Honey, is this a nudist beach?
By Martyn Page, Investment Director, Worldwide Financial Planning
April 134, 2023
IT’S 30 years since Warren Buffett first warned ‘It's only when the tide goes out that you learn who's been swimming naked.’ He was talking about how hurricane reinsurers were happy to accept money for underwriting catastrophic risks they thought would never happen. Until they did.
So, it’s no wonder that following the recent failure of not one, not two but three quirky US banks, investors currently fear they have inadvertently wandered onto a nudist beach. Are these three banks simply the first three dominoes to topple? Maybe. And, if so, is it the start of a major financial crisis, like the burst property bubble and credit crunch of 2008? That seems much less likely. Nevertheless, everyone has been taken aback by the sheer speed at which it happened.
The first two banks closed because of their sizeable exposure to crypto currencies. No surprise there. Those closures may have been symptomatic of the financial strains induced by the rapid increase in interest rates, but they did not constitute a systemic threat.
However, it was collapse of California’s Silicon Valley Bank (SVB), the second-largest banking failure in US history, that caught people’s attention. This was the first bank run of the Twitter age with repercussions exacerbated by the tangentially related run on and forced rescue of Credit Suisse, Switzerland’s second largest bank. Rather than a bank for crypto, SVB was a bank for startups. In the days following its collapse, the shares of mainstream banks and dull insurance companies around the world fell by 5-10 per cent or more. Why? Because fear of contagion is contagious.
Some US regional banks fell by 50 per cent as a nervous market ditched shares in anything that looked like it might be the next vulnerable bank to explode, ie, anyone whose customers and assets looked similar to SVB. Were seasoned investors panicking? Yes, they were panicking. So were American depositors. Big banks like Citigroup and JPMorgan Chase were swamped with requests from people seeking to move their money away from small regional banks.
The US central bank was quick to set up a blood drip (credit lines) to all banks to ensure they remained adequately capitalised if deposit withdrawals were to further speed up. After a few nervous days, this halted the outflows of deposits, much of which ended up in money market funds. Unlike banks, money market funds do not have $250,000 depositor insurance because they can’t go bust in the same way as banks can. But they do offer interest rates of around 4 per cent - much more than the measly 0.4 per cent paid by many regional banks.
In reality, the collapse of SVB was more like an old-fashioned Keystone Kops run on a bank triggered by a bunch of venture capital finance director lemmings all frantically swapping texts about whether to move their money elsewhere. Depositors wanted all their money back and SVB didn’t have enough assets to repay them. That’s because unlike proper banks, which are highly regulated and frequently stress tested, SVB had not insulated its lending from the asset-depleting effect of the Fed’s rising interest rate policy. Not entirely coincidentally, SVB had no chief risk officer from April to December 2022.
But SVB was no regular bank. Nor was it regulated like one. SVB mostly had one type of customer (a finance director) working for one type of business (a startup) parking one type of deposit (the venture capital needed to fund the business). Rather than generate cash, startups burn it. That makes it difficult to borrow money. SVB was different. It was prepared to lend money provided the startups put their venture capital in its deposit account. SVB then put this money into long-dated government bonds. US accounting rules stated that if these were held to maturity then all was well. But selling them before maturity, when prices were down, would hit the bank’s capital buffers hard. And that’s what happened. When SVB tried to raise fresh capital (by issuing more shares) more depositors fled – all at once. It was game over.
People said that regional regulators in California needed to have better oversight. And they were right. One member of the Federal Reserve Bank of San Francisco board of directors was also the chief executive of SVB. Don’t worry, he isn’t now. But during his time on the board, he had pushed for a relaxation of stress tests on regional banks – including SVB.
The US has a two-tier system for regulating banks. The giants are required to be strongly capitalised and are subject to severe stress tests to check this. However, the US has dozens of smaller, regional banks whose regulation is much less strict. That’s because, individually, none is regarded as posing a systemic risk to the financial system. Thanks to the ability of social media to spread fear faster than a Californian wildfire, we now know that’s no longer strictly true.
Following the 2008 banking crisis, US regulators encouraged banks to hold government bonds as these were regarded as highly liquid assets that could not go bust and were therefore safe. However, quite amazingly, the banks’ annual stress tests did not incorporate scenarios where US interest rates rose to much higher levels. Which is what has happened.
As you know, Fed Chairman Jay Powell has been relentlessly raising US interest rates without pausing to see what side effects these actions might have – or Operation Stable Door as it is unofficially but accurately known. One major effect is that when interest rates rise, the yields on bonds rise with them – which means the capital values of the bonds fall. The maths is such that the longer-dated the bonds, the sharper is the decline in bond prices when interest rates are rising.
When the Fed raised interest rates sharply the capital value of US government bonds fell. Nothing particularly unusual there. However, the Fed was no innocent bystander. It had blood on its hands. That’s because many banks had been acting rationally in holding the longer-dated government bonds that the regulators had urged them to do. They were acting rationally because, at the time when they bought these bonds, the Fed had told everyone that rising inflation was ‘transitory’ and that interest rates were therefore likely remain at low levels.
Furthermore, because of Covid-19, the US government made widespread stimulus payments directly into people’s bank accounts. Where the cash was saved, just about every bank was obliged to buy more long-dated government bonds. Then, when inflation suddenly didn’t look quite so ‘transitory’ the Fed rapidly increased interest rates and many of those bonds held widely by banks soon sat on their balance sheets as unrealised losses. This means that US banks will now be a lot more reluctant to lend.
So far, the contagion has been contained. But it would be wise to assume there will be after-shocks as businesses which have enjoyed cheap loans progressively discover that rising interest rates make it more expensive for them to renew those loans.
Remember, a lot of these banks are regional banks and their customers are small and medium-sized businesses. Businesses who employ a lot of people. They fund their lending with deposits and a lot of those deposits have fled to megabanks and money market funds. Thus, the rapid collapse of an atypical Californian bank looks like the mechanism whereby the US economy could be about to suffer a widespread credit squeeze. The recession that the US bond market has been signalling for months, might start here.
The stockmarket is responding to this. The collapse of SVB saw indiscriminate fear-driven selling of bank shares. As the fear of contagion decreased, bank share prices crept back up. But they have not returned to previous levels because less lending alongside the need to offer higher deposit rates to attract people back likely means lower profits. We can also be sure that US regional banks will see stricter regulation in due course. That means smaller players will be taken over and lending will become tighter.
We can expect these events to bring the timing of the peak of US interest rates much nearer. Where does this leave investors? Right now, we have three conflicting views. The US bond market that says interest rates will be cut soon to cope with a recession. However, the US equity market is currently ignoring this and thinks that company profits will do well enough – and if they don’t then rate cuts ought to support share prices. And finally, we have the head of the US central bank still chanting that interest rates may need to be higher for longer. They can’t all be right.
Conventional wisdom says that central banks keep raising interest rates until something breaks. In this case it was the collapse of Silicon Valley Bank and the forced rescue of a major, though ailing Swiss investment bank. Are we then on a nudist beach? No, but the lifeguard who hoisted the green flag has been removing people’s dry clothes while they bathed in apparent safety.
Martyn Page is the Investment Director of Worldwide Financial Planning which is authorised and regulated by the Financial Conduct Authority.
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