Executive Summary:
- Despite recent rhetoric, we believe your bank deposits are secure, as is your bank.
- It is not possible to insure the banking system’s entire deposit base, in other words, the amount exceeding $250,000 per account, but additional bank failures, if any, will be few.
- SVB was a failure across multiple private and public individuals and agencies.
- First Republic Bank may have value to an acquiror, but the stock appears worthless.
- This is not a financial panic and will subside. The main issues confronting markets in 2023 are the length of time it takes to quell inflation and the debt ceiling debate within a divided Congress.
It’s a business that can be a very good business, when run right. There’s no magic to it. You just have to stay away from doing something foolish. It’s a little like investing. You don’t have to do anything very smart. You just have to avoid doing things that are ungodly dumb.
Warren Buffett on investing in banks, 1996
In the case of Silicon Valley Bank, dumb was rampant. For more than fifteen years leading to 2020, SVB, as it came to be known, had seen assets rise in a high, but generally typical fashion for a bank positioned for growth. For over twenty years, average annualized growth of assets grew 24% per year, but there were single years of outsized growth, such as +50% in 2008, 37% in 2010 and 49% in 2014. For 2019, 2020, and 2021, however, assets grew 25%, 62% and 84%, respectively. In dollar terms, this amounted to asset growth of $12 billionin 2019, $40 billion in 2020 and $78 billion in 2021, before retreating $16 billion in 2022. These are massive moves for a bank the size of SVB.
While a hero on Wall Street, SVB had always been something of an anomaly. In the financial panic of 2008-09, SVB saw asset growth and booked respectable profits. When the Federal Reserve attempted to raise interest rates in 2018, earnings doubled, but 2022 was not met with the same success. Despite a sizable outflow of deposits, assets, book value and net income fell, but only modestly, while operating and free cash flow both increased over 50 percent. Was this dichotomy of financial results the reason the chief risk officer, Laura Izurieta, left last year? In their vague reporting, the media would have you assume so, but her hands are not clean. She was directly responsible for buying long-term bonds, at historically low interest rates, prior to the Federal Reserve increasing rates last year. It has been said her “contribution” alone created losses of almost $2 billion. For this, I’m sure she’ll be allowed to testify as to why she sold $4.2 million in SVB stock in December, 2021, which did not sit well with company management. Tarnished by the sale, she agreed to a separation agreement from SVB in April 2022, which provided a $7.1 million severance package. We advise you check local listings for the coverage, for we don’t know if her testimony will be covered on C-SPAN or CNBC’s American Greed.
SVB was the 16th largest bank in the U.S. and the second largest bank failure in U.S. history. Over half the deposit base was tied to the venture capital (VC) industry, mostly through technology and life science companies in their early stage of development. These “start-ups” are high risk, but over many years, SVB had developed expertise in funding and servicing their needs. Most local and regional banks rely on a diverse “retail” deposit base, but SVB was believed to have had only six percent of its base in such deposits. As a result, over $160 billion in deposits were uninsured by the FDIC’s $250,000 coverage ceiling.
The FDIC was concerned the failure of SVB could lead to other banks failing, something akin to 2008-09. As a result, the FDIC ultimately backstopped all SVB deposits. This is notable because the FDIC’s Deposit Insurance Fund balance on December 31, 2022 stood at $128 billion, less than SVB’s uninsured deposits. When those in Congress and elsewhere suggest the Government should backstop all deposits, their remarks may make for good press, but are clearly naive, if not void, of the facts. According to the Federal Reserve Bank in St. Louis, there is an estimated $17.6 trillioninbank deposits today. In 1990, the U.S. was 214 years old and had amassed a national debt of $3.2 trillion over that time span. Having about doubled in ten years, the national debt will be ten times the amount from just thirty years ago. Because politicians have recklessly imposed this burden on the shrinking half of the population who actually pay taxes, our government is unable to guarantee the safety of all bank deposits with anythingbut lOUs. The businesses briefly held hostage by SVB’s sudden closure affected the ability of companies to meet payrolls and pay other bills. The government rightfully created a temporary bank to fund SVB’s depositor needs, and currency was again changing hands in a few days. lOUs don’t allow for this.
As stated, SVB held long-term debt, which materially fell in price when rates rose and could only be sold for a loss when the need for short-term liquidity arose. By not better managing this duration risk, there have been accusations of mismanagement, even negligence of SVB management. Not to toot our own horn, but, over a year ago, when the Fed stated they were about to raise rates, we believed them. As such, if we purchased bonds at all, they were of a maturity of six months or less. How could SVB management not also see this?
Still, it is not just SVB management’s fault. Elected by shareholders, but admittedly are handpicked by company management and the existing Board, a Board of Directors’ primary responsibility is to protect shareholder interests. In addition, they establish corporate policies, conduct strategic planning and are responsible for corporate oversight. In their position, the board should be asking tough questions and act responsibly in a way that complies with their fiduciary responsibility, assuming they understand what they oversee. Some Republicans claim SVB’s failure is a result of woke, ESG (Environmental, Social, and corporate Governance) issues. Despite political differences, this misunderstands SVB’s Board. Yes, the Board of Directors were noted Democrats, but they used their perch at times for reasons having nothing to do with their responsibility. For example, two members were heavily involved in political fundraising (Kate Mitchell, Garen Staglin), while another pushed political agendas supportive of SVB’s VC client base (Mary Miller). One was part of an improvisational theater troupe for ten years (Elizabeth Burr), who saw her role not as a steward for shareholders and other stakeholders, but as an activist for “forcing companies to embrace diversity.” She has also been a director of Rite-Aid since 2019, which has been a trainwreck and near business failure in recent years. The only true banker outsider on the Board was relatively new, Tom King, a 35-year investment banking veteran, mostly with Citigroup, but subsequent to SVB, was CEO of investment banking at Barclays. Ironically, he retired from Barclays at the end of 2021 because he did not want to be subject to UK laws making senior bankers legally responsible for their unit’s mistakes.
Then there’s the Government. In 2010, following the near collapse of the banking system in 2008-09, then-President Barack Obama signed into law what has been widely known as Dodd-Frank. This called out banks, with $50 billionin assets or more, as being “systematically important” to the financial system, and implemented stricter regulations upon them. Among other things, they were required to undergo an annual Federal Reserve “stress test” to maintain certain levels of capital, which was held to offset unexpected losses, and liquidity such that they could quickly meet any reasonable and sudden cash obligation. These banks were also required to file a “living will,” which outlined their process for a quick and orderly dissolution if they were to fail.
The further time moved away from the Panic of 2008, the greater the cry from banks near or at the $50 billion asset threshold became. In 2015, during President Obama’s administration, Congress held public hearings, and none other than SVB’s chief executive officer, Greg Becker, was urging Congress to raise the threshold. InMr. Becker’s testimony, he argued that the regulations born on a $50 billion bank would require his and other banks to spend time and money complying with rules instead of providing loans to companies creating jobs. SVB had $40 billionin assets at the time.
In May 2018, Mr. Becker and others got their wish. Today, with SVB’s failure, politicians and the media are criticizing the Dodd-Frank “rollback” as leading to SVB’s collapse. This rollback eliminated the $50 billion asset size threshold, instead elevating all its regulatory elements on banks with $250 billion or more in assets. This was signed into law under a Republican administration, but heavily criticized by certain Democratic lawmakers. Yet again, we’re hearing only part of the story. The rollback gave the Federal Reserve the right to apply the regulations to particular banks with at least $100 billion in assets, which, by 2020, included SVB, and it said that banks that met that $100 billion threshold would still face periodic stress tests.
Yes, President Trump signed the rollback into law, but it was considered a bipartisan vote at the time, with 50 Republicans and 17 Democrats voting their support. InCongress, the bill passed more along party lines, 258 to 159, but 33 Democrats still supported the bill.
The case for the Democrats placing blame on Mr. Trump may have merit, but not solely, or even largely, because of this. Some point to the President’s Federal Reserve appointees, who declined to use the supervisory power still possessed in the 2018 law, to address known problems with SVB’s balance sheet. President Trump appointed three of the seven Federal Reserve Board Governors. If this helped lead to SVB’s collapse, then what about Dr. Lael Brainard, who was appointed by Mr. Obama, and the three Governors appointed by Mr. Biden?
While there’s enough blame to go around, in our mind, SVB’s board and executive management failed their shareholders. Too, there’s a glaring hole in Dodd-Frank’s stress test. While they test asset/liability metrics, it doesn’t “stress” the balance sheet to material changes in interest rates, which has injured each bank in the news recently. How this is excluded is beyond our comprehension, so instead of Republicans and Democrats looking for ways to blame one another, perhaps they should come together to form a bipartisan solution. On behalf of the American people, we’ve been waiting for civility and compromise from our politicians for years and they are welcome to start here.
The Federal Reserve raised the discount rate 0.25 percent on Wednesday, elevatingit to a range between 4.75% and 5.00%, its highest level since 2007. The corresponding prime rate is 8.00% today. The prime rate is a benchmark banks use to set rates for most all loans. It especially factors in determining the rate on adjustable-rate mortgages, home equity lines of credit and credit cards. To put this is perspective, the prime rate was 3.25% during 2020-2022, tied with 2008 for the lowest in 65 years. During the two years following the outbreak of Covid-19, if one wanted to borrow $100,000 for ten years to improve their home, the monthly payment would be $977 per month. Today, that same $100,000 loan over ten years requires a monthly payment of $1,213, a 24 percent increase.
Until SVB, the Federal Reserve was effectively in control of the economy, but recent events likely change this. The text of The Fed’s message Wednesday suggested they could cease raising rates sooner than expected. While the banking industry is generally sound, the failure of Silvergate, SVB and Signature, with a few others in question, materially affected consumer confidence. With the Fed already removing liquidity from the economy and consumers moving bank assets for a better return, if not for personal concern over the safety of their deposits, banks have less to lend. The economic leverage of making a loan for a business venture cannot be ignored. The bank lends money, a business opens, it hires employees, the employees need a place to eat, a new restaurant opens, it hires employees, they need banking services, a bank opens and so on. This is called the multiplier effect, in other words, the economic value of a dollar of investment is multiplied many times over. Of course, the reverse is also true, which is why the government was so quick in responding to the cash needs of SVB’s businesses.
With inflation still at six percent, well above the Fed’s target of two percent, for the Fed to signal the pace of interest rate increases could slow suggests they believe the banking system may do some of the work for them. A recession will also, and one seems more likely now than a couple of weeks ago.
While attributed to many, and occasionally used by us, the phrase, “the time to buy is when there’s blood in the streets” is credited to Nathan Mayer Rothschild, the 19th century British businessman and financier and member of the Rothschild banking family. The flow of blood in bank stocks of all kinds has been powerful since the collapse of SVB. We believe there is value among banks, but the safest segment is the large, too big to fail, enterprises: Bank of America, The Bank of New York Mellon, Citigroup, Goldman Sachs Group, JPMorgan Chase, Morgan Stanley, State Street and Wells Fargo. Of these, our preferences are Bank of America and JPMorgan Chase.
We believe most regional banks are sound, but the news affecting those that aren’t is not fully known. While we don’t at all believe the better regional banks are at material risk, this does not mean their stocks aren’t subject to being guilty by association. No other bank defines this association today thanFirst Republic Bank (FRC).
FRC was founded in1985 and has grown both organically and via acquisitions. Known as a bank for the ultra-wealthy, Merrill Lynch acquired them in 2007. One short year later, however, when Merrill Lynch was days away from collapse, Bank of America acquired Merrill. In 2010, the new owner sold FRC to bank management and private equity for fifty-five cents on the dollar, versus what Merrill Lynch had paid three years prior. FRC soon went public again and has grown assets in similar fashion to SVB. For example, their asset base of over $200 billion has also doubled since 2019. While FRC ended 2022 with $13 billion in shareholder’s equity, the problem, if reports are true, is the bank has an unrealized loss of $25 billion in their securities portfolio. If too many Treasury, agency and municipal securities are required to be sold to meet liquidity needs, then shareholder’s equity is wiped out. Still, the bank has earnings power and, if for no other reason than the bank’s client list, FRC has value; we simply don’t believe it’s worth the risk, even in today’s decimated stock price.
The federal government’s ability to issue new debt ended January 19, 2023. Since then, the Treasury Department has used “extraordinary measures” to prevent a default on paying the government’s obligations, but the fact that taxes are generally paid earlier in the year will help delay default until a time between July and September. For the markets, the primary concern over not raising the debt ceiling is the government defaulting on its Treasury obligations. No one believes the United States becomes the next Argentina, but it could cause creditors to demand higher interest rates, which could then raise rates for all other types of debt, including mortgages and consumer borrowing.
A similar impasse with the debt ceiling last took place in 2011, during President Obama’s administration. The media reported the pending collapse of the government, the markets behaved badly, and Republicans were eventually faulted for needless stubbornness and opposition. We find the Republicans’ cause worthy, after all, the national debt is $31,636,558,943,851, which is $94,541 per citizen and $246,868 per taxpayer. Too, whether intentionally timed or not, Mr. Biden unveiled his 2024 $6.8 trillion budget two weeks ago that, if passed, will add $1.8 trillion to the national debt next year. Put another way, the taxpayer will be responsible for an additional $14,045 by the end of September 2024. Despite this, by following the same playbook, it will be difficult for the Republicans not to meet the same fate as they experienced in 2011.
For us, this upcoming debate ranks at the top of concerns for the market. Inflation and recession fears are close behind, but we see the former as fostering the greatest volatility. Whether or not Mr. Biden and House Speaker McCarthy can come to terms to avert a shutdown, or even if we briefly do shutdown, this will pass. By then, interest rate increases will likely have stopped and the recession, assuming we have one, will be mild, if only because employment remains solid. Of course, there can always be a black swan event, and we’ll need to endure the Parade of Politicians next year, but, as is much of daily news and opinion, for an investor, this is simply noise. Looking beyond it, the stock market should offer upper single digit returns for the next couple of years. This isn’t the double digit returns of a few years ago, but is easily enough for us to remain invested.
Please know we are always grateful for your trust and business.
Kind regards,
