Market Update -
The Banking System

March 20, 2023

 

A Letter to Our Clients

Over the last three weeks, “bank failure”, “SVB,” and “FDIC” have become household terms. You can’t turn on a new channel without a scrolling banner foretelling a crisis in the making. 

However, having lived and worked through banking crises in the past, it’s important to choose our words carefully. This is not a banking crisis. Remember 2008? That was a banking crisis. Remember the Savings and Loan meltdown in 1990? That was a banking crisis. What we are experiencing now is not a banking crisis. 

However, it is important. 

So, we want to take about 7 minutes to share some background, perspective, and how to respond. 

 

Watch this video or continue to read this letter to learn more.

Setting the stage

Banking, at its core, is a relatively simple business. Banks receive deposits and try to generate income from those deposits by lending them out. Some banks do it conservatively with simple things like mortgages and car loans. Other banks do more nuanced and occasionally risky things like lending deposits to businesses with little or no assets. 

Silicon Valley Bank (SVB) out in California, up until pretty recently, was a bank that was generally admired for its ability to kind of sit in the middle of the tech epicenter and finance some of the most innovative and adaptive tech companies we've seen in recent years. They were founded about 40 years ago, and the bank was essentially designed to lend to those with generally different business models than what appeals to traditional banks.

Accordingly, and with a tailwind of huge levels of liquidity and cash reserves sloshing around from the economy, SVB grew to become the 16th largest bank in the U.S. And yet we are talking to you because they don't exist anymore.

So, what went wrong?

Well, we will get there. But first, let us review a little bit of the timing of what happened.

Timeline of Events

  • On Wednesday, March 8, the management of the bank decided it was high time to update the value of their assets. And that wasn't good. They surprised investors by saying the assets were worth about $2 billion less than they had previously been.

  • And so the next day, their CEO goes around with a bullhorn and basically starts telling all the customers immediately. This is kind of the same thing as yelling fire in a crowded theater - It's not going to end well.

  • Unfortunately, all these events rolled together. None of their customers wanted to be the last man standing. And so, there's a withdrawal request of over $42 billion, which of course, the bank didn't have on hand, resulting in a negative cash balance of a billion dollars by the end of March 9, pretty much 48 hours of turnaround.

  • With a negative cash balance confirmed on Friday, March 10, regulators step in, take over the bank, seize all the deposits. 

  • Bada bing. Bada boom. We've got the largest bank failure since 2008.

  • On Monday, March 13, all SVB clients, including businesses, gained access to their capital. Thanks to the backstop of the FDIC. And so, both insured and uninsured deposits were transferred into a newly created bridge bank.

Now, if the narrative that a well-respected bank could go from existing in a reasonable place to being out of business in a couple of days is causing you to scratch your head or freak out, you aren't alone. And yet there's a lot more than meets the eye here. Two main points. Let us zoom in, and then zoom out with Monday morning quarterbacking, which is basically what we are  doing here with the benefit of hindsight.

Zoom In

SVB made four key decisions that were, at the very least, unwise and, at the very most, maybe just dumb.

  1. The bank made a business out of lending a lot of money to borrowers that had pretty much few assets and little income. Does anybody remember the tech boom of the 90s?

  2. They lent that money to borrowers, who all frequently talked to each other

  3. The bank was really focused on the more challenging corners of the market, like crypto and early-stage tech. Corners that often struggle when liquidity disappears or gets expensive.
     
  4. There's growing evidence that the bank had gaps in its risk management. In fact, for almost a year, they didn't even have anybody in the job of head of risk management. Now, it's unclear if having a risk management department head would have resulted in better matching of their assets and debts, but it definitely wouldn't have made things worse. 

Zoom Out

Now, if we zoom out, we can review kind of why this all occurred. As Warren Buffett quipped, once, you don't find out who's swimming naked until the tide goes out; that may be an appropriate description of what occurred here. 

The critical backdrop to the banking issues of the last couple of weeks is that the Federal Reserve has been removing dollars from the financial ecosystem by raising rates. When rates go up, lower probability projects, riskier things, and riskier companies become less viable. And those initiatives that are funded become more expensive. As a result, credit becomes both harder to come by and more expensive to get.

Everyone from public companies to banks to private companies to individuals like you have to be cautious and thoughtful about the dollars they have and the dollars they want to have. By design, that dynamic results in fewer speculative deals, which hurts many of the clients that SVB and its brethren had been targeting for years. And so easy money becomes hard money, and cracks begin to show.

Zoom Out Further

If we zoom out even further and look at the data. Most indicators don't predict a crisis on the horizon. Inflation has been high, but pressures continue to abate, and the momentum has clearly stalled. The job market remains remarkably strong, with relatively low leverage levels, while cash balances are high for consumers and businesses. While the withdrawal of liquidity is clearly going to cause problems, many of which we don't even know quite yet, the economy still has plenty of positives.

We see SVB as more symptomatic of poor decision-making than systematic of flaws across the spectrum. Given the large and rapid government intervention, particularly on the regulatory side, we also believe that bank assets will likely attract more scrutiny in the future, and there'll be increased pressure for FDIC changes.

So, what does this mean?

Do we need to go out and overhaul our portfolios generally?

Generally, no. 

Even if we knew the future, which we don't. As we've shown repeatedly, the large benefits of investing come from the power of compounding, which is predictable, not the power of timing, which is close to impossible. This is the time to ensure you've got a good plan in place and that you are laser-focused on your long-term goals and far more focused on your economy rather than the economy. 

It's also worth noting that between 2008 and 2012, there were over 400 banks that failed. And yet markets continued to function, and incentives continue to provide opportunities for those who remain focused on the long term. While we certainly can't predict the future and recognize this is a difficult market to navigate, we remain focused on what we can control - historical evidence over sensational headlines.

As always, we're here to help. Please don't hesitate to reach out if you have any questions.

Your team at Spaugh Dameron Tenny

MM202603-304700

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