Silicon Valley Bank and Equity Market Volatility
On Friday, March 10, Silicon Valley Bank (“SVB”), headquartered in Santa Clara, California, the nation’s 16th largest bank measured by its consolidated assets, went into Federal Deposit Insurance Corporation receivership. Put less formally, SVB went bust after a run on it by depositors who became unnerved by reports that the bank was in financial trouble.
These depositors were, for the most part, not your ordinary retail “mom and pop” customers of your local regional bank, instead, they were tens of thousands of start-up companies funded primarily with capital infused from California-based venture capital firms. By some estimates around half of all venture capital-backed companies in the United States banked at SVB.
SVB was, indeed, in financial trouble when this run on it occurred. In fact, the run was precipitated when prominent venture capitalists in California advised their backed companies to pull their deposits from SVB immediately.
SVB was in financial trouble for several reasons, but one important cause is that its bond portfolio which was heavily tilted to long-term Treasury bonds had taken large losses as a result of the series of unprecedented interest rate hikes which the Federal Reserve had engineered in 2022. While many observers have argued for some time that the pace and scale of the interest rate hikes were “playing with fire,” SVB is the first instance of a major financial institution being burned. SVB thus became the largest bank failure since 2008 and the second-largest bank failure in the history of the country.
These events rattled markets on March 10th, with major indices such as the Dow, down 4.4% for the week, booking its worst week since June 2022, and the S&P 500, down 4.5%, its worst week since September.
After close of business on March 10 and throughout the weekend, commentators discussed whether the fire would be limited to SVB or whether there would be contagion to other banks. Some financial practitioners, such as Bill Ackman, the billionaire CEO of Pershing Square Capital Management, argued that unless all deposits in SVB were rescued, including deposits over the FDIC insured amount of $250,000/account, the “giant sucking sound you will hear will be the withdrawal of substantially all uninsured deposits.” Other commentators took a less alarmist view and argued that the failure of SVB “appears company specific for now”, i.e., SVB played a unique role as the “crucial lender to US technology startups.”
This debate was resolved at 6:15PM on Sunday, March 12, when the Treasury Department, the Federal Reserve and the FDIC issued an announcement that the FDIC would complete its resolution of SVB “in a manner that fully protects all depositors.” The announcement also stated that a New York State Bank, Signature Bank, was closed that day and that “all depositors of this institution will be made whole.”
Despite these actions of governmental authorities, it is fair to say that a major bank failure is not a good thing, generating a new type of fear. Yesterday, on March 13, broad US market indices were down slightly, whereas the banking sector suffered a steeper decline. While the equity markets as of this writing today are broadly up in light of a somewhat positive inflation report, more volatility is likely in the days and possibly weeks ahead as this situation evolves.
In particular, in one week the Federal Reserve will meet to consider interest rate policy. Until last week, markets had generally anticipated a 25-basis point increase in the federal funds rate, but remarks by Chairman Powell to Congress suggested that a larger increase was possible given his view that inflation was not decreasing to the extent he had anticipated or hoped. This led to speculation that a 50-basis point increase was very possible.
In light of the collapse of SVB, a collapse that can be directly tied to the large interest rate increases engineered by the Fed last year, the Fed is now even more than ever caught between the Scylla of its desire to combat inflation and the Charybdis of its responsibility not to further inflame the wreckage caused by the collapse of SVB.
These events may raise a number of questions to PMA clients, we think three pertinent ones are as follows:
1. What is the exposure of PMA portfolios to bank equities?
Though banks play an outsize role in supporting our economy, they make up a smaller relative percentage of US stock market capitalization and PMA’s model portfolios. We estimate that a diversified group of banks currently represents less than 6.5% of the total equity allocation in our model portfolios (note that this specific level will vary on a client-by-client basis, though 6.5% is a reasonable estimate). More specifically, exposure to SVB Financial Group is markedly lower, estimated at less than 0.1% of our equity allocation (again, as noted above, this specific level will vary on a client-by-client basis, though is a reasonable estimate across the board). In other words, the direct impact to our portfolios from volatility in the banking sector has been minimal thus far.
To be sure, as we saw through the 2008-2009 Global Financial Crisis, banks are systemically important to the US economy and the impact of trouble with banks can more broadly ripple across the markets. We have not seen this happen yet, as actions from the federal government have so far significantly eased tensions, though we are carefully monitoring the situation.
2. What actions should PMA clients take now?
While these are trying days, and more trying days may lie ahead, PMA can only repeat the advice that it has given on other occasions over the difficult past three years, beginning with the unprecedented market declines of February/March 2020. That advice is to counsel against panic or to make fundamental changes to investment strategies during times of crisis. As we wrote in late February 2020:
First, selling stocks during a time like this means turning paper losses into realized losses. You do not truly realize losses until you sell. Second, for clients in taxable accounts, selling now may generate large capital gain taxes, a consequence of the decades-long bull market. Third, we have always stressed long-term investing in the context of a natural and deep-seated optimism about the long-term prospects of America and the world’s future. It’s hard to hang on in difficult circumstances but it has proven to be the best strategy in the past.
Or, as we wrote in mid-March 2020:
Of course none of this is to say that the performance of the markets this month has been anything other than upsetting, bringing to mind another old saying or joke – that the job of a pilot and an investor are defined by ‘years of boredom punctuated by moments of terror.’ The investor, however, has something critical that the pilot lacks – a moment of time to catch his or her breath and to remember his/her long-term goals. Accordingly, selling out of the stock market during these periods of volatility and moving exclusively into cash or bonds is a type of ‘market timing’ effort that is not the recommended strategy.
3. What lessons can be learned from SVB’s failure?
While the executives of SVB are undoubtedly and deservedly going to be severely criticized for what has happened, one criticism that cannot be levied upon them is that they invested the bank’s assets in high-risk investments. Though the end result of insolvency was the same, this is a far cry from the excessive risk-taking related to complex mortgage-backed securities that ultimately triggered the 2008-2009 crisis. Treasury securities, in theory, have no default risk – assuming investors believe in the full faith and credit of the United States government – only interest rate risk, and it is this interest rate risk that ultimately caused losses on SVB’s bond portfolio.
Instead, these executives neglected to follow an investing principle that PMA has so long advocated, sometimes to the point that the advice may sound boring or hackneyed, and that is the principle of diversification. This principle the SVB executives violated by investing $127 billion of the bank’s dollars in long-term bonds, making a massive and singular bet against a rise in interest rates. It lost this bet, and, one may say, the rest is history. Therefore, once again we will repeat one of our favorite quotes by renowned writer and guru Peter Bernstein: “Investment management provides only one dependable way to survive through the uncertainty of the future: diversification.”