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When Headlines Worry You, Bank on Investment Principles

Over the past week regulators first took control of Silicon Valley Bank. Two days later, regulators took control of a second lender, Signature Bank. Then a new “crisis” was reported in Europe with Credit Suisse triggering a broad sell-off of big-bank shares in Europe and elsewhere. Even though the issues appear to be something that the overall banking system can more than manage, cue the hysterics and the herd mentality that followed. this reminds us of a quote from billionaire

Charlie Munger

A teacher asks a class a question: “If there are 10 sheep in a pen and one jumps out, how many are left?” The entire class but one boy said there are 9 left. That one boy said none are left. The teacher said, “I don’t think you understand arithmetic” and the boy replied: “you don’t understand sheep".With increasing anxiety, many clients are asking if their investments are exposed directly to these and other banks, or what changes need to be made to their portfolios. We know that the similarities are scary on the surface. All news outlets are reporting a major bank collapse and we all think back to the last time this happened in March 2008, when Bear Sterns was reportedly in trouble, which was the start of the “global financial crises”. It is natural to worry this will trigger a repeat of 2008. It is very possible, even likely, that the current drama worsens before it gets better, but there have been numerous changes to the global financial system that has it in much better shape than it was in 2008.Rather than ruining your Sunday rummaging through your investments or looking for negative headlines, both of which add no value and will only make you anxious, we want to remind you that uncertainty is nothing new and investing comes with risks, but ignoring the “noise” can help avoid making shortsighted missteps. Consider the last three years alone: a global pandemic, the Russian invasion of Ukraine, spiking inflation, and ongoing recession fears. Despite these concerns, as of February 28, 2023, the annualized return of the stock market has been 11.78% (source: Dimensional Fund Advisors US$). Below we summarize the relevant information about the events that transpired over the past week, focusing on the facts rather than fearmongering.Who is Silicon Valley Bank (SVB)?Poor Risk Management This is not 2008The Banking Sector is all about Confidence

SVB was launched in 1983 to focus on tech startups in the San Francisco Bay area.
Mainstream banks had little expertise in tech and naturally avoided small companies with little or no revenue, no profits, and scarce collateral to back loans.
Clients range from life sciences, venture capital, private equity, and even the premium wine market.
It supplied mortgages to rich Silicon Valley entrepreneurs and expanded overseas to fund the hot tech markets in India, Israel, and Britain.
Deposits increased from $65 billion in 2019 to $189 billion in 2021.
SVB’s funding model was far too risky and proved fatal when interest rates rose.
Tech client deposits were funded by initial public offerings, venture capital investments, and the like.
Rather than being prudent with the deposits, profit was the main objective.
Deposits were not held in low-risk assets such as Treasury bills, as they paid almost nothing in a zero-interest-rate market.
SVB opted instead for longer-dated/fixed-rate securities bonds with higher interest to increase profits.
Their strategy worked until interest rates increased, causing cash flowing into startups to slow, so they had to withdraw their deposits to pay their operating expenses.
With deposits shrinking and the requirement to meet withdrawal requests, SVB had to sell its long-term/fixed-rate securities at a loss – when interest rates rise, the prices of fixed-rate bonds fall.
When SVB clients heard about how much deposits were shrinking, they pulled more than $40 billion within a few days.

No bank is free of risk, but it didn’t take a genius to figure out that SVB was riskier than most. Its business was centered in a volatile tech sector whose profits were largely dependent on low-interest rates. Further, its fixed-rate securities accounted for 56 percent of its assets, about double that of many of the “big banks”.

SVB did not conduct regular stress tests on their operation funding, nor did they implement any precautions if their hyper-concentrated tech client base funding decreased. The bank’s risk management failed miserably.

While we do not take pleasure in any business failing, the irony is that the SVB’s owners had a history of whining about the evils of regulation and government intervention in the banking system, where now they were pleading for a full bank bailout.

This time around, the assets sitting on bank balance sheets aren’t toxic – and that means the banks still trust one another, so they are still lending to each other every day. In 2008, it was the opposite. Banks owned so many troubled assets, and these securities were so intertwined, that it was nearly impossible to know who had exposures to what. Because there was such a complex web of mortgage-backed securities – investments tied to undesirable U.S. mortgages – the trust between institutions disappeared and they stopped lending to each other. These loans are made behind the scenes every single day, and they keep the system humming. It was as though all the oil in the financial system dried up, and financial markets froze.

Today, U.S. banks are also in much better financial health compared to 2008. The metrics used to measure their strength are technical, but in short, banks are sitting on much larger cash cushions this time around, which serve as “shock absorbers”, and are well above regulatory minimums and miles above the levels before the global financial crisis.

This is particularly true for major banks. The 2008-09 crisis proved that some banks are simply too big to fail. Regulators spent years determining which banks fit this bill, implanting strict requirements for minimum cash reserves compared to smaller banks (such as Silicon Valley Bank), as well as adhering to multiple additional guidelines.

The regulators themselves have also changed how they operate in a crisis. Before 2008-09, it was almost inconceivable that a major bank could fail. Today there’s a full playbook for it. The Federal Reserve took control of Silicon Valley Bank and Signature Bank, in a matter of days, then quickly laid out plans to insure all their deposits.

This time around a major issue is something that barely existed in 2008: social media. Twitter, Facebook, Instagram, and the likes weren’t nearly as interwoven into daily life as they are today. Chat applications such as WhatsApp hadn’t even been created.

The risk today is contending with how quickly information spreads on social media, and the digital fearmongering was overpowering last week. In public venues such as Twitter, venture capitalists made it seem like their universe was about to implode. Multiple newspapers have also reported on private group chats with tens or hundreds of startup chief executives debating whether to pull their money from Silicon Valley Bank.

Confidence

Banking is all about

confidence

. You put money in the bank today because you are confident you can take it out tomorrow; to you, a dollar that you have deposited in the bank is equivalent to a dollar in your wallet. If you show up at the ATM at any time of day or night, you expect it to give you your dollars. However, the bank doesn’t just put your dollars in a box and wait for you to take them out; the bank uses its depositors’ money to make loans or buy bonds, and just keeps a little bit around for people who need cash. If everyone asked for their money back tomorrow, the bank wouldn’t have it. But everyone is

confident

that, if

they

ask for their money back tomorrow, the bank

will

have it. So they mostly don’t ask for it, so when they do, the bank

does

have it. The widespread belief that banks have the money is

what makes it true

This may seem obvious. Also, as obvious, is that this is an unstable equilibrium. If people stop believing it, it stops being true. If everyone stops believing in a bank, they will all rush to get their money out, and the bank won’t have it, and their lack of belief will be retrospectively justified. Whereas if they had kept believing, their belief would also have been justified.

There is a deep social purpose to this

confidence

. Banking is a way for people collectively to make long-term, risky bets without noticing them, a way to pool risks so that everyone is safer. You and I put our money in the bank because it is “money in the bank,” it is very safe, and we can use it tomorrow to pay our mortgage or buy a coffee. And then the bank provides loans in the form of mortgages: Homeowners could never borrow money from anyone of us for 25 years because we might need the money for a coffee tomorrow, but they can borrow from

us collectively

because the bank has diversified the risk among lots of depositors. Or the bank makes small-business loans: Those businesses could never borrow from

because we need the money and don’t want to take the risk of losing it, but they can borrow from

us collectively

because the bank has diversified that risk among lots of depositors and also lots of borrowers

But the basic problem remains,

confidence

We know that deep down we are all creatures of social confidence and that preserving that confidence is crucial. Where trust in banks makes them trustworthy and distrust in banks makes them fail. More specifically, if there is a “run on a bank”, and that bank goes bust and doesn’t pay depositors, then there will be a run on other banks. This “run” can start with a bank that is

bad

, that is undercapitalized and made poor decisions and, in some sense, deserves to fail, but it can spread to other banks that are

good

. Where “good” and “bad” are not really the things that matter: What makes a bank good is not just its capital ratios and liquidity position but also

confidence

, and however good the ratios it is hard for a bank to survive a loss of

confidence

If you are in charge of a bank, and there is a run on some other bank, and your bank is fine, you might be tempted to put out a public statement saying “that bank was bad, so there was a run, but our bank is good and has no affiliation to that bank, so there is no need to worry about us.” Sometimes that is right, the bad bank was idiosyncratically insolvent, and you should just avoid it. But experience teaches that it’s often wrong. You run toward the fire because that’s the only way to put it out. That is exactly what the biggest banks in the US did by pledging $30 billion of cash for First Republic Bank, to stem the turmoil that has sent depositors fleeing from regional banks and shaken the country’s financial system.

It was rational for each depositor to take their money out and avoid exposure to SVB, but the collective result was quite bad for SVB and for the banking system. Silicon Valley Bank’s customers, it turned out, were individually rational but unable to act cooperatively in a mutually beneficial way;

in the prisoners’ dilemma of a bank run, they all chose to defect.

If you want to discuss the ongoing events in more detail or review your portfolio, we are always available. Please email, call, or set up a meeting with our

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Have a wonderful Sunday.