After one of the most difficult years in capital markets in the last four decades, the US equity and fixed-income markets started 2023 on a positive note. Market participants appeared to anticipate that the US Federal Reserve was near the end of its interest rate increase campaign and that inflation would continue to fall towards the Fed’s target. There was also a sense of optimism that the US may avoid a recession and the economy would experience a “soft landing” of slower growth but no recession. US equity markets rallied to begin the year, led by technology stocks and lower interest rates.
However, as the quarter progressed, the economic numbers did not support the assumptions that investors were making at the beginning of the year. Inflation remained at a higher level than expected, although some progress has been made. The Federal Reserve continued to send a message to the market that it would continue to raise interest rates until inflation was under control. After strong employment numbers and higher-than-anticipated inflation results, the S&P 500 index gave back some early gains as investors seemed to recognize that interest rates would still be increasing in 2023.
However, the biggest story of the first quarter was the failure of Silicon Valley Bank (“SVB”) in March, along with Signature Bank, which specialized in services for cryptocurrency companies. These were the first bank failures since the Global Financial Crisis of 2008-2009. Their demise rekindled fears of another banking crisis like what preceded the 2008 global recession. The Federal Reserve and US Treasury took quick action over the weekend following SVB’s historic collapse to guarantee all deposits at SVB, even those beyond the $250,000 FDIC limit. Those actions, combined with other large banks stepping in to make deposits at First Republic Bank to alleviate a similar deposit run on that bank, seemed to calm the fears of bank customers and the overall market. Still, the stock prices of many medium-sized banks plummeted in March over fears the crisis would spread to other banks and become systemic. As fears of a banking crisis subsided, at least for now, US equity markets rallied to end the quarter with a gain of 7.5%.
WHAT HAPPENED AT SILICON VALLEY BANK ?
The failure of SVB Bank happened remarkably quickly. On March 8th, the bank announced that it was going to take a $1.8 billion dollar loss on the sale of bonds in their portfolio. The bonds they held, mostly US Treasury and Agency bonds, had declined in value due to the increase in interest rates over the last year. They also announced they were going to attempt to raise approximately $2 billion in new capital by selling stock in the market. In response, investors drove their stock down by approximately 60% the next day. The following day saw over $40 billion in deposits leave the bank. On Friday the 10th, the FDIC seized SVB and put it under FDIC control to protect the remaining depositors. Fears of a similar “Run on the Bank” and deposit outflows spread to other, similarly sized banks causing many to see significant declines in their stock prices and
deposit outflows. Over the following weekend, the FDIC announced that it would guarantee all deposits at SVB in an attempt to alleviate the panic.
Although the details of what happened at SVB continue to unfold, the cause of their failure falls into two categories: 1) Risk management mistakes by bank management; and 2) The impact of Federal Reserve interest rate increases on the overall financial system.
SVB was unique for a bank its size in that many of its customers were concentrated in the Venture Capital (VC) / Technology Start-Up sector and to some degree, concentrated geographically in the Bay Area / Silicon Valley and other regions with similar types of companies. Large banks are typically diversified both geographically and across industries, so they are not as exposed to a downturn in any one sector.
Many of these VC investors and technology start-ups had virtually all their cash reserves on deposit at SVB. The founders and managers of these companies are uniquely connected and were already sensitive to preserving their cash positions amid fears the overall economy was slowing. When word started to spread amongst them that SVB was in trouble, many quickly moved money out of the bank in lockstep. They felt there was too much risk to their companies to wait and see what might happen. From their perspective, the survival of their businesses was at stake. So, the result was a classic run on the bank, but instead of people lining up in bank lobbies, deposits were moved out of the bank from smartphones and laptop computers via wire transfer requests. This resulted in $40B of cash deposit outflows in one afternoon.
Their second mistake was the management of their bond portfolio. This is where the problems of SVB differs from the 2008-2009 Global Financial Crisis. The crisis of 2008 was rooted in financial institutions’ holdings of increasingly exotic mortgage-backed debt. After the housing bubble of the mid 2000’s and multiple years of irresponsible mortgage lending, many banks were holding mortgage-backed debt. These bonds were considered “low risk” because they were backed by residential mortgages and many of them even carried AAA credit ratings. However, we now know that many bank holders of these assets lacked understanding as to how these securities were structured and their underlying assets. When the housing bubble burst and defaults started to spread, people realized these bonds were extremely risky and the market for these bonds collapsed. This was the underlying reason firms like Lehman Brothers and Bear Stearns went out of business.
Regulatory reform after the financial crisis changed what types of bonds financial institutions can hold. Most bond holdings are now US Treasuries or Agency-backed bonds issued by Fannie Mae and Freddie Mac. The risk of default for these kinds of bonds is extremely low. However, just like any investor’s portfolio, when interest rates rise, the value of the bonds you own declines to match the prevailing level of interest rates (a process called “mark to market”). Many banks were holding Treasury bonds that lost 10% or more in value as rates increased. That is not a significant problem if the banks can hold those bonds to maturity as prices eventually recover and they get the full repayment of the bond value at maturity. But if they are forced to sell early, like SVB was, to meet deposit outflows, they must recognize the loss — thus reducing their overall capital.
All banks need to manage their risk, both from increasing interest rates and loan defaults. One of the biggest criticisms of SVB is that they went without a Chief Risk Officer for 8 months in 2022. Banks do have tools at their disposal to manage interest rate risk. They can use a type of derivative, known as interest rate swaps, to effectively hedge their risk exposure to increasing interest rates. Press reports suggest that while SVB had used interest rate swaps, they had removed all the swaps at some point in 2022. This overall failure of risk management, both from being too concentrated in specific industries and geographic areas, coupled with a breakdown of their internal risk management, led to their failure and the ensuing market turmoil.
IMPACT OF FEDERAL RESERVE ACTIONS
A second major component of the recent bank crisis is the actions of the Federal Reserve. Critics argue that they waited too long to begin raising interest rates after the Covid crisis. The US Federal Government pumped approximately $5 trillion dollars into the economy from 2020-2022 to alleviate the impact of the Covid shutdowns. This spending was one of the primary causes of the inflation that began flowing through the economy in 2021 and continues today. The Fed initially believed the increase in inflation was transitory but later realized the problem was becoming structural and in early 2022 began the most aggressive round of interest rate increases in Fed history.
Such a rapid increase in interest rates was inevitably going to cause problems for companies and businesses that were overleveraged or too dependent on cheap money. SVB was one of the first casualties, but they will likely not be the last. Real estate prices, both commercial and residential, have begun to drop as higher interest rates begin to impact the property sector and the economy.
There is an old Wall Street saying that when the Fed steps on the brakes, someone inevitably hits the windshield. We are probably just starting to see some of those victims, though the full impact and timing are unknown.
ECONOMIC FALL OUT
The Fed’s goal is to slow the economy to bring down inflation. Early on, there were hopes that they could accomplish a “soft landing,” meaning the economy would slow and inflation would decline but avoid entering a recession. More economists now see a recession as likely towards the end of 2023 or early 2024. The combination of 1) higher interest rates, 2) the declining availability of credit as banks react to the recent industry issues and work to shore up their balance sheets, and
3) the end of Covid-era stimulus and the spending down of household savings built up during Covid — could all combine to cause the growth of the economy to slow, if not enter recession.
WHAT SHOULD YOU DO
Recessions are a normal and inevitable part of the economic cycle. They can cause pain for those not prepared, but also present opportunities. The recent problems in the banking sector may help the Fed accomplish its goals of lowering inflation. As credit becomes more difficult to obtain, many parts of the economy will slow or become distressed from this lack of financing. The impact of interest rates increasing by 4.5 to 4.75% over the last year will also contribute to an economic slowdown. If economic and inflation numbers continue to decline, the Fed may be finished raising rates. Many market observers think that we are near that point.
We see several opportunities and strategies to consider during this time:
- Fixed-income investing has become more attractive over the last year. If the Fed is done or close to done raising rates, locking in longer-term bonds at today’s high current rates may be beneficial for those looking to increase their portfolio income or to generate a return.
- Bordeaux continues to actively manage our clients’ cash holdings. We have moved most excess cash holdings into traded money market funds that offer safety and higher yields. Additionally, these funds are not exposed to the deposit risks of bank custodians.
- We also are looking for investment opportunities in assets that have recently declined in price due to market dislocations that may recover as rates stabilize or even decline later this year or next. Two examples of these are distressed credit investing and secondary purchases of private equity assets. Bordeaux believes that both could offer an attractive entry point given today’s market environment.
- BWA encourages clients to continue managing liquidity and make sure you have enough cash or near-cash investments for your expense needs in the next 18-24 months. Forced selling at an inopportune time to support your lifestyle or liquidity needs is a permanent destruction of wealth that cannot be recovered.
Economic turmoil and recession are inevitable characteristics of our economy. They can cause short-term pain and worry for those not prepared or accustomed to these cycles. But they also generate opportunities for patient investors.
Please let your advisory team know if you have any questions or concerns about your financial situation. We will continue to monitor the economy and markets to safeguard your assets report back to you with any ongoing issues that are warranted.
The material has been gathered from sources believed to be reliable, however BWA cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Market index information, where included, is to show relative market performance for the periods indicated and not as standards of comparison, since these are unmanaged, broadly based indices that differ in numerous respects from the composition of Bordeaux’ portfolios. Market indices are not available for direct investment. The historical performance results of the presented indices do not reflect the deduction of transaction and custodial charges, or the deduction of an investment management fee, the incurrence of which would decrease indicated historical performance. The S&P 500 Index includes 500 leading companies in the US and is widely regarded as the best single gauge of large-cap US equities. The Barclays Capital U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar denominated, fixed-rate taxable bond market. The Russell 2000 Index is comprised of 2,000 small-cap companies and is widely regarded as a bellwether of the U.S. economy because of its focus on smaller companies that focus on the U.S. market. The Nasdaq Composite Index is an index of more than 3,700 stocks, weighted by market capitalization. This information may contain certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance, and actual results or developments may differ materially from those discussed. No investor should assume future performance will be profitable or equal the previous reflected performance.
To determine which investments or planning strategies may be appropriate for you, consult your financial advisor or other industry professional prior to investing or implementing a planning strategy. Investment Advisory services are offered through Bordeaux Wealth Advisors, LLC. Advisory services are only offered where Bordeaux and its representatives are properly licensed or exempt from licensure. No advice may be rendered unless a client agreement is in place.