Things you need to know from over the weekend:
- The Federal Reserve (FED) allowed Silicon Valley Bank (SVB) to FAIL while simultaneously rescuing Depositors – This was NOT a bailout nor should it have been.
- Signature Bank (NY) is also shuttered due to Crypto exposure concern – Depositors made whole.
- These events do not effect our client’s deposits as we custody client assets at TD Ameritrade which does not use Regional Banks, like SVB, as part of their FDIC Insured “IDA Program Banks”.
Now with that out of the way, below is our detailed commentary on the events since last Friday encompassing how it happened, the fallout, the response and a potential silver lining.
Who is Silicon Valley Bank? And why did it collapse on Friday (actually it started long ago)
There were some savvy investors/hedge funds that saw the writing on the wall even after SVB bank President Greg Baker told Bloomberg back in May 2021:
“I always tell people I’m confident I’ve got the best bank CEO job in the world, and maybe one of the best CEO jobs out there.”
Confident? Did you have any clue what was going on not only at your bank, but in the financial world? Did you know that the FED was intent of raising rates to combat inflation that was spinning out of control all while congress and the administration was spending money like drunken sailors? Were you aware that the Fed was on course to raise rates at every meeting beginning in January 2022 - taking the terminal rate from 0% to somewhere north of 5%? Were you unaware of the risks of a ‘long duration bond portfolio’ that was anchored to low rates on YOUR customer base? Were you aware that the FED was pushing rates higher and the treasury was issuing new bonds that paid higher rates causing your lower rate bonds to decline in value? Were you aware that you serviced the tech/startup/VC world? Where was your ‘risk management team? Did you have a risk management team? Did you have anyone on your team that lived in 1975 - 1982 that had ANY history and experience with a rising rate environment? Ok soapbox speech is over, for now.
These are only some of the questions that so many people are asking. In January 2023, after SVB announced earnings, one hedge fund manager Raging Capital Ventures, implored investors (and regulators) via Twitter to dig deeper into their earnings statement. Identifying the HTM (Hold to Maturity) accounting ‘trap’ that allows banks to AVOID mark to market losses on bonds that it doesn’t plan to sell. They identified more than $15 Billion dollars of ‘losses’ IF the bank were forced to mark to market or worse yet, have to sell that portfolio. They told the Twittersphere that the bank was ‘functionally underwater’. But alas, no one in a position of control chose to address this concern. Not one regulator in California, no one at the FED and no one at the Treasury paid any attention.
In any event. This was all about the drama that the collapse of SVB had on the banking industry. Really more so on smaller regional banks and the role of regulators and the impact this could have on future FED moves.
I would put the blame squarely on SVB’s lack of risk controls, and the California Dept of Financial Protection and Innovation – DFPI – as they are responsible for protecting consumers and overseeing the operations of state licensed banks…along with a host of other financial institutions in California.
The question now is, can the FED continue to raise rates in light of this recent disaster? (more on our opinion on this below) Last Monday, Fed Fund futures were pricing in a 30% chance of a 50 bp move, by Thursday that percentage chance shot up to almost 80%. This morning, Futures are pricing in a 50% that the FED does nothing next week, no matter what the Consumer Price Index (CPI) and Producer Price Index (PPI) show. And in a nod to ‘deep throat’, Goldman Sachs (GS) tells us that THEY no longer expect the FED to make a move on rates next week. (Remember, GS is one of the mouthpieces that the FED uses to float ideas to the marketplace.)
For those who think this is a ‘bailout’, think again as equity and bondholders got sacrificed, as they should have been. Bank management got thrown out and should face consequences.
It was the depositors that got saved from bank and state regulatory FAILURE and gives confidence in the U.S. banking system overall. A bailout is defined as ‘giving financial assistance to a failing BUSINESS OR ECONOMY to save it from collapse’. We did not SAVE the business. Again, we allowed the 17th largest US bank to FAIL. We rescued depositors (rightfully so) and gave credibility to the US banking system. Period.
Remember, there is nothing wrong with a bond portfolio on the face of it, there is only something wrong if it is inappropriate for the bank (which this was) and IF you are forced to SELL it (which they were) at a deep discount. This is why we at CFS have been OUT of these types of long duration bonds since early 2021 for our clients. This was bad for SVB but good for the buyer because those bonds will mature and pay back 100% of the principal and thus there is zero risk of loss or default.
In my mind, this was created by a hysteria of a handful of Venture Capital firms that encouraged a run on the bank, and a run on the US banking system, coupled with poor long term judgment on behalf of global risk management at the bank. And btw, those same Venture Capital firms are at it again, targeting First Republic Bank, shockingly another San Francisco bank (see the pattern here?).
Remember, the loss is NOT realized if they can hold the portfolio to maturity then there is no issue. SVB found itself in the position of not being able to do that, thus the complete collapse.
In the short term, prepare yourself for more volatility, which shouldn’t come as a surprise to our readers, as we have been predicting that for a few weeks now. Also, recall that all the big banks announced massive increases in loan loss reserves this quarter as they warned us about the coming storm this past earnings season. In the end, none of this should surprise anyone as the Fed was intent on breaking something and break it they did.
Potential Silver Lining? A CFS Call
Now many are asking if the FED will take the SVB disaster into account before raising rates again. Early last week, I would have said don’t be ridiculous. The SVB issue is specific to SVB and while the ripple effects could be significant for some this is NOT a Bear Stearns or Lehman Brothers moment at all. But after the weekend drama I do think they have to reconsider that move. While this is not by any stretch a global financial crisis, a la 2007 – 2009, I do think the markets have to digest it and figure it out.
With that being said, I feel pretty confident in making this call and as our readers know we don’t make “calls” very often. In our opinion, we have seen the top for 2-year Treasury yields. It’s not going any higher than it’s been because there’s no reason for it to. Even though we at CFS have been saying that since late 2022 there is real tangible proof due to the SVB fallout. Financial conditions are now contracting hard, due in part to the events of last week, but also because monetary policy operates on a lag. Remember, the first Fed Funds hike of the cycle took place in March 2022, exactly a year ago.
If you want to fight inflation, one sure way to do it would be a full-blown panic in the financial system and a synchronized mass-failure of small regional banks from coast to coast. Probably not going to have to worry about the price of gym memberships and Porsche leases in that environment. Is this the Fed’s plan? I don’t think so. I’m fairly confident we’ve seen the end of the hiking cycle. The upcoming March meeting could be a small hike or no hike. Remember that every hike pushes the bond losses on banks’ balance sheets even deeper into the red. You would not, as a regulator, continue inflicting these losses while simultaneously sitting in meetings about rescues and resolutions.
They’re not going to hike rates and rescue banks simultaneously, are they? Because that would be pretty dumb, even for the Fed.
As explained above, SVB’s failure is not a federal regulation story, SVB blew up with 10-year Treasurys on their books. It’s a story of what happens when the central bank blows a decade-long bubble in venture-backed startups culminating in the crypto-SPAC free-for-all of 2021. Then you try to reverse it all within a single calendar year with five hundred basis points of consecutive rate hikes. Remember, we have railed against this for a year.
The biggest beneficiaries of zero-percent interest rates were tech founders and the bankers who loved them, Silicon Valley Bank being the epicenter of the whole thing. When rates began to rise and the Initial Public Offering (IPO) spigot began to close, the failure was underway. It took two years for the lack of deposits and burgeoning bond losses to weaken the bank and then a single 24 hours in which $42 billion was withdrawn in the first-ever Twitter-inspired, mobile-app enabled digital bank run.
During the Savings & Loan Crisis of the 1980’s, people had to physically show up to a branch to pull their deposits. Now you can do it by phone, from your bed, your bath or your beyond. This is a new risk nobody was ready for.
Anyway, want to see it repeated at another two or three hundred banks this spring? Keep hiking rates. I don’t think they will.
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*These independent view and opinions are those of Daniel Milan, JD and are not necessarily the opinions of CoreCap Investments and/or CoreCap Advisors.
*Consumer Price Index (CPI): a consumer price index is a price index that is the weighted average market basked of consumer goods and services purchased by households. Changes in measured CPI track changes in prices over time.
*Producer Price Index (PPI): is a price index that measures the average changes in prices received by domestic producers for their output.
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