Implications of Silicon Valley Bank Failure

Silicon Valley Bank (SVB), one the country’s 20 largest banks as of early March, experienced a classic run on the bank, where depositors attempted significant withdrawals that resulted in the Federal Deposit Insurance Corporation (FDIC) shuttering it and taking it over on Friday, March 10.

Concerns about liquidity and solvency were first signaled by management earlier in the week when they announced they were contemplating a dilutive equity issuance to access more capital. This catalyzed a loss of faith among depositors that was exacerbated by the unique interrelatedness of the bank’s client base, which consisted primarily of major venture capital (VC) and private equity (PE) firms and the technology startups in their portfolios.

In the current environment, SVB was uniquely vulnerable:

• Depositors, mostly tech and biotech/health care firms, were not well diversified. Other regional banks typically have more diversification by industry and between individual and corporate clients.
• Their account balances mostly represented operating cash and thus were in continual drawdown mode, with cash burns accelerating as capital markets closed and interest rates rose.
• Only 7% of accounts were fully insured by the FDIC, i.e., below the $250,000 threshold.
• Unlike most banks, which use deposits to extend high-quality loans and issue mortgages, SVB collateralized deposits differently. It disproportionately owned US Treasuries and mortgage-backed securities (MBS), which declined in value when the Federal Reserve raised rates.

By Sunday night, March 12, the FDIC agreed to guarantee 100% of all depositor funds, including previously uninsured deposits—supporting jobs, payrolls and the continuity of these companies as going concerns.

The Fed, for its part, issued a new loan program: the Bank Term Funding Program (BTFP). It allows banks and other depository institutions to pledge US Treasuries, agency MBS and other qualifying assets at par value in exchange for loans with maturities of up to one year. This liquidity source essentially eliminates the need for banks to sell high-quality securities at a loss to meet deposit withdrawal shortfalls. This program represents a major effort toward preventing contagion to other banks.

Regulators at the Fed have also had to admit that oversight of SVB was likely lighter than it previously was and less than ideal due to the 2018 rollback of Dodd-Frank rules—an issue that will likely get revisited by Congress.

The financial services sector was pounded, with many regional bank exchange-traded funds (ETFs) and broader bank ETFs down 15%-30% in the last three days. Equity and preferred shares of financial services companies have declined disproportionately relative to other sectors. Embedded in the market action are investor fears of contagion and concerns over a flatter yield curve, lower net interest margins and higher deposit costs. Investors are also worried about capital flight to the largest and best capitalized banks, lower loan growth and potential asset impairments.

For the most part, we do not consider these fears to be well-founded, and we believe most banks are prepared to weather a recession if one comes. The issue is very different than it was in 2008, when solvency concerns arose given lower-quality assets on financials’ balance sheets. Rather than bad credit, this episode is about mark-to-market risk from rising interest rates. Most banks know how to manage that.

The most dramatic action has been in the Treasury market, where bonds have rallied aggressively. Since last week:

• Two-year Treasury yields fell from above 5.0% to close to 4.0%, before settling at 4.22% at Tuesday’s close.
• 10-year yields, the most important for stock valuations, fell from over 4.0% to 3.66%.
• These dynamics led to a steepening of the two-year/10-year yield curve from -109 basis points to -58 basis points as of Tuesday’s close—a move that is typically associated with impending recession.
• Fed Funds futures priced a new expectation that the Fed would no longer hike toward a terminal rate of between 5.5% and 5.75%, but to just below 5.0%. Furthermore, the bond market is discounting as many as four cuts by next January.

Since last Friday, the S&P 500 Index has gained 1.5%, with investors rotating away from financials and toward a diverse mix of sectors, with communications services, technology and utilities leading the way.

The Fed, increasingly, is between a rock and a hard place, having to trade off market stability risk for credibility on inflation.

Despite market enthusiasm for the Fed to pause its rate-hiking campaign, the data on inflation suggests that would be a very bad idea. Tuesday’s Consumer Price Index (CPI) report revealed that headline inflation came down as expected to a year-over-year rate of 6.0%; core inflation was worse than hoped for, however, and is still running at 5.5%. Critically, services inflation accelerated in February and has not yet peaked, arguing that excess demand in the economy is still visible.

We expect the Fed will raise rates by 25 basis points next week and continue to signal that it is data driven and therefore not necessarily finished increasing rates. The Fed cannot risk missing on inflation, as that would reset inflation expectations, implying higher rates for longer down the line.

The SVB failure may be a canary in a coal mine. Rather than fundamentally changing the facts, it impacts psychology and behavior.

In our view, the odds of a recession, rather than a soft landing, have increased. Consumer psychology is a fragile thing, and bank runs can be very anxiety-producing. Should conservatism be the response of the banks to this crisis, then slower lending, reduced risk taking and weaker access to capital could hasten the cash burn process and insolvency of unprofitable startups. This could lead to a pullback of consumption and an increase in savings rates, with the labor market potentially beginning to exhibit signs of cracking.

We believe 2023 consensus earnings estimates for the S&P 500 are too high and more equity market volatility is likely. While interest rates have pulled back and stock valuations relative to bonds have improved a bit, absolute price/earnings ratios are too high, at 17.9x on estimated consensus earnings of $220 per share versus our forecast of $195.

Among US stocks, focus on quality yield, growth at a reasonable price and earnings potential—attributes that can be found in health care, select semiconductors and software, financials, energy and materials/miners.

Real assets like gold remain a decent hedge for recession/stagflation.

Of course, always keep in mind your individual investment goals, time horizon, and risk tolerance.