15 March 2023

SVB’s Downfall and the Outlook for the Fixed Income Market

The recent turmoil in the banking sector serves as a reminder that the roots of a crisis can often be traced back to losing sight of the basics. Over the past week, time tested principles have emerged from the shadows and returned to the spotlight:

  • Monetary policy operates with long and variable lags – While inflationary pressures remain very much elevated, a prime risk with hiking so quickly is policymakers compromise their ability to assess how an economy lulled into complacency from zero interest policy and quantitative easing responds to a less accommodative regime. As history has shown, tightening cycles often end when something breaks, and the odds of an accident is certainly higher when stimulus is withdrawn at breakneck speed. Higher rates and quantitative tightening are weighing on business models that have thrived during the era of cheap money. Silicon Valley Bank (concentrated deposit base - technology sector start-ups), Signature Bank (concentrated deposit base – cryptocurrency) and Silvergate (concentrated deposit base - cryptocurrency), all experienced explosive deposit growth over the last 3-5 years. However, undiversified exposures to sectors that are struggling under the weight of restrictive monetary policy served to hasten their demise.
  • For financial institutions prudent asset liability management is crucial - A confluence of factors contributed to the downfall of Silicon Valley Bank (SVB), but its glaring mismatch between asset and liabilities was certainly a major contributor. SVB struggled to grow its loan books nearly as fast as the surge in its deposits, so they turned to longer-dated fixed income securities to generate sufficient yield on capital. For reference, loans plus securities as a percent of deposits exceeded 100% in Q3 2022.1 Deposit liabilities are short-term; investing in longer duration fixed income assets when the Fed is engaged in the fastest hiking cycle in 40 years gave rise to large unrealized losses on SVB’s balance sheet, a tenuous position that other banks also find themselves in. Large unrealized losses aren’t necessarily a problem unless a bank is forced to sell assets to cover withdrawals, which SVB was ultimately forced to do after high profile warnings about the state of the bank’s finances triggered a run on the bank.

Regulators ended up seizing control of SVB on Friday and Signature Bank on Sunday. The Federal Reserve, the Federal Deposit Insurance Corporation and the Treasury took the extraordinary step of backstopping uninsured deposits held at both institutions. The triumvirate also unveiled the Bank Term Funding Program (BTFP), where banks can obtain loans for up to one year with eligible collateral (Treasuries, agency debt, MBS etc.) valued at par (even though these securities are worth less).

How we responded

When navigating a crisis, it is imperative to test whether your investment thesis is still valid. When the facts have meaningfully changed, you have to be willing to tweak the playbook. While we entered this tumultuous period neutral on the banking sector, we exited a few small positions in regional banks as we determined they might be vulnerable going forward amidst increased scrutiny in the sector.

In rates, we executed a tactical trade to take advantage of outsized volatility. We put on a 2s10s steepener and exited the position at a profit after the curve became significantly less inverted.

Where do we go from here?

Over the last several months, we have been skeptical of the rally in risky assets, arguing that for the first time in a decade it paid for investors to remain patient. Risk-free assets offered attractive yields (6-month bill yields were over 5%, yields on treasuries were at one point greater than 4% across the yield curve), while equities and credit valuations were failing to price in a meaningful probability of a downturn.

The disorderly activity in the banking sector has led to a material cheapening in valuations. We are monitoring US banks particularly closely as spreads versus industrials are approaching stretched levels. Within the sector, we prefer Global Systemically Important Banks (G-SIBS) to smaller regional banks given their superior profitability, strong asset quality, business diversification, and effective management teams. Moreover, the high-profile failures of regional banks are likely to lead to increased regulation on the category going forward as the emergency response by authorities confirms the systemic risk they represent to the system. Likely measures include some combination of stress tests, forced capital raises, and/or the imposition of Total Loss Absorbing Capacity (TLAC) rules on regional banks (which systemically important banks are already subjected to), which stands to weaken sector profitability. Additionally, while the announced measures have helped in slowing contagion, the regional banks remain challenged by deposit flight. Ongoing quantitative tightening by the Fed has added to this precarious backdrop as it has given rise to an unequal distribution of excess reserves in the system with large banks holding ample reserves while regional banks hold very little.

Many have cautioned against the potential fallout of a synchronized withdrawal of monetary stimulus on financial stability. Recent market turbulence imparts a valuable lesson that shocks can come from sources that you least expect. It has become abundantly clear that the world has changed dramatically during the era of zero interest rate policy. The demise of SVB was sealed by a combination of unsustainable growth linked to the technology sector, poor risk management, coupled with the accelerants of social media and mobile banking. As developments continue to unfold, we remain vigilant for other pockets of vulnerability and retain a high degree of dry powder to take advantage of dislocations as they arise.

1. Source: JP Morgan Data as of March 10, 2023. Securities include hold to maturity and available for sale categories.


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