March Madness

by John M. Fidler

Just in time for March Madness, financial markets have been roiled by headlines and fears over the banking system. I’m sure you have all read of the failure of Silicon Valley Bank Shares (SIVB), as well as two much smaller banks, Signature Bank and Silvergate Capital, which were heavily focused on cryptocurrency.

Over the weekend, the Treasury Department, Federal Reserve, and FDIC announced a series of dramatic moves in an attempt to restore confidence in the banking sector. These measures include fully protecting depositors, regardless of insurance status, and creating a new emergency liquidity facility called the Bank Term Funding Program. This week, the fears moved to Europe with Credit Suisse stock falling over 30% in 2 days before rallying on news that the Swiss National Bank may backstop the floundering investment bank.

So, why is the current market environment, one of relatively decent economic growth, strong employment, and robust bank credit quality, leading to these types of events? How are interest rates impacting the economy and the banking system? And how did Silicon Valley Bank differ from a “normal” bank? 

First, the market and economic backdrop: 2022 saw a bear market for nearly all asset classes. In 2023, markets have rallied, but we still believe this is a bear market rally within a larger downtrend for most equity markets.

Source: FactSet

The weakness over the past year in stocks and bonds has been driven by the Fed hiking rates at the fastest pace ever in an effort to stem the tide of inflation (which remains 3x the Fed’s 2% target as of January).

Source: Federal Reserve of St. Louis

As a result, financial conditions have tightened substantially year-on-year, resulting in a steeply inverted yield curve, typically a precursor of a recession.

But while financial markets show evidence of stress, even deflation, the broader economy has remained resilient with continued positive real growth and sustained inflation above 5%. The Atlanta Fed is even calling for 1Q23 GDP north of 2%.

Against this backdrop of rising funding costs and falling bond prices, banks’ profitability has been squeezed. A typical regional bank takes deposits from customers and uses them to predominantly fund loans. The remaining funds are invested in securities or kept in cash reserve to meet short term liquidity needs. 

Source: Federal Reserve 

As we can see below, Silicon Valley Bank (SIVB) had a very different model.

Source: BCA

As the name implies, Silicon Valley Bank existed to provide deposit services (and to a lesser extent, loans) to start-up technology companies in Silicon Valley, as well as the venture capital (VC) firms that provide those start-ups with capital. The unique feature of Silicon Valley Bank’s clientele is that they don’t typically finance their operations with debt. So, as VC boomed over the past few years, SIVB was flush with deposits, which grew over 300% in the few years prior to their collapse. This compares to deposit growth more on the order of 35-40% for the banking industry as a whole. Because their customers had little loan demand, Silicon Valley Bank plowed that growing deposit pool into securities, which made up 55% of its balance sheet. Many of these were long duration Treasury and mortgage bonds, purchased at extremely low (1-2%) yields over the past few years when rates were low.

As rates rose rapidly in 2022, those securities plummeted in value. By putting these securities in their held-to-maturity (HTM) portfolio, versus their available-for-sale (AFS) portfolio, a bank doesn’t have to pass those mark-to-market losses through to their earnings. This situation works fine, provided there isn’t a short-term need for liquidity as deposits go out the door.

However, since late 2021, deposits had been going out the door. Silicon Valley Bank had incredibly high funding concentrations in the start-up tech and healthcare space. These deposits were controlled entirely by the venture capital companies that worked with SIVB directly and indirectly through the customer base they controlled. Over the past year, these start-ups were drawing down deposits in order to operate their businesses. With VC funding drying up as investors fled the crashing tech sector in 2022, there were no offsetting deposits coming in. Then, the very VC community that relied on SIVB started the run on the bank as it became clear that Silicon Valley Bank might not be able to survive.

In order to mitigate the loss of liquidity, Silicon Valley Bank had to turn to its depressed securities portfolio, where management’s decision to chase yield in longer-dated maturities had created an unsustainable and reckless duration mismatch. Because of the dramatic rise in interest rates, these securities were/will be sold at enormous losses.

FDIC caps insurance at $250k per depositor. Because Silicon Valley Bank clients were so concentrated in large tech and healthcare, most accounts exceeded the limit by large amounts. In fact, nearly 95% of Silicon Valley Bank’s depositors were uninsured. Again, this is highly unusual in the banking industry. A typical regional or community bank would have closer to 50% of its deposits fall under the insurance cap. This was the primary cause of panic that exacerbated the situation. It should be noted that the FDIC, Treasury Department and Federal Reserve made a joint statement guaranteeing all depositors at Silicon Valley Bank late Friday.

So, basically Silicon Valley Bank took a wave of deposits in 2020-21 (much higher than industry growth), ramped up loans to the extent they could/wanted to, but also piled into bonds with maturities of 10-30 years, and stuck with them, without hedging, at very low yields. This is an example of a business model and risk management approach that was unique in the US banking system and, at best, unsustainable. Worse still, Silicon Valley Bank top managers were permitted to sell their shares 2 weeks ago, just before a mismanaged capital raise.

Traditional community banks are funded by well-diversified core deposits, and most large depositors tend to be full service customers, including borrowers. This was not the case at Silicon Valley Bank. The bulk of, or at least a meaningful percentage, of deposits at a traditional community or regional bank fall under the existing FDIC limits. This was not the case at Silicon Valley Bank. Traditional banks typically deploy the bulk of their deposits into shorter duration loans versus long duration bonds. This was not the case at Silicon Valley Bank.

This is not to say that the banking system, and the economy in general, won’t continue to experience knock-on effects from the Silicon Valley Bank debacle. On the positive side, the FDIC may elect to increase the limit for deposit insurance. But increased risk aversion, cost of capital, and regulation is likely to have an impact on bank loan growth, which accounts for roughly 30% of credit creation in the US.

Quite a bit has changed in the past week. This implicit tightening of financial conditions has been recognized by the fixed income markets this week, as the bond market went from pricing a terminal Fed Funds rate of around 5.5% this Summer (on Friday) to pricing about a 4.5% rate (on Monday), going from implied rate hikes to implied rate cuts. Just last week, Fed Chair Powell was hinting at a potential 50bp hike this month, and on Thursday, March 9, markets were pricing a 70% chance of this; by Tuesday, March 14 the market was pricing a 50% chance of no increase! 
 

Source: Bloomberg, @carlquintanilla

We remain skeptical that the Silicon Valley Bank collapse will derail the Fed’s rate hike cycle in a meaningful way. Yes, we saw a deflationary event over the past week, with the potential for far-reaching impact on future loan growth. But the actions taken by regulators over the weekend look to have attenuated systemic risk; the vast majority of banks do not face the same structural issues that SIVB did; the new Fed facility implicitly guarantees deposits at a level higher than the current FDIC insurance limit and explicitly allows banks to repo underwater securities at par; inflation is ratcheting down but remains high (higher than it was a year ago, in fact); and unemployment remains at historic lows, with job openings still also historically high (though recently falling from all-time highs).

Therefore, we continue to think that growth will continue to decelerate slowly as the Fed remains restrictive, likely resulting in a “garden variety” recession of 2-3 quarters of negative 1-2% GDP growth in late 2023/early 2024. While pockets of the market (e.g. the energy sector) appear to be pricing in imminent recession this week, we continue to think inflation will remain sticky. The housing inflation component of CPI is slow-moving and has still not caught up with the significant home price appreciation that occurred in 2020-21. China is in the midst of reopening their economy from zero-COVID, which is likely to lead to inflationary growth across international markets, which will have knock-on effects for the US. On a more structural/secular basis, de-globalization has been a macro trend since around 2017 and it accelerated during COVID. On/near-shoring, just-in-case supply chain management (versus just-in-time) and resource nationalism are not going away. Nor is increased geopolitical risk. All these factors are implicitly inflationary. As such, we think it will be hard for the Fed to engineer headline inflation below 3-4% in the medium-term (barring a true hard landing recession with an unemployment rate north of 7%, which is not our base case).

The investment implications of these factors dovetail with the major lesson to be learned from SIVB, which was succinctly described by Gillian Tett in the Financial Times this week:

“SVB is not the only example of an institution making a dumb one-way bet that rates would stay indefinitely low; Britain’s pension crisis erupted last Autumn because of similar assumptions. So if anybody is still making that bet now, they urgently need to think – and think seriously – about a world where rates could stay higher for longer than anyone thinks… We cannot assume that any respite in rate rises will last; whatever the herd thinks now.”

We couldn’t agree more. This same thinking has factored into our investment framework since mid-2021, and we believe, now more than ever, it is logical to build portfolios that are highly diversified at the asset class level. This means a mix of super-high-quality companies with robust cash flows and balance sheets; (relatively) high-yielding short-duration fixed income (with tactical duration extensions if we see 10-year Treasury yields back above 4%) as a deflation hedge; commodities and commodity companies as an inflation hedge; and risk-mitigating alternatives as a portfolio diversifier. In the current TARA era (There Are Reasonable Alternatives), such conservative portfolios make more sense than they did in the TINA era (There Is No Alternative) of 2019-21 when VC funds were flush with cash, and SIVB was making their risky bets on low rates continuing forever.