Investors are rightly concerned following the collapse of two major banks in the course of a few days. The failure of Silicon Valley Bank (the 16th biggest bank in the country) was followed quickly by regulators seizing the assets of Signature Bank. These were, respectively, the second and third biggest bank failures in United States history. The market is now watching San Francisco-based First Republic Bank after it announced that it needed an infusion of capital from JP Morgan and the Federal Reserve to stay solvent. Several other smaller institutions, such as Western Alliance Bank, have seen their stock sell off over 50% in a few days as investors flee the sector.
It’s not surprising that many see echoes of the 2008 financial crisis as these developments unwrap. After all, if you had to boil down the Great Recession to a single idea it would be bank failure.
In this commentary, we hope to provide a simply stated explanation for what happened to these institutions over the last week along with a broader discussion on if there should be concern that the contagion will spread to the rest of the economy. It concludes with a direct response to the question which investors have been asking us: what should I do?
RECENT DEVELOPMENTS
It should be understood that the failures of Silicon Valley Bank and Signature Bank were unique situations. Signature Bank was a very crypto-focused institution with an unconventional balance sheet. Silicon Valley Bank (SVB) focused primarily on providing financing for smaller tech companies and was “uniquely dependent on the growth of tech firms”. CNBC points out how this demonstrates “the risks of banks concentrating in one area”. As a lender in the technology sector, SVB was also specially exposed to rate hikes in a way that most banks are not. The Hill calls the demise of the bank the “latest tech victim of high interest rates”.
Silicon Valley Bank also made some extremely problematic liquidity decisions. In 2021, just before Fed interest rate hikes began, the bank locked $91 billion of its portfolio into long-term government treasuries yielding just 1.64%. As the bank only had deposits estimated at $175.4 billion in December, this meant that the institution decided to make a huge amount of its value illiquid to chase a slightly higher interest rate. When rates rose, the bank lost $15 billion on its portfolio and was, in short, put into a position where it had to realize steep losses to meet client withdrawal requests. While SVB wasn’t alone in its foolish bond purchases— banks are estimated to be sitting on $620 billion of unrealized losses-- we have not seen evidence of any other banks which willfully tied its own hands with such dramatic scale.
FED & GOVERNMENT ACTIVITY
For what it is worth, the government has taken a logical course of action in its attempt to calm markets. First, while it is unclear why a private sector buyer couldn’t be found for Silicon Valley Bank, it is a good thing that these banks were not bailed out in full. To do so would reinforce irresponsible behavior. Treasury Secretary Janet Yellen stated, “We’re not going to do that again.”
While it can be debated, it is also understandable that federal authorities have stepped in to protect all depositors of the failed institutions; even those who unadvisedly kept hundreds of millions of dollars in an environment at SVB which they knew not to be FDIC-protected. While we understand the argument that those depositors should pay the price for their irresponsible behavior, the alternative of “bailing out” depositors would likely be to create a series of tech industry bankruptcies.
The government has also, wisely, created a liquidity program which will allow banks to borrow more easily against long-term assets. A program like this would have aided SVB in its problem with being trapped in long-term bonds when it needed badly to access its capital.
What is uncertain is whether these bank failures will change the course of The Federal Reserve, who until now were widely expected to hike interest rates several more times this year. Goldman Sachs analysts no longer expect the Federal Reserve to hike rates in March citing “stress to the banking system”. The idea that rate hikes are suddenly off the table is at odds with the Fed’s mandate of fighting inflation first. Forbes points out that this (a slowing economy) is “exactly what the Fed wants.” Why, then, would they back off of interest rate increases?
The truth is that The Fed is moving into uncharted territory—and the rest of us are being pulled along with it.
BROADER CONTAGION?
While we don’t believe that either Signature or Silicon Valley Bank are emblematic of your average financial institution and don’t—in and of themselves—indicate a broader rot in the sector, that is only part of the concern. The better question for investors is whether the two bank failures create a deterioration in psychology; a sort of “self-fulfilling prophecy” where the first bank run leads to the next in a vicious cycle.
An equally big concern is whether these bank failures cause other institutions to become more cautious and less willing to lend. In doing so, they may reduce the availability of financial liquidity when it is needed the most.
Investors tend to think of a broad business or economic cycle as a gradual “ebb and flow” from the top to bottom. In his book Mastering the Market Cycle, Howard Marks describes the “credit cycle” as being more akin to a window: it is either open or shut. Banks are either lending or they aren’t, and the “window” can open or close in an instant— especially in times of panic. Banks can be just as susceptible to psychology as the average investor. During good times, banks tend to be increasingly eager to lend, competing for risky loans at (to the bank) unfavorable terms. During dark periods they are hesitant to make loans even on favorable terms for fear of losing money.
There is no way to know whether the failure of two banks last week will create a domino effect that takes down more banks—even good, sound institutions—in the aftermath. It is also uncertain if banks will tighten lending and, as a result, take financing out of the economy when the gears most urgently need lubricant. Following these failures, the only thing that the average citizen can do is to invest as if there is a heightened possibility of economic deterioration—which there is.
WHAT SHOULD I DO?
That leads to what many clients are asking us this morning: what should I do?
While the risk tolerance, goals, and expectations are different for every investor, there are several items which stockholders should consider as general advice.
First, investors should review their portfolio for direct exposure to smaller financial institutions. This could come through a fund like the SPDR S&P Regional Banking ETF (ticker: KRE) or through other more general small-cap and mid-company funds. Our clients can rest assured that our core portfolios carry almost no exposure to smaller banks. The financial institutions in which our clients have investments are the mega-cap heads of the financial space such as JP Morgan, Goldman Sachs, Visa and Berkshire Hathaway. For readers that do have exposure to these smaller banks, they must consider whether it makes sense to continue investing in this space.
For those concerned that failures in the banking sector will spread to the broader economy—a legitimate worry—note that we always discourage selling out of fear. However, you can stay in the market while still investing in a more “defensive” allocation:
- Forego smaller companies with the bulk of your funds and invest in large-cap and mega-cap companies. We would expect these to be more resilient to economic decline.
- In addition to avoiding the financial sector, avoid other sectors which tend to do poorly during an economic downturn. These may include consumer cyclical stocks and technology companies.
- Allocate away from “growth” companies and toward “value” companies. Examples of the latter include stalwarts like Proctor & Gamble or Johnson & Johnson.
This combination-- large “value” companies which avoid riskier business sectors-- are not certain to appreciate. However, they at least represent the type of investment which will more ably “weather a storm”.
Clients may also consider moving more heavily into bonds, even if it is a short-term move born out of fear. With bond yields rising, stocks become less attractive. For example, six-month United States Treasury Bills (T-Bills) presently yield an annualized rate of 4.83%. Imagine if Silicon Valley Bank had been able to put its money in these! The point is that, if investors can get nearly 5% in short-term bonds, maybe it is okay to downshift some holdings out of stocks.
While we wouldn’t consider it advisable, anyone with absolute confidence in a market downturn may still be tempted to sell rather than face additional losses. Selling without a plan will feel therapeutic in the moment—it will also put the investor in a position to try to “time the market” and predict a bottom. We emphasize that anyone who liquidates must only sell their investments in combination with a specific plan to re-enter the market. For example, investors may wish to participate in a dollar-cost-averaging strategy where they sell 100% to cash and re-enter the stock market in increments over the course of a fixed period (such as ninety days). Otherwise, you run the risk of taking some losses and then also missing out on a rebound.
For any investors who are unsure of what to do, we would encourage them to reach out for a complimentary portfolio analysis.