A minor earthquake hit the financial system late last week, with the bankruptcy and seizure of Silicon Valley Bank (SVB) and Signature Bank (SBNY). We expect this to reverberate throughout the financial system and lead to aftershocks. Fortunately, this is far from a “big one.” While we expect more fallout, we do not think this will spiral into a financial crisis on the order of the global financial crisis (GFC) or other similar events. From an investment perspective, this rumble on the financial faultline has brought returns back to about unchanged on the year, having started the year with a strong rally (one that was somewhat inexplicable to us).
Silicon Valley Bank and a Backup:
The issue at hand for SVB was idiosyncratic due to the nature of its business. The bank’s deposit base was declining given its depositors are skewed to venture capital-backed start-up companies that have been under pressure in recent months. To meet redemptions, the bank was forced to sell government-guaranteed bonds (inherently safe) that had lost significant value as a result of Fed-induced rapidly higher interest rates (extremely rare in speed). This stratospheric rise in rates was bound to eventually break something, and this seems the first fracture. Stockholder value is normally the first line of exposure in business failures, and that has now been wiped out for shareholders in SVB and a couple of others. The outcomes for those who bank there seemed potentially catastrophic (and who knows, maybe could have been), but with the FDIC now in the picture, depositors both under and over FDIC limits should get 100% of their deposits back.
The broader banking system, we believe, is on a sturdy foundation. Recall that during the global financial crisis, AAA-rated structured products ended up being worth pennies on the dollar. This is not the case today. SVB bonds lost value because interest rates rose, not because they were poor credits. The largest banks have much more stringent/conservative accounting treatments than what was used at SVB and may ultimately be beneficiaries, as they are viewed as “safer/safe.”
We do not expect this to lead to a systemic banking crisis, but we would expect financial conditions to tighten further as bank behavior will change. We believe the Bank Term Funding Program announced by the Federal Reserve on March 12 should help prevent further contagion in the system. This program allows banks to borrow against Treasury and mortgage holdings at par. This is important, as it provides liquidity to meet deposit outflows but also prevents banks from having to realize losses on Treasury/MBS exposure, which in turn avoids impairment on their respective solvency measures.
Further, we do not think that depositors will flee the banking system en masse. Given the inverted yield curve, short-term interest rates offer the best value in financial markets. Overall, we believe post-GFC regulations have prepared the financial sector to be more resilient during challenging financial market conditions.
Equity market impact:
In the broader equity market, we expect tighter financial conditions combined with surprise financial bankruptcies like SVB will give markets a reason to pause. These events and the aftershocks could also influence the Fed to slow tightening. This too would take some pressure off of both borrowers and lenders. What’s been the surprise of this Fed tightening cycle is that more damage hasn’t been done. While growth stocks have seemingly been hit hard and crypto suffered worse, there’s been tremendous resilience in the overall economy and employment markets. In every tightening cycle dating back to the early 1990s, there have been minor or major crises: Orange County bankruptcy in 1994, Asian currency crisis in 1997, Long-Term Capital Management crisis in 1998, and the GFC starting in 2007. While the road may be rocky, unlike when those events happened, corporate and personal savings accounts remain well-funded, and employment remains strong.
In summary, the quake in Silicon Valley has been a disruptor and an eye-opener, but we do not believe is the "big one" that might launch markets off the precipice. While as advisors we are not running for cover, we do remain cautious in our allocations in respect of stubbornly high inflation and a slowing economy. Volatility in markets will remain high, and a modest market pullback is very possible, but we do not believe a calamity is in the making.
We hope this helps provide a bit of clarity to all the headlines. Please be in touch with James or me if you feel we can be of further guidance.