Let's start with a quick primer on what started all of this. The pandemic, and the epic monetary and fiscal policy response, led to a surge in money supply and liquidity, with tech startups and venture capital (VC) as key beneficiaries. In turn, that led to a massive surge in deposits at Silicon Valley Bank (SVB), with which those cohorts were particularly chummy.
In order to boost yields on those deposits, SVB loaded up on longer-term government bonds. The bank reacted to rising rates and losses on securities it bought in early 2021 by designating them as "held to maturity" (HTM), in the interest of mark-to-market losses not flowing through the bank's income statement. As a result, per accounting rules, SVB could not hedge the risk. Oops. In addition, given the 2018 rollback of some Dodd-Frank regulations—including upping the size of banks subject to stress tests from $50 billion to $250 billion, SVB was not subject to stress tests, including in the event of a sharp spike in interest rates. Double oops.
At the same time, the tech sector has been under extreme pressure, and SVB's industry concentration meant their exposure and downfall was really twofold: More than 95% of SVB's deposit base was not FDIC-insured (ranking them #99 out of the top 100 banks); while more than 55% of their assets were invested in long-term government bonds (ranking them #1 out of the top 100 banks). SVB had unrealized losses on its portfolio; but they also had the concentrated industry-exposure problem.
SVB made a surprise announcement on Wednesday, March 8 that it would need to raise more than $2 billion from its equity holders, having just sold its entire portfolio of "available for sale" (AFS) securities to meet liquidity needs and taking a $1.8 billion loss on the sale. Signature Bank (SB), SVB's "East Coast brother," fell soon thereafter.
A run on SVB began when many of their depositors needed immediate cash, with "fire" shouted in the crowded building, so to speak, by a couple of key stakeholders via social media. As such, SVB was forced to realize their portfolio losses, and the lack of new deposits or lending opportunities coming in highlighted the fragility of a model like SVB's. By Friday, March 10, no buyers of SVB had stepped up.
With the effects of rapid news flows, especially via social media, and banking that can be done quickly and via mobile devices, the bank's collapse happened with lightning speed. It was the second-largest bank failure in history, second only to Washington Mutual's during the Global Financial Crisis (GFC). In terms of the speed factor, we are in a brand new era. However, history can still be a guide. Below is a table highlighting major financial crises since the mid-1970s; with dates, whether the economy had an accompanying recession, whether there was an attendant bear market, and if/when the Federal Reserve cut rates in response.
Source: Charles Schwab, Bloomberg, National Bureau of Economic Research (NBER), as of 3/20/2023.
What's been done so far in this crisis
The Fed, in conjunction with the Federal Deposit Insurance Corporation (FDIC), has taken a double-barreled approach: a guarantee to cover all the deposits of SVB and SB; and a new short-term lending facility, the Bank Term Funding Program (BTFP). That program allows banks to borrow, at par value, U.S. government bonds for up to a year, regardless of their present mark-to-market price. Those terms were also applied to the traditional discount window. This helped stabilize confidence in the immediate wake of the failure of SVB and SB (even if it wasn't a permanent confidence fix).
Several regional banks faced increased deposit withdrawals over the past week, and as a result, as shown below, borrowing at the Fed's discount window has spiked. That borrowing means the Fed's balance sheet ballooned again (second chart below), such that more than a quarter of the liquidity withdrawals from the Fed's quantitative tightening (QT) have been reversed. By the way, this should not be construed as the relaunch of quantitative easing (QE), which has been used historically by the Fed to boost growth. The expansion of its balance sheet this time is because banks are under pressure and have been forced to use the discount window; while at the same time, the Fed is still facing down elevated inflation and has been trying to slow growth.
Fed steps up
Source: Charles Schwab, Bloomberg, as of 3/15/2023.
Fed's balance sheet shoots higher
Source: Charles Schwab, Bloomberg, as of 3/15/2023.
The Fed balance sheet is the U.S. Federal Reserve System's balance sheet of assets and liabilities.
Weekend update (not with Colin Jost or Michael Che)
Credit Suisse (CS) marked the latest chapter of the recent crisis, but its woes were not akin to SVB's. The global bank has been plagued with scandals, losses, and questionable business strategies—long before SVB hit the news. UBS Group stepped in to buy beleaguered CS in a "shotgun wedding," paying 3 billion francs ($3.3 billion) in an effort to stem the crisis, and the price-per-share representing a 99% decline from CS's peak in 2007.
It is the first combination of two large and systemically important global banks since the GFC. The Swiss National Bank (SNB) backed the deal with a liquidity backstop, a guarantee to cover up to 9 billion francs ($9.7 billion) of UBS's losses, and by waiving the requirement to get shareholder approval. The CS statement said the deal would close by the end of 2023 and that there are no options for UBS to back out of the deal.
The elimination of the need for shareholder approval is creating tremors. Though certainly not bailed out, equity holders of CS did get a few cents on the dollar, while the contingent convertible (CoCo) bond holders are getting wiped out. This is making waves given that unsecured bondholders have historically ranked above equity holders in the capital structure. Many European banks—in the aftermath of both the GFC and the eurozone crisis a few years later—issued CoCo bonds to strengthen their balance sheets. At a minimum, uncertainty about the regulatory backdrop for large global banks will remain elevated.
Related, the Fed and five other global central banks—Bank of Canada, Bank of England, Bank of Japan, European Central Bank and Swiss National Bank—announced coordinated action to boost liquidity in U.S. dollar swaps which will "increase the frequency of seven-day maturity operations from weekly to daily." The increase in swap lines will "enhance the provision of liquidity," describing the agreement as "an important liquidity backstop to ease strains in global funding markets." The Fed announced that daily operations will begin today and will continue at least through the end of next month.
Another beleaguered bank, First Republic (FRB), received about $30 billion in deposits from 11 large U.S. banks to shore up its balance sheet. The troubled lender's credit rating was downgraded by S&P Global Ratings (and is on watch by CreditWatch), despite the rescue package. The cash support should alleviate some of FRB's shorter-term liquidity problems, but according to S&P Global, does not resolve the "substantial business, liquidity, funding and profitability challenges" it may face.
Finally (is there ever really a "finally" these days?), a coalition of mid-sized U.S. banks made a request to extend FDIC insurance to all deposits for the next two years, believing a guarantee would contain a possible wider run on banks. "Doing so will immediately halt the exodus of deposits from smaller banks, stabilize the banking sector and greatly reduce chances of more bank failures," the Mid-Size Bank Coalition of America said in a letter to regulators. "Notwithstanding the overall health and safety of the banking industry, confidence has been eroded in all but the largest banks," said the group in its letter. "Confidence in our banking system as a whole must be immediately restored," adding that deposit flight would likely accelerate should another bank fail.
This is not 2008 again
The GFC was a more significant and contagious event given the messy combination of under-capitalized/over-leveraged financial institutions, flimsy capital-markets-based funding, prior laughable lending practices, and the alphabet soup of toxic/opaque/impossible-to-value derivatives. Solvency was the primary issue during the GFC, while it's more about liquidity today. Today's largest banks are well-capitalized and are already benefiting from deposit flight from the weaker banks. In addition, our country's capital-markets-based financial system is not intricately linked with its regional banks.
Regulators have tools and have been quick to act, while they were much slower to act during the GFC. The failure of SVB and SB were tied to problems unique to those banks, including largely unhedged interest rate risk and outsized exposure to the venture capital/startups/crypto world. The main channel of contagion so far is more psychological than systemic. The U.S. and global banking system has significant liquidity buffers, in addition to regular stress tests. On that note, courtesy of the 2018 rollback of some Dodd-Frank regulations, SVB was not subject to stress tests.
Banks' balance sheets have been under heightened scrutiny over the past week, but it's the liabilities side that bears the risk. The assets side, for most banks, remains in good health. As a percentage of total loans, noncurrent loan balances held by banks are near historical lows—and could likely deteriorate without a significant impact on bank capital. In addition, nearly half of the value of U.S. bank deposits is insured. Quantitative and fiscal tightening over the past year have reduced aggregate deposit balances in the system, which has helped push up the percentage of insured deposits.
Yes, the more than $600 billion of unrealized losses—per the FDIC's Quarterly Banking Profile—on which U.S. commercial banks are sitting is staggering. However, those unrealized losses are due to the increase in interest rates, not a significant deterioration in credit quality. Leading into the GFC, commercial banks' holding of Treasuries and Agencies was just north of $1 trillion; today they are nearly $4.5 trillion (more than double what they were then as a share of total bank assets).
As noted, U.S. banks do not have a discomfortingly high uninsured deposit ratio or unrealized losses on HTM securities in excess of capital. In the event of a need to raise cash, the Fed's facilities are at the ready, minimizing the need to realize HTM losses. This does not mean the crisis is over, as other smaller banks could face liquidity mismatches; there could also be risks lurking in the "shadow" banking system, which typically consists of lenders, brokers, and other credit intermediaries who fall outside the realm of traditional regulated banking.
As shown below, equity volatility (VIX) has been fairly muted, although the same can't be said about bond market volatility (MOVE). There have been remarkable moves in Treasury yields: from a high of more than 4% as March began, the 10-year yield has plunged to 3.4%; from a high of nearly 5.1% on March 8, the two-year yield has plunged to 3.8%.
Divergence in bond vs. equity volatility
Source: Charles Schwab, Bloomberg, as of 3/17/2023.
ICE BofA MOVE Index is a yield curve weighted index of the normalized implied volatility on 1-month Treasury options.
Speed and mobility, meet disinformation
As noted, the combination of lightning-fast news dissemination, especially via social media platforms like Twitter, and the ease and immediacy of mobile banking was a toxic brew for SVB. Gone are the days of in-person bank runs from "It's a Wonderful Life." Today, money can be moved on your phone in an instant.
Sadly, the information flow over the past week has not always been sound or accurate, and often quite misleading. As an example, many a report/article/tweet has lumped brokerage firms in with banks, but they're different. Brokerage investments are separate from bank deposits, while access to liquidity is a key factor (the lack thereof was at the heart of the failure of SVB). In addition, some notes making the rounds have labeled U.S. Treasury securities as the new "toxic asset" when in fact, the securities remain safe; it's the forced selling that was the problem in the case of SVB.
On that note, rating agency S&P Global put out a report last week noting that they "view the risks from unrealized losses as manageable" and that "most banks have the capacity to hold their (nontrading) fair-valued assets to maturity, and in doing so neutralize the impact of unrealized losses over time." This key distinction has been missing in many of the "analyses" prevalent in places like Twitter.
One of the most common refrains we've heard from pundits in the no-recession camp was the lack of a credit crunch—typically a precursor to recessions historically. What we did have already in this cycle could be thought of as an asset crunch; but courtesy of the current banking crisis (of confidence), a credit crunch is likely upon us.
We won't go as far as saying the implications to markets are behind us, but it's possible that the bulk of the asset crunch was felt (obviously) on asset prices—including stocks, bonds, homes, etc.—but not the economy. That might suggest the coming credit crunch would be felt more on the economy, and perhaps less so on already-depreciated assets.
Even before the collapse of SVB, lending activity was tightening across the spectrum of commercial/industrial and consumer loans, as shown below. The Fed's Senior Loan Office Survey (SLOS) was released in early February, and it showed every category of lending in recession territory. It's hard to imagine that things loosen from here (the data is quarterly).
In particular, lending activity for commercial real estate was already shrinking. With the pandemic's influence on hybrid and remote working, the adjustments by companies to their real estate footprint have only just begun. Small banks have been particularly aggressive in commercial real estate, with loan books more than double those of larger banks. Add in the deterioration in tax revenues for states like California and New York are likely to lead to state budget problems, even if municipal stress is mild in the majority of states.
Lending standards were already tightening
Source: Charles Schwab, Bloomberg, Federal Reserve Senior Loan Officer Opinion Survey on Bank Lending Practices, as of 1Q2023.
C&I = commercial & industrial.
Heightened volatility across markets is likely to persist until there is more clarity on not just the banking system, but Fed policy and the economy. It's increasingly likely that the rolling recession we've been highlighting will be rolling into a formal recession. That's certainly the message from leading indicators. The Leading Economic Index (LEI) from The Conference Board has fallen on a month-over-month basis for 11 consecutive months—a streak that has never occurred (back to 1960) without the U.S. economy already being in a recession, as shown below.
Leading indicators suggest recession
Source: Charles Schwab, Bloomberg, The Conference Board, as of 2/28/2023.
What say you, Fed?
A pause by the Fed would seem to be prudent in light of banking system's woes (that said, last time we checked, we had no influence on Fed policy); however, market pricing shows a higher likelihood of a 25-basis-point hike. The Fed is mindful of the risk of backing off its inflation fight prematurely, but they also understand that credit crunches and recessions are inherently disinflationary, and the recent release of inflation expectations per the University of Michigan consumer sentiment survey have hooked lower. It's not an easy call.
Expectations for near-term Fed policy have been all over the map lately. As shown below, in the aftermath of Fed Chair Jerome Powell's hawkish comments in front of Congress in early March, by March 8 (blue line) the fed funds futures curve had the terminal rate at 5.7% with only a slight downslope into year-end. By March 10 (orange line), when SVB failed, the terminal rate expectation had dropped to 5.3% with rate cuts starting by year-end. As of last Friday's close (green line), the terminal rate expectation had been slashed to 4.8%, with a series of rate cuts by year-end now priced in.
Fed funds futures all over the place
Source: Charles Schwab, Bloomberg, Federal Reserve, as of 3/15/2023.
Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data.
As we have pointed out in multiple reports, a quick pivot from rate hikes to rate cuts might help stocks, all else equal; but it's not a positive signal about the economy. Markets may find themselves in a familiar dilemma moving forward: having to readjust expectations (yet again) for the path of monetary policy in the face of a Fed that is trying to battle inflation while also attending to a banking crisis.
Market leadership shifts
Up until the crisis started brewing within the banking sector, the market's outperformance this year had been dominated by what we've dubbed as one massive mean reversion trade. Sectors that underperformed last year—namely, Technology, Communication Services, and Consumer Discretionary—have outperformed this year. As you can see in our oft-used quilt chart below—but sorted weekly instead of monthly—those sectors took a slight breather around the SVB crisis, as more "traditional" defensive areas like Consumer Staples and Utilities outperformed. However, investors have jumped right back into the aforementioned "growth trio," while decisively shunning cyclically oriented parts of the market.
Significant shift in sector leadership
Source: Charles Schwab, Bloomberg, as of 3/17/2023.
Sector performance is represented by price returns of the following 11 GICS sector indices: Consumer Discretionary Sector, Consumer Staples Sector, Energy Sector, Financials Sector, Health Care Sector, Industrials Sector, Information Technology Sector, Materials Sector, Real Estate Sector, Communication Services Sector, and Utilities Sector. Returns of the broad market are represented by the S&P 500®. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance is no guarantee of future results.
Perhaps most notable—and likely a surprise to no one—has been the significant hit to the Financials sector. The quilt chart above highlights that the last two weeks for the sector have been severe enough to bring it to the second-worst spot on the year-to-date leaderboard, only behind Energy, which has languished after a stellar 2022 (there's that mean-reversion theme again).
The underperformance of Financials isn't a welcome sign but also is not surprising, as it's typically a phenomenon when the broader market is struggling. As shown below, Financials have historically been in last place when the S&P 500 is down by 1% in any given month (as of Friday's close, the S&P 500 is down 1.4% this month).
Broader story and conclusion
Amid all the focus on banks, there is a broader story that will continue to be told in the months and quarters ahead. The era of easy money is over—an era that bred capital misallocation, a record number of "zombie" companies (lacking the cash flow to fund the interest on their debt) and loads of speculative excess and risk-taking. The bill is coming due courtesy of the most aggressive tightening cycle by the Fed in four decades and the attendant return of the risk-free rate.
As has been said, when the Fed has its proverbial foot on the economic brake, something(s) inevitably will find their way through the windshield. SVB was the first significant catastrophe. However, what's unfolded since SVB's demise does not look like a crisis on the order of the GFC. The global financial system is in better shape, with significantly better-capitalized banks. That said, lending standards are likely to tighten further, from an already-tight stance pre-SVB, with defaults likely to rise. What had been as asset crunch is likely morphing into a credit crunch, adding to the case of a rolling recession rolling into a formal recession. Whereas the asset crunch has already hit markets, the credit crunch is likely to be felt more on the economy.
So far, the equity market has been fairly resilient through this crisis. For stock pickers, we continue to suggest staying up in quality and down in duration (companies with near-term cash flows/earnings). Diversification and periodic rebalancing are essential tools to help navigate an environment with heightened volatility.