Coming into this week the thinking was that today’s payrolls report would be the big event for the week. Ahh, but Mr. Market had other ideas. How about a Fed Chairman banging the drum for larger rate hikes followed by the second largest bank failure in U.S. history?
Yea, that will keep people on their toes!!
The week started with Fed Chairman Powell testifying in front of Congress. There was a lot of talk and some very strange questions, but basically Powell noted the following:
- The economy seems to be doing pretty well.
- Inflation isn’t moderating as much as the Fed thought it would.
- They might hike rates by more than the market is pricing in at the moment.
This was taken to mean a possible half-point rate hike on March 22nd, not the quarter-point most people were thinking was on tap. The chart below shows the odds assigned to both a quarter-point and a half-point hike at the March meeting. A month ago, the odds of a 50bps hike was exactly 0%. After Powell spoke the odds spiked to close to 70%.
Other sectors of the bond market reacted similarly. Bond yields spiked higher across the curve, and it was notable that 2-year yields surpassed 5% for the first time since 2007.
Friday’s payroll’s report was pretty solid and added to the idea that the economy isn’t slowing down much at all. Job growth in February ran ahead of expectations with a gain of +311K. The good news from an inflation standpoint, though, is that average hourly earnings growth grew at the lowest rate in a year.
Normally, the payrolls report would be the main event. But it was really just a side-show.
Smells Like Orange Country Circa 1994
Bank runs have been around ever since…..well, ever since banks were created. Remember this?
The whole premise of the story is based on a good old-fashioned run on the bank. Depositors clamoring for their money back, the vault is empty….cue sappy Christmas movie.
Enter Silicon Valley Bank (SVB) stage left. Founded in 1982, the Palo Alto based bank’s main strategy was collecting deposits from businesses financed through venture capital and also financing the same venture capital industry. The bank is big – at the end of 2021 they held assets of over $200bn and employed 8500 people. It was the 16th largest bank in the U.S.
Usually banking problems start because the loan book runs into trouble – think the bad loans from the housing bubble or the bust in commercial real estate back in the 1980s. But SVB’s problems are much simpler.
It’s no secret that the world of tech start ups and VC funding has been struggling the last couple years. Capital is becoming scarce, profitless (and even profitable) tech companies are laying people off and downsizing, and VC’s are growing very reluctant to fund speculative new startups.
How does this impact SVB? Well, much of their deposit base comes from just this sector of the economy. Not great.
This industry specific characteristic is also being compounded by the fact that the banking industry in general has been experiencing an outflow of deposits the last couple quarters. Why keep your money at the bank earning less than 1% when money market funds are paying over 4%?
In normal times a bank would liquidate assets to meet outflows. The easiest thing to sell would be the investment portfolio made up of government and mortgage bonds. But these aren’t normal times for bond portfolios. We are all too aware of the large losses in the fixed income markets last year. The chart below shows the unrealized losses sitting on U.S. bank balance sheets – roughly $600bn.
Now normally this wouldn’t be a problem for a couple of reasons. Many banks have hedged this risk and have gains on their hedges to offset the bond losses (the gain on the hedge isn’t shown in the chart above). And, secondly, most banks aren’t seeing a massive outflow of deposits that makes them a forced seller in a weak market.
But SVB proved to be special – they either haven’t hedged or their hedges haven’t worked, and, as noted before, their specific market niche is going through unusual problems. To quote an ST piece a couple weeks ago:
‘At the peak of the tech investing boom in 2021, customer deposits surged from $102bn to $189bn, leaving the bank awash in “excess liquidity”. At the time, the bank piled much of its customer deposits into long-dated mortgage-backed securities issued by US government agencies, effectively locking away half of its assets for the next decade in safe investments that earn, by today’s standards, little income.’
The negative feedback loop is pretty simple. Deposits leave…..the bank has to sell government and mortgage bonds at a loss…..this loss hits the capital of the bank…..analysts, investors, and depositors start to worry about how much capital the bank really has if all the bonds are marked to market…..more deposits leave….more asset sales. Rinse and repeat.
The wheels on the SVB story came off pretty quick. As you can see below, the stock has been weak for some time, but lost -60% of its value on Thursday of this week.
SVB tried to raise new capital on Thursday, but the plans fell through overnight, and the FDIC stepped in and took the bank into receivership on Friday. SVB’s failure will go down as the second largest bank failure in U.S. history.
We are going to learn a lot more over the next few days. Over the immediate term, it will be telling if the FDIC finds a buyer for the bank over the weekend or is forced to liquidate the institution. You would think a well-funded bank will be interested in picking up SVB for pennies on the dollar. But if no buyer shows up, or if the price is unusually low….that will tell us something.
Beyond that, the general consensus on the situation is as follows:
- This is a big bank failure, but at the moment it’s not systemic in the way Washington Mutual was.
- SVB’s failure appears to be much more related to the structure of this specific bank’s deposit base and securities portfolio more than anything else.
- SVB’s decision to fund a long duration fixed income portfolio at sub 2% yields with flighty deposits from a particularly volatile business sector (startups) is pretty unique.
- For example, 95% of SVB’s deposit base is uninsured versus 40% for banks of a similar size. These depositors should (and did) flee the bank at the first hint of trouble.
- Additionally, for all the talk about losses in bank bond portfolios, most well-run banks have hedged their interest rate risk. SVB either didn’t hedge or didn’t do it very well.
- Most banks will be fine, especially those with a well-established retail deposit base (think Chase, Wells, etc.). The stocks for both companies were actually up on Friday.
- Finally, this feels much more like the Orange County bankruptcy back in 1994 than it does the systemic banking crisis of 2008.
Time will tell which of these views proves to be accurate or not.
Oh, one other thing. Remember all the talk about a half-point Fed hike in a couple weeks that we referenced earlier? Now the market isn’t so sure. Odds now favor just a quarter-point move.
Odds could even favor no hike at all in two weeks if we see another few days of stress in the banking system. How quickly perceptions change!!
(Other) Charts We Found Interesting
- The magazine cover indicator strikes again. Forbes ranked SVB as one of the best banks in the U.S. just four days ago.
- Regardless of which way you look at it, yield curve inversions have typically preceded recessions.
- Used car prices actually increased in February. This wasn’t expected.
- The money supply continues to contract.
- How much are you being compensated for buying investment grade corporate bonds versus just buying a six-month T-Bill? Not much.
- Another way of saying that the top market cap companies are still richly valued.
- It’s easy to forget how recent the phenomena of ubiquitous AC has become in many areas.
Have a good weekend
Charles Blankley
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