reported to have 5%, while the industry average is closer to 13%. This forced SVB to sell their longer-term bonds and realize losses which required SVB to try to raise over $2 billion in new capital which spooked venture capital firms that then spooked SVB’s customers that then ran to the bank to take out their money.
The details are much less clear surrounding Signature Bank, a New York based regional bank with $110 billion in assets and over $88 billion in deposits. It was the 29th largest US bank and a leader in crypto lending. It was one of the few banks that accepted crypto deposits. Two days after the collapse of SVB came the collapse of Signature, the third largest bank failure in US history. Regulators warned the stability of the financial system may be threatened if it remained open and their faith in management was lost due to the lack of “reliable and consistent data”. The Justice Department and SEC were looking into whether the bank took sufficient steps to detect if clients were laundering money in an ongoing criminal probe. It is not clear whether this had an impact on the closure decision. The NY Department of Financial Services took possession of the bank Sunday and it became the third regional bank to collapse in the last few weeks (Silvergate being first). On March 9th Signature announced financial data and said it limited crypto deposit balances to increase diversification, a similar announcement to their December one. Because this was immediately following SVB, it spooked customers into quickly withdrawing a significant percentage of deposits Friday.
What Is Happening with Credit Suisse?
This is significant in that it broadened the concern beyond US banks and brought investor concern across the ocean. I covered European banks during my time on international equities and Credit Suisse was always a problem child. The issues just keep coming one after another with Credit Suisse, including being convicted of allowing drug dealers to launder money in Bulgaria, entanglement in a Mozambique corruption case, a huge leak of client data to the media, a spying scandal involving an executive, and the list goes on. This seems to be another case of a crisis in confidence. Customer deposits have declined since Q1 of 2021, but the pace quickened in the back half of 2022. On March 9th the SEC delayed the publication of their annual report which fueled panic. On March 14th Credit Suisse reported they found material weaknesses in their financial reporting. This panic was heightened on March 15th when the chairman of Credit Suisse’s largest shareholder, Saudi National Bank, said it would not invest any more in the company. Its bonds are now signaling deep financial distress. The Swiss National Bank announced on the March 15th that it is prepared to lend $54 billion to Credit Suisse. The rest of the story here is yet to play out and we will be watching closely.
Will There Be More?
The failure of SVB and Signature Bank raised concerns over potential losses on the bond holdings of other US banks, especially regional banks, many of which also invested heavily in long-duration Treasuries following an influx of pandemic related deposits. According to the FDIC, at the end of 2022 US banks had $620 billion in unrealized losses in their held-to-maturity portfolios, so this is not isolated to SVB and Signature. Also, according to the Federal Reserve Financial Stability report, there were over $7.5 trillion in uninsured deposits in US banks at the end of 2022.[3] Over 80% of the deposits at SVB were uninsured. At Signature, it appears it was about 90% of deposits. These deposits are uninsured; therefore, they will be flightier at the first hint of real bank viability concerns.
Regulators moved swiftly to alleviate concerns over the health of the banking system. The FDIC backing deposits above $250,000 was a big move. This measure was put in place to stop people from lining up at ATMs and pulling their money out of banks, hopefully preventing another bank run, and with the intent of addressing liquidity concerns.
Furthermore, late Sunday the US Treasury, FDIC and Federal Reserve announced they would act to stabilize the US banking system through the Bank Term Funding Program (BTFP). This liquidity program allows US banks to borrow, for up to one year, at favorable market terms if loans are backed by Treasuries, high-quality agency debt, or Mortgage-Backed Securities (MBS). Collateral will be taken at face value instead of at market prices, avoiding forced sales in response to stress. This will allow high-quality bonds to act as a source of liquidity rather than banks being forced to sell them in times of stress. Since the Global Financial Crisis, banks must keep liquidity coverage ratio above 100%, holding enough high-quality assets (notably Treasuries) to meet deposit outflows.
Whether SVB is the canary in the coal mine, showing the cracks in the global financial system, remains to be seen. Moody’s identified six other US banks that have elevated levels of uninsured deposit funding. Moody’s also downgraded their outlook for the US banking system as a whole from neutral to negative on March 14th. The regional bank index (KBW) is down about 20% since this began. We are watching for signs of contagion. It is normal for there to be an immense amount of panic and fear in the system after something like this as investors tend to try to figure out who is next. In a concerning show of bank strain, banks did borrow heavily in the week ending March 15th from two Fed backstop facilities. They borrowed $152.85 billion from the discount over that week, more than the $111 billion high that was reached during the financial crisis. They also borrowed $11.9 billion from the newly created BTFP. Large banks rallied together to help stabilize First Republic Bank on March 16th by pledging to deposit $30 billion.
There are risks in commercial real estate where tens of billions in office debt is maturing this year, there is the leveraged loan market where private equity firms have layered companies with debt and signs of stress are showing in housing, distressed corporate bonds and some consumer delinquency data. So yes, these banks were the first things to break, but they may not be the last.
What Does it Mean for Investors?
These three bank failures in a row are significant because they signal the end of the easiest part of the road for the Fed. The part where financial stability remained strong and unemployment remained extremely low, giving them cover to raise rates as quickly as necessary. Now they must choose which piece of their mandate is most critical at any given time. We think the months ahead will bring more pain and the situation is still very much evolving.
The Fed was going to continue hiking until something broke and right now that something seems to be regional banks. The SVB situation is a reminder that Fed hikes are having a real effect. Policy reactions thus far are strong signals that US officials will do what is needed to keep this from becoming a systemic banking crisis, but we are monitoring for signs of contagion.
This is not a favorable time in the economic cycle to have large exposures to financials, so we were underweight financials, and equities as a whole, coming into last week and did not have direct exposure to the shuttered banks. We have had clients ask if they should buy into the selloff of regional banks. We do not typically buy into oversold conditions in ways that are opposite of our current overview unless the opportunity is exceptionally compelling. This situation is still evolving. While valuations are lower than they were, concerns over bank earnings and balance sheets remain and lending standards are likely to tighten going forward. Furthermore, regional banks may have a tougher time keeping deposits.
The easy part of the hiking cycle is in the past for central banks. They had healthy economies, low unemployment and financial stability that was giving them cover to hike rates. However, now that financial stability is in question, they need to pace themselves. Inflation remains a clear problem, but now they have their mandates moving against each other and they need to prioritize. The market is calling into question whether there will now be any hike this month. On March 16th, the ECB signaled resolve as it continued its hiking cycle, raising the target rate by 50 basis points.
At this point, we believe that that the Fed will go 25 basis points, but things are evolving rapidly and this could change if financial stability is further called into question from here. However, in order to be able to use their tools to fix things like a slowing economy and financial stability, the Fed needs inflation under control. We have been saying that the only way we see the Fed cutting rates is if the economy falls off a cliff and we maintain that positioning. February retail sales data painted a picture of an economy that is cooling as consumer spending fell. Consumers’ wallets are shrinking on a real basis and consumption growth should continue to slow.
We remain defensive in our positioning with a high-quality tilt to our portfolio. We are looking for companies that are less cyclical in nature, have solid balance sheets, and have pricing power. We also continue to allocate capital to inflationary beneficiaries, infrastructure, and gold.
We favor high-quality segments within fixed income. Given our economic outlook, the fixed income portion of a client’s portfolio needs to act as a ballast. Yields on Treasuries remain attractive, and we have a large allocation to short-term Treasuries. Our clients are being paid well to wait for a better entry point into riskier assets. We remain cautious on corporate bonds as we have not seen spreads widen between corporates and Treasuries in a way that would be consistent with an incoming recession. We are avoiding high yield completely. There were several one-off actions by central banks around the world that injected money into the system in the beginning of this year that boosted reserves. However, going forward we think we will return to global liquidity drainage. This will be a drag on risk assets, and we should start to see things like investment-grade and high yield credit spreads start to widen again.
What Should You Do?
The $250,000 FDIC limit on guaranteed deposits seems like it has been waived for now, at least at SVB and Signature. However, from a risk management perspective, we would still recommend diversifying your account exposure, so you remain below the threshold in each account.
Within our client accounts if we ever have more than $250,000 in cash, the custodian diversifies it on the backend between partner banks so there is not more than $250,000 in any one bank. We also have cash management solutions designed to earn interest while still preserving your capital. If you are interested in learning more about these solutions, please contact us.
As always, if you have any questions, please reach out to us.
Kasey
[1] Banks are allowed to hold these bonds in “Available for Sale” and “Held to Maturity” accounts at cost. They don’t need to recognize mark-to-market losses immediately if the bonds lose value. However, if they have significant deposit outflows like SVB experienced, they need to sell these bonds and realize the losses to meet those needs.
[2] https://www.sec.gov/Archives/edgar/data/719739/000119312523064680/d430920dex992.htm
[3] https://www.federalreserve.gov/publications/files/financial-stability-report-20221104.pdf, page 41
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