I suffered an embarrassing moment last week.
A client contacted me last Friday afternoon to ask my opinion about the Silicon Valley Bank (“SVB”) crisis that had hit the headlines that day.
I was finishing up another busy week and mistook the SVB bank run news with the Silvergate bank failure earlier in the week. I fired back a snarky quip that the collapse of a single “cryptocurrency” lending bank (Silvergate) was a pimple on an elephant and was an isolated event. Oops.
I was corrected over the weekend for sure; the SVB bank failure is a serious event that is already having meaningful banking, capital market and policy ramifications.
It was hard to concentrate on the excellent Players Championship golf tournament on Sunday with the news of a second bank collapse – Signature Bank – and while awaiting the predictable news that the federal government would backstop 100% of deposits at all US banks to stem the risk of a systemic bank run – they did.
The easiest way to get your mind around a bank run crisis is the great scene from the classic movie, “It’s a Wonderful Life”. Remember Jimmy Stewart pleading with his frightened Building & Loan deposit customers to not withdraw their money? He reminded them he didn’t have their money stored in the vault, it was lent to them and others to build homes in Bedford Falls. Depository institutions are not designed to survive a liquidity crisis from fleeing deposit customers, which is why they are regulated.
Now that I’m fully up to speed on SVB, here’s some observations.
What a mismanaged bank. As a former banker, I recall banking 101 that teaches the proper matching of the term of your assets (loans and investments) to your liabilities (deposits). It’s coming out that SVB bank executives chose this risky course to maximize profits.
Commercial deposits are “non-sticky” deposits, which means the cash can leave the bank as soon as it arrives. After a brutal year for venture capital tech companies in 2022, they started to drain their bank deposits to pay bills. At SVB, over 90% of its deposits were above the FDIC limit ($250,000), mainly held by venture capital companies. That’s a future liquidity problem-in-waiting.
In the meantime, too much of SVB’s deposit capital was invested in long-dated fixed interest rate Treasury bonds and mortgage loans. Each of these asset classes suffered major paper losses in 2022 due to the spike in inflation and US interest rates.
The combination of material unrealized investment losses and sizable deposit outflows didn’t take long to cause a bank capital problem, which exploded last week in spectacular fashion with the failure of the 16th largest US bank. Signature Bank had similar balance sheet imbalances and a concentration in VC tech as well.SVB had become the “go to” bank for VC firms and grew rapidly with the boom in the VC sector since COVID. The bank’s concentration of business (loans and deposits) in a single high-risk sector is especially poor risk management for a bank of any size.
The failing of two poorly run mid-sized banks shouldn’t create a national banking crisis – but it did. Moreover, there’s concern about lasting damage to the emerging tech industry. I read where SVB financed 50% of all VC companies! The US economy needs a vibrant emerging technology sector and SVB just blew a gaping hole in their access to bank capital. Which bank(s) will step into the breach?
Backstopping bank depositors is not a bailout; all bank stockholders will be wiped out, which is proper. However, it begs the question: How was a nationally chartered bank allowed to be so incompetent, failing even basic risk management principles? Where were the bank regulators?
Part of the answer is political influence. The federal government was effectively lobbied to pass a 2018 law relaxing regulatory oversight on all but the largest banks. The assumption was that mid-sized banks couldn’t cause a bank run and didn’t need oversight. That assumption and law didn’t age well, so expect new onerous bank regulations that may swing the pendulum too far in the other direction.
The Fed Reserve’s fingerprints are found on this debacle too. Their zero interest rate policy finally caught up with them after all the COVID related money printing. The last two massive federal government “rescue” spending bills were an outrageous waste of trillions of borrowed money; the Fed should have realized the inflation impact of such spending largesse much sooner than it did.
The result is they lost control of the inflation dynamic. Their scramble to catch up by jacking up the Fed Funds rate at lightning speed in 2022 led to the worst bond bear market in history and the impact has now bled into the US banking system.At present the Fed is in a real policy pickle. They must still fight elevated inflation without causing further damage to the national banking system. The bond market is already signaling the Fed will have to halt interest rate increases due to the new banking crisis.
If the Fed does indeed pause interest rate hikes, it could trigger a perverse short-term stock market rally. Stock investors remain obsessed with the Fed Reserve, ready to buy once they get word of a rate pause. All the while, inflation remains a nettlesome problem in 2023, so careful stock selection will be imperative in a bear market rally scenario.
The reality is that short-term investment yields are now much higher outside of the banking system and banks are likely to see more deposit outflows. If the banks are forced to raise deposit yields to compete, then loan rates will have to rise as well or their profit margins will suffer. It goes without saying that regional and community banks will face serious operating challenges in this new financial landscape.
Our advice is to take another antacid, stay fully invested and look for bargains when the stock and bond markets overact to headline events.
Until next time, be well….Tim