Month: March 2023

The 2023 Banking Crisis: A Wake-Up Call

The 2023 Banking Crisis: A Wake-Up Call

Dear friends,
The first quarter of 2023 was eventful, baffling and utterly predictable all at the same time. As with all manias, the bubble in crypto currencies finally burst last year and financial markets are seeing the repercussions. Unsurprisingly, the retrenchment in crypto currency prices exposed weaknesses and fraud. Crypto exchanges, service providers and investment funds have failed. Celebrities and others who promoted crypto-currency investments are being sued by investors who have suffered heavy losses. Regulators, who had previously seemed content to let crypto participants “innovate”, have suddenly discovered the virtues of regulation and enforcement, ostensibly their reason for existence.
The rot was deep enough to have impacted the ordinarily staid world of regional banking. Two regional banks associated with technology and crypto finance, Silicon Valley Bank and Signature Bank, found themselves the hapless targets of bank runs. The runs were a result of several factors: high risk lending practices, a large proportion of uninsured deposits relative to other banks, a balance sheet overexposed to long duration bonds and a savvy customer base that were quick to withdraw funds when rumors of potential failure spread. The FDIC placed both banks into receivership, and remarkably, extended deposit protection to all deposits, retroactively erasing the $250k limit on deposit insurance. This extreme step was taken to stem the flood of deposits fleeing regional banks, headed directly for accounts in banks believed to be Too Big To Fail.
The speed with which these banks failed was breathtaking and caught most depositors, investors, regulators and ratings agencies by surprise. On Wednesday March 8th, SVB announced it had sold $21 billion in long-dated bonds at a $1.8 billion loss to raise cash to meet depositor withdrawal requests. SVB also announced they would raise $1.75 billion in capital via common and preferred stock sales. By Friday March 10th, just two days later, the FDIC had taken over the bank and placed it into receivership. The stock never traded that day and was frozen at $106.04 per share, the price it had closed on Thursday. That day, the ratings agencies S&P and Moody’s, presumably blindsided by the collapse, promptly lowered their credit ratings for SVB from investment grade BBB and Baa1 to D and C (respectively). By Sunday March 12th, Signature Bank suffered the same fate as the FDIC placed the bank into receivership with the stock frozen at $70 per share. Moody’s and Fitch responded by lowering their ratings from Baa2 and BBB+ to D and C (respectively). In most cases, when a bank is at risk of failure, the market sniffs it out and there is time (weeks and in some cases months) for investors to position themselves appropriately. In this case, the failure was so swift the market and investors were largely unprepared (as evidenced by the levels the stocks were last trading at).
The banking crisis wasn’t limited to the US alone. Over in Europe, on March 19th one of the world’s most storied banks, Credit Suisse, was ignominiously sold to its chief competitor UBS in a weekend deal enforced by the Swiss government. This action broke all sorts of convention, shaking up the markets again.
Though we understand the reasons for some of the extraordinary steps undertaken by regulators and authorities, we do wonder whether some of this might not have been avoided. As anyone who has watched the classic “It’s a Wonderful Life” knows, no bank can survive a crisis of confidence. Once fleeing depositors reach a tipping point, a bank is no longer a going concern. Deposit insurance was designed to reduce the likelihood of runs and protect smaller
depositors who might lack information on the health of their bank and would be at a disadvantage to more sophisticated depositors. In SVB’s case, the bank’s business model had two Achilles heels. First, it relied on large depositors (tech startups and tech entrepreneurs), whose accounts were not covered fully by FDIC insurance. SVB also held a portfolio of long dated treasuries, which lost substantial value due to rising interest rates. Banks are allowed to carry loans and bonds at par on their books if they intend to hold them to maturity. Once the run started, SVB was forced to liquidate some of these bonds to meet withdrawal requests causing it to recognize the losses. This was the death knell, with the bank run accelerating as soon as SVB’s large depositors became aware of this dynamic.
On March 12th, in an effort to stabilize the banking system, the Fed took the unprecedented step of creating a new liquidity facility called the Bank Term Funding Program (BTFP) which allows banks to pledge longer dated treasuries for immediate liquidity at par. The hope is this facility should help prevent similar bank runs from occurring. In the subsequent weeks of this facility’s establishment, there have been no further failures in the US and the banking sector has shown signs of stabilizing. That said, while the cause of these bank failures is very different, we are reminded of the early days of the Great Financial Crisis when the prevailing wisdom was that the failure of a few smaller, over-leveraged financial institutions was an isolated incident that would not cause wider financial contagion. We’re not predicting a repeat of the 2008 cataclysms. However, ten years of zero interest rate policy has indulged a great deal of speculation in various markets, and we believe vigilance remains the prudent route.
Despite the current turmoil, markets have been remarkably resilient with both stocks and bonds posting positive returns for the first quarter. Large cap technology stocks, which took a beating last year, have rebounded and were the equity safe haven of choice for investors fleeing bank stocks in March. We’ve also seen both gold and silver perform well, which is to be expected when there is a crisis of confidence in the banking sector. Short term rates have crept higher as the Fed continues its ongoing battle to stop inflation before it becomes entrenched. This has created a great opportunity for cash investors as yields on short term CDs, treasury bills and money market funds approach, and in some cases eclipse, 5%. These are yields investors have not seen in over 15 years.
While 2022 saw a major correction in risk assets (with speculative assets taking the greatest hit), we don’t believe the asset bubble has fully deflated. We expect 2023 to be volatile as the Fed continues to grapple with inflation and maintain our preference for quality assets – highly rated bonds and equities with strong balance sheets in defensive sectors. With volatility comes oversold conditions and buying opportunities which we will look to take advantage of.
Please let us know if you’d like to discuss any of the above in more detail.
Best,
Louis and Subir

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