UPDATE ON THE US FINANCIAL SYSTEM
Investors Should Overcome The Fear of Failure
As you have no doubt heard by now, the U.S. financial system has seen several bank failures over the past week, including its second-largest ever with the failure of Silicon Valley Bank (SVB), which was taken over by regulators this past Friday. This followed the announcement middle of last week of the wind-down of Silvergate Bank and, in turn, has since been followed by the weekend takeover of Signature Bank by state regulators.
Such events are both unnerving and, thankfully, unusual, particularly given the relatively robust framework put in place post-2008 to attempt to prevent banks from being able to put themselves into such positions in the first place. So, does the past week imply that there are some chinks in the armor? Well, as we will explore herein, the business models employed by the above institutions were subject to certain significant idiosyncratic risks that ultimately left them more vulnerable to liquidity and solvency risks. As a result, although the market does not yet appear to have been completely reassured, we do not currently see the sort of conditions that would be likely to precipitate a crisis within the broader financial system. Meanwhile, for those areas where issues do exist, the broad policy response out of the Fed, Treasury, and FDIC should be more than sufficient to backstop the institutions affected and prevent any contagion from spilling into the broader banking and financial systems.
Sometimes The Old Ways Are Best
Even a preliminary post-mortem on the failed institutions would reveal the presence of potentially dangerous substances in their system at levels not previously tested within the banking sector. In the case of both Silvergate and Signature, both companies had built a heavy reliance on cryptocurrency companies, a space that was brutally battered over the past year by unexpected volatility, large declines in cryptocurrency values, and the spectacular collapse of cryptocurrency exchange FTX. Silicon Valley Bank, meanwhile, was found to have a toxic level of concentration within the tech startup space: boasting that over half of all US startup ventures were among its clients, the bank found itself with a much less diversified – and, critically, less sticky – deposit base. As the Federal Reserve has raised interest rates dramatically over the past year or so, the days of “free money” came to an abrupt end and, with that, venture financing became more difficult to obtain, leading more such startups to begin drawing down their bank deposits.
This effectively led to a drawdown on SVB’s deposits sizable enough to require the bank to liquidate securities to meet redemptions. As a bank, such securities consisted of very high quality bonds – typically US Treasury or Agency securities; while such bonds are considered free of any default risk, they do carry duration risk – aka interest rate risk – and this is where the Fed’s monetary tightening campaign has once again played a pivotal role: as interest rates have risen sharply, the value of the bonds held by banks has declined – at least on paper! So long as a bank is carrying such a bond on its books with the intention of holding it to maturity, it does not need to recognize such paper losses. In the case of SVB, however, the need for quick liquidity forced it to sell some of these bonds, thus realizing the losses. As news of the losses spread and the company announced its intention to raise additional capital to shore up its finances, depositors became increasingly concerned and began yanking deposits – particularly since many of them had well in excess of the FDIC-insured limit – creating a good old-fashioned bank run in the process.
In a more traditional banking framework, a much larger piece of a bank’s deposit base is made up of retail customers, leaving the banks catering to such clients – i.e., most US banks – significantly less exposed to the dynamics affecting any single segment of the economy or financial system. In addition, such retail deposits tend to be relatively slow moving, providing relative stability to the bank’s source of funds. Further, within the traditional banking model, a bank’s use of funds will typically be dominated by loans; in the case of SVB, however, which saw its level of deposits mushroom during the venture capital funding boom of the past several years, an unusually large percentage of deposits was used to purchase fixed income securities – the bank simply did not have the capacity to make loans fast enough to absorb its incoming deposits. As a result, it loaded up on bonds in an ultra-low interest rate environment, leaving it even more exposed to the beating the bond market would begin to experience once rate hikes began last year; as deposits began to flow out and its ability to hold those bonds to maturity – as it had intended – evaporated, the need to realize what were now significant paper losses on those positions suddenly became a reality.
If Something’s Worth Doing, It’s Worth Overdoing
That’s Jay Powell’s personal mantra, I believe. Let’s face it: from being late to every party it has ever been invited to, to invariably stealing the punchbowl whenever it leaves, the Fed has worked hard to earn a reputation for spoiling everyone’s fun by overdoing whatever it undertakes. Equity market volatility, asset bubbles, bond market losses, and more than its fair share of recessions have all come out of a Fed that often seems slow to react and then heavy-handed as it attempts to catch up. It is often said that this approach leads the Fed to “keep going until something breaks” and many have come to believe that the current turmoil within the regional bank space is that something. This has literally transformed the market’s monetary policy expectations overnight. Investors had taken Powell’s recent hawkish comments as a sign the Fed would make a grab at a +0.5% hike at its March meeting next week on top of expectations for an additional 50bps – 75bps in hikes over the next several meetings through mid-2023; as of the market close on Monday, however, that outlook has been decimated, with the market looking for only a single quarter-point hike in March and then…nothing! No more hikes, merely cuts beginning in June and proceeding at a fairly healthy clip through year-end. Of course, this will likely prove overly optimistic if markets stabilize and banking system concerns recede. Nonetheless, it does highlight the widespread belief that the Fed has taken things about as far as it can for the time being, requiring it to temporarily deprioritize its battle against inflation in order to avoid disrupting the financial system and tread quite a bit more lightly going forward than had previously been expected.
Worrying Works: Nothing I Worry About Ever Happens!
If you’ve been watching the prices of regional bank stocks this week, then you know the market is worried…which seems unusual, frankly, in light of the federal regulator bazooka that was brought to bear late Sunday. Having deemed the failing banks systemic risks, all deposits – not just those within the FDIC limit – are being guaranteed. In addition, the Federal Reserve has set up an additional short-term liquidity window for banks at which they can borrow on their fixed income assets at par value regardless of the current market value, thus saving them from having to incur losses by selling the bonds outright. In theory, that should have been the end of that! A broad cross section of regional bank stocks took it on the chin Monday, however, and while expectations for peaking profits and tighter margins for banks as a result of the current fallout may be contributing to this, that excuse seems a little “light” to explain the degree of volatility being observed.
As a result, it’s likely that the market is taking a wait & see approach, remaining wary until it’s made clear that the danger of contagion has truly passed. Never ones to assume that there are no shoes left to drop, we would nonetheless be surprised by the emergence of any kind of major upset at this stage, particularly one that could not be contained by the above policy responses.
In the meantime, we continue to believe the broad financial system as a whole remains solid and unlikely to be impaired by the sort of issues that have plagued the recently-failed institutions discussed above. Most major financial institutions are extremely well-capitalized and are considerably more tightly regulated than they were prior to the Great Financial Crisis. Meanwhile, beyond the extraordinary measures brought about by policy makers and regulators in recent days, there are a wide array of protective measures in place, both public and private, to stand behind the value and safety of your investments, such as FDIC protection on bank deposits (which, in theory at least, may not be capped at its mandated $250,000 limit per investor, at least temporarily) or the SIPC protection that stands behind the cash and securities values of investors’ holdings at brokerage firms. Notably, the custodians employed by Pacific Portfolio carry significant supplemental coverage to provide incremental protection for your investments in the event that the government-funded programs are not sufficient.
We encourage you to contact your advisor should you wish to discuss in more detail the safeguards in place around your investment portfolio; please also feel free to reach out to our CEO, Larry Hood, or Jim Ayres, our firm’s Chief Investment Officer, with any questions or concerns you may have with regard to the safety of your investments, as well as the market or economy.
