Blain’s Morning Porridge 13th March 2023 – The Fallout from SVB has only just Begun
“There is never only one cockroach”
This morning: Swift Action by the Fed and around the globe has averted a major tech catastrophe, but the Silicon Valley Bank debacle highlights failure and further crisis to come. Hard Hats Stay On!
There are other things going on in the world…
For instance, it was a superb weekend for Rugby – the Scotland vs Ireland match was a classic, although the Scots were outclassed in the second half. Out of deference to my English chums, I shall not mention how humiliatingly their team was overrun and gubbed by the French – who simply looked superb as they inflicted England’s biggest ever home defeat and left England players looking like carthorses headed for the glue factory… Best I say nothing about it….
This morning the only thing markets are watching is the fallout from the Silicon Valley Bank Collapse last week. As 50% of the global tech sector banked with SVB, it became an immediate systemic economic crisis. Around the globe, central bankers and treasuries spent the weekend looking to stem crisis across banking.
Yesterday, the US Treasury, Fed and FDIC stepped in and acted decisively to protect the economy and bulwark the banking system. HSBC has stepped into buy SVB UK for £1. Lines have been extended to other banks in crisis, the Fed Window will give 100% on any collateral, etc etc… This morning, it looks like the market will rally/bounce on their solutions, which effectively involves the mass bailout of uninsured depositors to stop a wave of crippling defaults across the Tech sector.
Critically, failing banks will be allowed to fail – and shareholders and lenders (as opposed to depositors) will be wiped or suffer losses.
From an economic perspective, it’s the right thing to do. From a moral hazard threat, its probably, on balance, still the right thing… although it was foolish of Tech Firms to have allowed themselves to choose a crap bank likely to fail, leaving them struggling with their money trapped in the wreckage. Choose your financial partners carefully.
From the perspective of the mechanics of global banking – SVB highlights there is a hell of a lot of work to be done reconciling how banks are handling rising rates and understanding basic risks. There are massive unaddressed consequences and risks across finance we just aren’t seeing!
It isn’t over yet. My chum Marcus Ashworth, on Bloomberg, makes the point this morning: “there’s never only one cockroach.” (Bberg’s Ashworth and Mark Gilbert are financial writers who justify the usurious costs of the Bberg Business News service!)
The reality, as always apparent with hindsight, is SVB was an accident waiting to happen in plain view – wholly reliant on a single sector rather than on discrete diversified funding sources. It’s now being shown to have been incompetent at the basics of managing banking risk.
There was no choice but for Central Banks to act. Can you imagine what would have happened if Washington remained in a dither and failed to agree a package? This morning Tech firms would be defaulting on rents, deliveries and wages. The market would be writing them off. The steady flow of redundancies and pull backs we’ve seen across the biggest Tech names, would become a raging torrent of defaults and closures. The effects across the economy would be catastrophic.
Looks like we dodged a bullet… well partially at least…
Effectively SVB committed the cardinal banking sin of borrowing short from its tech firm depositors and lending long by investing in long-dated “available-for-sale” Government bonds, and “hold-to-maturity” illiquid corporate bonds. As rates rose, and depositors found they needed money, the bank “discovered” the rise in interest rates had hammered the value of its liquid Treasury portfolio, and to sell its HTM illiquid bonds would trigger such a loss as to make the bank immediately insolvent.
SVB had some $27 bln in its AFS rainy day fund. However, since 2019 its HTM portfolio of illiquids has grown from $14 bln to $100bln!!! If they sold a single bond from it, they would have had to mark the whole portfolio to market – creating, at a rough guess a $30 bln loss. (See below).
When banks die, they die fast. Its liquidity that kills them. All it takes is a mere hint of crisis. Depositors fear the bank doesn’t have the money to repay everyone, and scramble to get their money out before its too later. Any bank trying to fund itself in crisis (as SVB was trying to do) is doomed. So it has proved. Peter Theil of Founders Group warning everyone to get out didn’t help, but its demise was inevitable. (As many comments have noted this morning – its classic Prisoner’s Dilemma: if everyone keeps their head.. no one will lose, but everyone knows the first to break ranks will get out Scot-free!)
Of course, over time, the beauty of bonds is they would have repaid at 100.00, rather than the 70% they might be worth today.* That’s the way bond maths works: if you buy a 10-year 1% bond at 100 when rates are 1%, it will only be worth 69% if rates rise to 5%! Problem is – in crisis you can’t wait for bonds to mature. You can only sell them at what the market is prepared to pay.
(*) Not all credit bonds would have repaid at 100%. If there was a global Tech meltdown you can bet the number of Tech borrowers defaulting would have soared, creating a credit market meltdown, with the consequence of a wider credit crisis and rising long-term defaults as other borrowers found access to bond funding dried up. This banking liquidity crisis could well have become a credit market meltdown as well – like 2008.)
One of my key market mantras is “Fund when you can, not when you need to.”
What we need to understand are the whys and consequences of the SVB collapse. How did it happen, and what will it lead to? The crisis is one myself and many others have long been expecting. We knew that normalised financial conditions would trigger unexpected consequences and probably multiple negative events, but we were, of course, unknowing as to exactly how the axe of normalised interest rates and unwise expectations would fall.
Now we know – but its only one part of the equation.
Leaving long-term unlimited deposit guarantees in place across the banking industry would be a mistake. We may as well nationalise the banks in such a case. Banks need to be incentivised to manage risk and punished when they don’t.
What I’ve always found surprising is a common belief that rising rates are good for banks – rising rates meaning they could extract windfall margin on their lending. That should not happen. Customers should expect their returns to rise in line with rates – and if they don’t they should be free to invest elsewhere – like money market ETFs offering diversified banking exposures (which would have suffered in the event of wider systemic banking crisis..) Limited partners in a credit fund should clearly be treated differently from depositors in a regulated bank.
This crisis is not yet over. On Friday last week I wrote the crux of this crisis is valuations – what things are actually worth. We know:
- The valuations on illiquid HTM bond portfolios are a matter of holding a wet finger to the wind.
- “Valuations” on private debt and equity are largely determined by parties with a vested interest in making them higher, and in reality are only what the next “greater fool” will pay for them.
- Private Equity and Private Debt managers are going to struggle to demonstrate the veracity of their current valuations, meaning they will struggle with margin calls and raising new cash, creating a vicious negative feedback loop on these markets.
- If valuations across markets under pressure are wrong, what makes the market believe current liquid market stocks are right? They are just as susceptible to over-optimism and inflation!
We’ve now seen the consequences of overly easy monetary experimentation trigger yet another banking crisis – yet I’m looking at the other side of the equation: the investment buy side for the real crisis. It’s still to happen… What I do know is financing private assets just got much more difficult… unless you really, really brave!
Finally… they say lightning never strikes twice, but in 2007 Joseph Gentile was the CFO of Lehman Brothers’ global investment bank. Last week he was Chief admin officer of SVB!
Five Things to Read This Morning
Out of time, and back to the day job…
Strategist – Shard Capital