The Tide
Posted on Sunday, March 12th, 2023
We slept in this morning. The rain tapping on the window kept us in bed longer than usual. I was also exhausted after playing 18 holes of golf yesterday. Kind of sad that I could be so tired after just playing golf, but it is what it is. We did manage to come in 3rd out of 30 teams so that was a bit of a highlight for the weekend considering that I have spent every other minute reading up on banking structure, funding, and regulatory issues. By now you probably know the 18th largest bank in the US went up in flames in 48 hours late this week. This week’s note may be a bit longer than usual so hang in there.
What Happened?
Silicon Valley Bank failure Silicon Valley Bank (SIVB) has been shut down by regulators who cited both inadequate liquidity and insolvency. (It is the largest bank failure since Washington Mutual in 2008.)
The liability issue: extreme reliance on institutional/VC funding rather than traditional retail deposits. While capital, wholesale funding and loan to deposit ratios improved for many US banks since 2008, there are exceptions…SIVB was in a league of its own: a high level of loans plus securities as a percentage of deposits, and very low reliance on stickier retail deposits as a share of total deposits. Bottom line: SIVB carved out a distinct and riskier niche than other banks, setting itself up for large potential capital shortfalls in case of rising interest rates, deposit outflows and forced asset sales.– Michael Cembalest JP Morgan
SIVB’s niche was obviously in Silicon Valley and related to working with startup companies backed by private equity and venture capital mostly in the tech industry. The tech industry has probably been hit hardest given the rise in interest rates. The tech industry has seen investors turn away from it because as interest rates rise investors want cash now to re-invest so they are choosing dividend paying stocks like Exxon and Chevron. They can then reinvest those proceeds at higher interest rates. When rates were 0% no one wanted their money back as there was no place to invest. Hence the move away from tech related companies.
When tech was still hot and interest rates were low SIVB’s growth exploded.
“…being flooded with deposits from fast-money VC firms and other corporate accounts at a time of historically low interest rates might have been more of a curse than a blessing.” – JPMorgan
“SIVB was unique within banks given the amount of securities on their balance sheet (L/D ratio of 43% vs. banks at ~67%; securities as a % of earning assets of ~58% vs. banks at ~24%). We believe the banks we cover are in solid liquidity and capital positions and fears across the industry do not reflect fundamental factors. While the banking system as a whole maintains ample liquidity, it’s difficult to predict isolated instances where there is a short-term disparity between deposit withdrawal requests and on hand liquidity.” (Goldman)
The bottom line on SIVB is that they grew too quickly, were completely reliant on one business sector, invested poorly and did not manage their risk. They did not even have a Chief Risk Manager for most of 2022. Schwab Bank is nothing like SIVB. It relies on a much more diversified and stickier asset base. Understand as well that Schwab BANK and Schwab Brokerage (where your assets are held) are two different entities. Those assets are not commingled as those assets held in custody at Schwab brokerage are yours and not Schwab banks. Schwab brokerage is also the 3rd largest investment advisor by Asset under Management(AUM) behind only Blackrock and Vanguard. If Schwab brokerage were to fail it would mean the failure of western capitalism. While 60% of Schwab’s profits come from Schwab Bank that means that Schwab’s earnings are in trouble not its bank.
Warning Signs Indicator
We have been warning you for some time that given the rapid rise of interest rates something would break. Take a look at this chart. Any prolonged interest rate increase from the Fed tends to end in something breaking. It is simply a political choice. In trying to stop inflation from rising (the Feds mandate) they raise rates. When the Fed raises rates unemployment rises, which is not easily accepted politically. The Fed can clearly step away from its mandate if things are breaking and the system is failing.
In recent weeks we had this to say in our weekly letter.
Interest rates are rising. That is like the tide going out. We might be about to find out that some have been swimming naked. Lucky | Reilly’s Rules (wordpress.com)
The range in the market is getting smaller and smaller and at critical levels. It is getting ready to make a major move. We spend a good deal of time and money on some of the best street research money can buy. Our volatility research team is pounding the table that volatility is about to move much higher. It is not something that they say very often. The last time they raised this red flag was in August of 2022. The market moved 19% lower in 2 months. Not saying it is going to happen but some experts are raising the red flag. –Red Flag | Reilly’s Rules (wordpress.com)
The Plumbing – the real cause for concern
We are always focused on the plumbing of financial markets. That is where the real risk in markets resides. If you have read our note for some time, you have heard us rant that the day-to-day narrative in markets does not really matter. What matters is when markets develop liquidity issues or what we call plumbing problems.
For political cover the Fed will hike until something breaks. They can then clearly stop and reverse course. When the plumbing in the system breaks central bankers begin to panic. It is when central bankers begin to panic that markets stop panicking.
July Letter
Act Now! | Reilly’s Rules (wordpress.com)
What’s Next?
The fight against inflation will not be a one and done and being tactical is going to become more important. Kryptonite | Reilly’s Rules (wordpress.com)
In 2008 banks were overleveraged to residential real estate. That was mismanagement on a system wide scale. Everyone had the same assets, and they were declining in value. Silicon Valley had a liquidity crisis. This was a good old fashioned bank run. It could happen to any bank. There is something like $17 trillion in deposits in US banks. There is only $2.2 trillion in circulation. That is the fractional banking system at work. You can’t all have your money back today. It brings to mind the movie “It’s a Wonderful Life”. The Fed will have to backstop the deposits. This won’t be a bailout situation for the bank. The bank is dead. The depositors will have to get their money bank or the Fed risks losing control over the whole banking system- the plumbing. They will choose to raise the FDIC rates and save the system.
This exact circumstance is a reason why the fight against inflation will not be a one and done. This will take a decade to sort out and what has worked for the last 40 years (commercial reals estate, tech) will not and what hasn’t worked (oil, commodities, value stocks, non-US stocks) will outperform. We have been and are continuing to look for opportunities to deploy cash in the new leadership assets which will outperform in this new era of higher inflation.
The Fed has another decision. Now that their interest rate policy is starting to cause things to break they have two choices – both of which are bad. They can continue to raise interest rates and watch regional banks implode or cut interest rates and watch inflation explode. They will choose to save the system. They will choose inflation. It’s politics. We will invest accordingly.
“Short term volatility is greatest at turning points and diminishes as a trend becomes established.”– George Soros
I think we aspire less to foresee the future and more to be a great contingency planner… you can respond very fast to what’s happening because you thought through all the possibilities, – Lloyd Blankfein
A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty. – Winston Churchill
To learn more about us and Blackthorn Asset Management LLC visit our website at www.BlackthornAsset.com .
Disclosure: This blog is informational and is not a recommendation to buy or sell anything. If you are thinking about investing consider the risk. Everyone’s financial situation is different. Consult your financial advisor.