Several people have had concerns about the recent bank failures. The short version of this article is that the three bank failures we have witnessed in the past week appear isolated to firms with high concentration risk and poor risk management. There will likely be more. It’s not new. In 2008-09, the FDIC shut down over 400 banks.
How did it happen in this cycle? Plenty of complacency, incompetence, and cronyism to go around.
The biggest US banks: Bank of America, Citigroup, JP Morgan, Wells Fargo and others are considered “systemically important” or “too big to fail.” Hence, they have strict regulatory, liquidity, and capital requirements. The smaller regional and community banks who aren’t as well capitalized or as heavily regulated are considered at greater risk of failing. That is where the fear lies.
Silverlight, Signature, and SVB banks failed. Regulators stepped in to help calm the panic and to avoid a broader contagion. I’ll focus on SVB (a regional bank) because it is the largest and is causing more fear of broader bank failures.
All these banks were overwhelmed by similar forces:
- Rising interest rates. Rate changes an investors risk and reward calculation as lower risk assets paying higher rates becomes more attractive;
- Slowing credit and economy;
- SVB clients are primarily technology related startup companies most of whom are not profitable, are facing an industry downturn, and needing cash.
Each of these banks were ill-prepared for the rise in interest rates; and each had a high concentration of higher risk corporate clients (crypto firms or technology startups).
Risk = Return
You can’t have more return without higher risk. It is that simple. And if you put all your eggs in one basket, you better watch that basket. Concentration, or a lack of diversification, requires additional safeguards.
It’s an often repeated story in the history of financial markets. When a bank (or hedge fund or commodity trader or adviser or whomever) make a concentrated bet without evaluating what could go wrong, the consequences can be extreme.
One Person’s Assets are Another’s Liabilities
SVB bet on long-term safe securities. Safe from default risk. Not safe from interest rate risk. They purchased a large amount of long-term bonds paying a fix rate of about 1.60% (near historic lows).
When the IPO and SPAC markets dried up, their startup clients needed cash from their deposits to fund payroll and run their businesses. SVB did not have liquid assets to payout. Therefore, they needed to sell their long-term bonds to cover client withdrawals.
The Problem: Today, new long-term bonds yield closer to 4.00%. This makes SVB’s old bonds yielding 1.60% worth much less than they paid and less than was needed to cover client withdrawals. They made a last ditch futile effort to raise equity capital, but it was too late. End of story but not the drama.
When too many people wanted too much of their money too fast, the problem ensued. SVB failed to adjust their long-term assets to meet their short-term obligations. A stunning lack of risk management for bankers who are supposed to understand this stuff. Their lack of liquidity led to insolvency.
Who is to Blame? Managerial Incompetence or the Fed?
The rearview mirror is 20-20 in hindsight. In real-time, a perfect decision between risk and reward seldom exists. But this was a pathetic lack of basic prudence.
Prominent banking analyst Chris Whalen believes the Federal Reserve is responsible due to its aggressive rate hikes. I usually respect his knowledge and insight, but this is nonsense. Both the bond market and then the Fed (once they admitted transitory was wrong) telegraphed the path for rates.
Why would SVB make such a big, concentrated bet on long-term fixed rate securities at a time of historically low rates. When rates started rising, where was the risk management: diversifying the portfolio; matching assets to liabilities?
Complacency, Corruption, and Conflicts
• In April of 2022, SVB’s Chief Risk Officer resigned. No one filled the position during 2022 while the damage was rising.
• The corporate 10K filing on 12/31/2022, hidden in plain view, revealed the pending liability. Short sellers began making noises about it; yet 22 of 23 equity analysts had a “buy” recommendation on SVB’s stock.
• Cramer the Clown got into the act on Feb 8th saying both SVB and Signature were fine companies to buy (why does this dude still have a show)?
• In February, SVB’s executive team was busy selling massive amounts of their stock: CEO sold 11% of his holdings; General Counsel 19%; CFO 32%; CMO 25%
Bi-Partisan Complacency and Regulatory Capture
SVB’s CEO successfully lobbied Congress and its regulator to get SVB out from under regulatory scrutiny for banks deemed “systemically important,” by raising asset thresholds so they could fly under the radar. He premised his case as based on SVB’s “low-risk business……and deep understanding of the markets it served, and our strong superior risk management practices.” You can’t make this stuff up.
• In 2018, Trump (whose financial acumen includes bankrupting six of his own companies) signed the legislation.
• 50 Republicans and 17 Democratic Senators also signed the bill.
• SVB’s CEO held a fund raiser at his home for Democratic Senator Warner; his PAC also donated to his campaign.
• SVB’s CEO was also a board member of the SF Federal Reserve (SVB’s regulator). Why did the SF Fed acquiesce or look the other way?
The Financial Fallout
1. Stockholders get zeroed out (no change)
2. Bondholders might get pennies on the dollar (no change)
3. Depositors under the FDIC insured limit of 250,000 are covered (no change)
4. Depositors over the insured limit are now covered (big change). The FDIC invoked the “systemic risk exception,” which allows them to protect all depositors (Over 90% of SVB depositors were over the 250,000 limit).
The key is that a new precedent has been established where all depositors are now covered. Or not. It’s unclear how they dance around the “systemic risk exception.”
Questions and Takeaway Lessons
SVB lobbied for less regulatory scrutiny because they weren’t systemically important. Until they collapsed under their mismanagement. Then a bailout was deemed appropriate.
These were not large banks. Has this recent “systemic risk exception” codified that every bank is now too big to fail? Who decides? Will this get invoked in all cases? If so, are we effectively nationalizing the banks?
If a bank is not on hook for its actions, what perverse behaviors might this breed? In other words, why should bankers make millions of dollars if they aren’t responsible for their investment and risk taking activities?
Make no mistake. In spite of the press releases to the contrary, the costs will be borne by US taxpayers and bank customers in one way or another.
Jerry Matecun – Founder, President
Expert guidance to plan your future, preserve your lifestyle, and retire with confidence. For a confidential consult, contact me at jerry@compoundvalue.com.
