A lot of drama has unfolded since last month which is worth picking apart in this post. Much of what folks are reading in the financial press likes to echo what is clear and what is clear is often what is far behind us in hindsight. That’s one reason it’s so easy to hark back to the past when dealing with the collapse of a relatively large lender like Silicon Valley Bank (SVB). It’s been compared to the failure of Washington Mutual and with the fire sale of Credit Suisse, a Global Systemically Important Bank (or GSIB) to UBS, speculation that more turmoil is ahead has not died down.
Yet there is often more than initially meets the eye. I feel very strongly that the inflation we are currently experiencing in the rich world was due to a recency bias having to do with the surprising lack of inflation after the financial crisis. At that time, it’s theorized that the liquidity unleashed by the Fed wasn’t inflationary because most of it ended up repairing banks balance sheets, who then subsequently spent years tightening their purse string a before starting to lend again (click the link above for the economics nerds, it’s theorized there was also a decrease in the velocity of money that was a major contributor). For those that aren’t aware, recency bias is a term from behavioral psychology that has to do with the most recent events having a more prominent place in our minds than older historical ones, meaning we are more likely to act in response to recent events than acknowledging that the situation and circumstances may have changed.
Regardless of however many smart people work at the Fed, recency is a human cognitive bias that all of us, even PhD’s working at the highest institutions can be prone to. The surprise non-transitory inflation that caught many off guard and has caused the Fed to quickly raise interest rates are the underlying theme of much of the current troubles. Yet there are larger themes and risks lurking other than just regional bank balance sheets and how they manage their interest rate risk.
1 . Deposit Concentration Risk – Many fingers are being pointed at Peter Thiel for advising that all the portfolio companies of Founders Fund withdraw their deposits from SVB. Although he is the figurehead of Founders Fund, I can’t help but think that part of the finger pointing is because Thiel was a Trump supporter who financed the take down of gossip site Gawker, some speculate because it outed him as gay. It’s not a stretch to think many in the more liberal corners of the media see him as an ideological antithesis as well as a threat to their very existence.
Yet as described in this Axios article here a large organization such as Founders Fund, which manages $11 billion doesn’t operate on the whims of 1 personality when it comes to its counterparty risk strategy. That fell to the finance/treasury team which, if the Axios article is to be believed, was taken aback by the share sale announced by SVB on March 8. The team then not only moved its own funds out of the bank but directed capital calls away from the bank. This is where it then gets interesting and the facts turn to innuendo.
It is then rumored that Founders Fund directed its portfolio companies to also move their funds out of SVB and this could have well set off a chain of events that led to the bank’s collapse. Although I don’t know the current portfolio of Founders Fund companies, their website does list some of those they have worked with and it’s a whose who of Silicon Valley:
Space X
Palentir
Stripe
Air BnB
Affirm
Nu Bank
Figma
Spotify
Even if none of these companies were current portfolio companies of the fund, due to their early stage funding, they likely maintained deep connections with its management team. On top of that, the community of corporate treasurers and Silicon Valley CFO’s is likely quite small and word likely travels fast. It’s not hard to imagine how a rush could turn into a stampede.
The longer term takeaway for regulators may be the systemic risk that venture capital and private equity can pose to specialized lending institutions. The concept of SVB: a bank which caters to a niche industry backed by like minded business people is as old as banks themselves. Yet it should be a wake up call to regulators that a small cohort of venture capital funds can exert so much control as to cause a bank run on the 16th largest bank in the US. It likely won’t be long before regulators start stretching their tentacles towards the VC space for this very reason. Founders Fund may have inadvertently burned their entire industry to save themselves in the long run.
2. Will Blanket I’m Deposit Guaranty Return? – From the Lehman failure in 2009 until 2012, the FDIC and the US Government offered an unlimited deposit guaranty to banks. This put bank to bank deposits and corporate depositors at ease because they no longer had to worry about the risk of an individual bank. There have been some calls for this to return most notably by former Treasury Secretary Larry Summers.
Yet this poses the risk of moral hazard which is brought up more and more as the government steps in to rescue ailing industries and companies. By backstopping all deposits, banks and corporates no longer have a disincentive to diversify their deposits across institutions so this can create the same concentration risk that SVB experienced in its own deposits.
Indeed the flight of corporate deposits away from regional banks and into the big 5 US banks exhibited this risk in real time in the past few weeks. Corporate depositors know that the large banks are too big to fail and the government will backstop them, so they helped increase the deposit flight away from the smaller banks, exposing more small banks to the risk of failure. These actions almost necessitate the need to extend the deposit guarantee umbrella to the smaller banks.
Even if this guarantee is taken away in a year however, the central problem remains: the public still sees the big 5 as too big to fail so any future disruption in the small bank market will end up running into the same problem of a “flight to too big to fail.” Taking away the deposit guarantee, even a year from now, doesn’t solve this issue.
3. The Fed Lacks Control of Some Market Forces – Some bankers in the US expressed relief at the government’s swift handling of the SVB issue but that doesn’t mean the problem ended there.
The (forced) sale of Credit Suisse (CS) to UBS underlines that the market can take turns that even the smartest people cannot anticipate. CS had been suffering from a series of mishaps year after year, in my opinion most likely due to their lack of adequate risk controls. This included a big loss from the Archegos family office debacle and the collapse of supply chain firm Greensill Capital. 2 former UBS bankers had been brought in to right the ship but ended up powerless to market forces after the Saudi National Bank balked at purchasing more.
The difference between say a Wells Fargo and a Credit Suisse is that the Fed and the US is still large enough on the world stage to rescue a large bank, the Swiss government however, is not. It’s the reason it pushed UBS to buy CS rather than having the awkward situation of lobbying a foreign bank to buy a national champion or try winding CS down itself.
Now that one of the weakest has fallen, the rumor mill is starting to churn about another European Bank, Deutsche Bank. Whether this becomes the next domino to fall remains to be seen but it highlights the power of perception and fear in the marketplace right now and is one reason that simply just analyzing deposits, as Michael Burry highlighted on Twitter recently, doesn’t correlate directly with safety.
It seems that bank risk and asset liability management is considered a boring and passé topic until a crisis happens, then everyone is all of the sudden is a bank balance sheet expert and debating the merits of tangible equity and scrutinizing available for sale classifications. I wouldn’t be swayed by the layman’s analyses right now because it’s obvious that even some of the people who work in the field every day didn’t have a grasp on how to manage the risks properly.
How Investors Can Profit
Right now we face a trifecta of uncertainty consisting of: banking instability, high inflation and rate uncertainty at the Fed. Some cavalier investors may see the instability in the banks space as an opportunity to snatch some of the most volatile stocks up. As can be seen by the wild swings in FRC stock over the last week however, this is only for the most intrepid risk takers or those willing to sacrifice all their capital.
Rather than recommend risky bank stocks, it may be better to step back and understand what happens when volatility spikes, partially utilizing the information from my last post on bear market strategies.
When crisis spreads and volatility spikes, we do know that the following things happen:
1. Option Values Increase – Both puts and calls increase in value due to the underlying volatility
2. A Flight to Safety Occurs – Treasury securities tend to increase in value, especially over the long term as investors are happy to make some interest rather than lose principal in equity.
3. Stock, Junk Bond and Preferred Share Prices Fall
My previous post revisited some of the strategies that attempted to take as a stage of this. I have utilized some of these lately betting on things like a fall in volatility after the Fed calmed markets through puts on VIXY and buying call options on banks that saw their stock prices fall yet remained systemically important such as Truist Bank. I would direct you to my previous post for more information on those alternative strategies including going long on the VIXX and covered call ETF’s, JEPI being the latest iteration of this.
Preferred shares are an often overlooked portion of the capital structure by many investors yet they have some specific advantages and the market tends to be dominated by financial companies, many of which are seeing price pressures right now.
Preferred shares have the pricing of junk bonds but offer benefits of some share ownership. They also have their interest taxed the same as qualified dividends, usually capped at around 20% which is a big advantage compared to the ordinary tax rate of a junk bond. The higher your tax bracket, the more valuable this is.
The return of PFF which tracks the preferred share index over its lifetime and over the past 10 years is not impressive. The total return is only 3% over 10 years and 3.2% since inception.
However, this hides short opportunity windows where the price of the index falls sharply and then recovers in a 6-9 month period. I believe we are in one of those periods right now.
If we look at the 12 and a half year return of the index if you purchased it in the depths of the financial crisis, annual returns range anywhere from 10.5% to 13%. This strategy worked during the pandemic as well when PFF fell 33% and was yielding 7.1% at its lowest point. PFF is currently only 9% off of those lows from the pandemic and yielding approximately 7.4%.
If you believe that the majority of banks will not fail, that shareholders won’t be wiped out and that interest rates will not be this high forever, then now represents a pretty easy buying opportunity in PFF. I would even prefer this to buying the KBW Banks index which although offering a high dividend yield compared to stocks, has still tended to underperform the market as a whole over since the financial crisis.
The information provided by www.cashchronicles.com is for informational purposes only. It should not be considered legal or financial advice. You should consult with an attorney or other professional to determine what may be best for your individual needs. www.cashchronicles.com does not make any guarantee or other promise as to any results that may be obtained from using our content. No one should make any tax or investment decision without first consulting his or her own financial advisor or accountant and conducting his or her own research and due diligence. To the maximum extent permitted by law, www.cashchronicles.com disclaims any and all liability in the event any information, commentary, analysis, opinions, advice and/or recommendations prove to be inaccurate, incomplete or unreliable, or result in any investment or other losses. Content contained on or made available through the website is not intended to and does not constitute legal advice or investment advice and no attorney-client relationship is formed. Your use of the information on the website or materials linked from the Web is at your own risk.