“You don’t find out who’s been swimming naked until the tide goes out” – Warren Buffett, 1994 Annual Meeting
In last month’s blog the key focus was whether the Fed could tighten monetary policy significantly without causing a recession. The question should have been broader – can the Fed tighten policy without anything breaking? The answer is no, as we found out this past week with the failures of several financial institutions, most notably Silicon Valley Bank. Were the failures the Fed’s fault, as our central bank hiked interest rates at the fastest pace in 40 years, and pulled back the extra liquidity it was providing markets? Not necessarily. To paraphrase Warren Buffett, the proverbial tide has gone out, and we are starting to see who is not wearing swimsuits.
Silicon Valley Bank, a technology start-up and venture capital-focused financial institution based in Santa Clara, California, failed over the weekend. It was the 16th largest bank in the US with assets over $200bn prior to its collapse. It provided banking services to half of all venture-backed tech and life sciences companies in the US[1]. Leading up to its demise, the Silicon Valley Bank had invested its significant deposit inflows into longer term bond holdings it believed were safe, including U.S. Treasury securities. However, this created a mismatch between the long-term assets (bond holdings) and short-term liabilities (deposits). As the Fed increased rates rapidly this past year, the bank racked up significant unrealized losses on its bond holdings. FDIC Chairman Martin Gruenberg warned of the trouble brewing in the industry overall in a speech given on March 6th and said that the total unrealized losses on securities held by banks was a staggering $620bn.[2]
Silicon Valley Bank’s unrealized losses essentially eliminated its capital cushion, and if it was forced to sell its holdings, it would be bankrupt – which is what happened. In a last-ditch effort, the bank’s management tried to offload $21bn of holdings for a $1.8bn loss and raise equity funds. This prompted a bank run, as prominent venture capital and investment firms urged their portfolio companies to pull their funds from the bank. On March 9th, clients tried to withdraw $42bn of funds[3], the panic exacerbated by a high level of uninsured deposits (i.e., deposit accounts over the FDIC-insured level of $250,000). The bank collapsed and was shut down by California state regulators and taken over by the FDIC over the weekend. Two other financial institutions, Signature Bank, a New York-based regional bank, and cryptocurrency-focused Silvergate Bank, also failed after facing similar issues. This led to extreme price declines in financial institutions perceived to have similar problems, including large amounts of uninsured deposits, high levels of unrealized losses and/or at risk of a rapid decline in client confidence. Unrelated but also negatively impacting the financial system, Credit Suisse, the large Swiss-domiciled investment bank, reported that it had found a “material weakness” in its financial statements and is struggling to raise capital[4].
Is the financial system at risk broadly? Bank mismanagement and runs aren’t new events, unfortunately, and Silicon Valley Bank won’t be the last collapse. From 2001-2023, 563 banks failed[5]. In this case, the Federal Reserve, the Treasury Department, and the FDIC announced that all of Silicon Valley Bank’s deposits would be guaranteed. As well, the Fed rapidly established a “Bank Term Funding Program”, which allows banks to access loans collateralized by bank assets which have lost value in the short-term but are expected to be held to maturity. Also note that after the Global Financial Crisis, a stringent new regulatory framework was imposed on very large “Too-Big-To-Fail” financial institutions, and as a result large firms including Goldman Sachs and JP Morgan have higher capital and liquidity levels and are seeing deposit inflows from troubled institutions. As in the past, we are likely to have some failures, but a wholesale failure of the financial system is improbable.
Important to consider is how the financial system instability will affect the Fed’s monetary policy approach. The market has begun to hope that a silver lining to the bank failures is that we are unlikely to have rates move much higher in the near-term. While earlier this month the Fed emphasized that it would do what it took to contain inflation, now there is the increased possibility that it may pause or stop rate rises. Concerns about a recession has shifted to worry over the health of banks.
The Fed effectively now has two fights on its hands – a fight to control inflation, which is still trending at 6%, and a fight to maintain order in the financial system. How this plays out over the next few months will be important. Trust and interdependency are the basis of our financial system (reference: Jimmy Stewart as George Bailey to the citizens of Bedford Falls during a bank run in It’s a Wonderful Life). Many companies reached for extra yield in recent years given how low interest rates were, and now may face the consequences of not appropriately assessing risk and return. There was and is value to staying conservative, despite the pervasiveness of “FOMO” (fear of missing out). Sticking to old-fashioned fundamental investing remains the key to building long-term wealth. While these types of markets merit extra vigilance, elevated fear in the market can create attractive investment opportunities.
Remember that deposit accounts are insured by the FDIC up to $250,000. If you have accounts over that amount, it would be worthwhile to add additional accounts so that all of your bank assets are insured.
[1] https://www.ft.com/content/b556badb-8e98-42fa-b88e-6e7e0ca758b8
[2] https://www.fdic.gov/news/speeches/2023/spmar0623.html
[3] https://www.cnbc.com/2023/03/10/silicon-valley-bank-collapse-how-it-happened.html
[4] https://www.cnbc.com/2023/03/15/financial-shares-fall-as-credit-suisse-becomes-latest-crisis-for-the-sector.html
[5] https://www.fdic.gov/bank/historical/bank/
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This communication is for informational purposes only. Investment in securities involves significant risk and has the potential for partial or complete loss of funds invested. Views expressed are as of the date published or sent, based on the information available at that time, and may change based on market or other conditions.