Response to Silicon Valley Bank Collapse

March 13, 2023

The markets have had a lot to digest over the last several days from the banking sector. As investors, we understand the risks associated with investing in stocks and bonds. But when our safety blanket of cash is in question, that can create unforeseen fear. Starting late last week, through the weekend, and into this morning ASI’s investment committee has been working diligently to evaluate the situation. We have been reaching out to trusted investment partners to gain a better understanding of this dynamic environment. As of this morning, the situation seems to be getting back on solid ground and appears as though it is contained to a relatively limited segment of the banking sector. Of course, we don’t know what news will break in the coming hours, days, and weeks, but we will stay informed as new information comes to light and make any adjustments we deem necessary in your portfolio. In times like this, we rely on our experience in the markets to guide our decisions. Hasty and ill-informed decisions can be avoided when calm heads prevail in times of stress. We would like to take a few minutes to explain what has happened over the last few trading days and provide you with our perspective.

Silicon Valley Bank (SVB) is the second largest bank failure in the history of the Unites States, second only to Washington Mutual closing its doors in 2008. That undeniable fact has prompted many investors and bank customers to replay in their minds the events that led up to, and during, the Great Financial Crisis. Similar to circumstances during the GFC, SVB failed because customers lost faith in the bank’s ability to meet their cash withdrawal requests, prompting them to begin pulling all their cash from the bank, or at least any funds in excess of the FDIC-insured balance of $250,000. But there are some important facts to SVB’s insolvency that are different from those of WaMu 15 years ago.

Individuals and companies deposit their cash in bank accounts with the expectation that they can withdraw that cash whenever they need it to pay bills, meet payroll, or re-invest in their businesses. Most of the time, banks have more than enough cash on-hand to cover withdrawal requests. Thus, banks deploy excess customer cash into revenue-generating business opportunities. Two common options utilized by banks are lending services to customers (i.e. car loans, business loans and credit cards) and investments in a capital account.

Silicon Valley Bank grew its business by serving venture capital firms focused on the strong tech industry within its region. During 2020 and 2021, its customers were flush with cash. According to the Wall Street Journal, SVB’s total customer deposits grew from just over $60 billion in early 2020 to nearly $200 billion in March 2022. Just a few months later, the tech industry was one of the hardest hit as the Fed lifted interest rates to curb inflation. Customer deposits turned to withdrawals to fund their struggling businesses. At the same time, the value of the investments SVB made in their capital account dropped. Many of the lessons learned during the GFC relate to such investments. During the GFC, banks that suffered the most were heavily invested in low-rated bonds, such as high-risk mortgages. To their credit, SVB did not make that mistake. According to filings, they invested a large portion of their capital account in longer-term US treasuries, which are considered one of the safest investments in the world. The default risk of those bonds is nearly non-existent, supporting the claim of safety; although, pundits will point to the debt ceiling debate waging in DC right now as an elevated risk to US government bonds. We’ll come back to that in a minute. SVB’s portfolio, although invested in high-quality bonds, was still subject to interest rate risk. With rates appreciating, bond values declined. Even
the safe haven of US treasuries was not immune to the shift in the yield curve. So, if SVB needed to sell securities in the capital account to satisfy customer withdrawals, they would lock-in substantial losses. Those unrealized losses at the end of 2022 were reportedly over $17 billion.

On Wednesday of last week, SVB said that it sold securities worth $21 billion at a loss of $1.8 billion, according to the Wall Street Journal. To shore up its balance sheet, the bank was attempting to raise $2.25 billion in capital. After that news was released to the public, the stock price cratered. Banking customers feared the worst and began pulling cash in earnest. On Thursday, customers tried to withdraw $42 billion of deposits, according to a filing by California regulators. It snowballed from there. On Wednesday, the stock price was $267.83. On Friday when regulators took over the bank, the stock price had fallen to $39.25.

Already reeling from the closure of Silvergate Capital’s bank, whose own problems stemmed from its crypto business connections, SVB’s failure created a contagion effect in the banking industry. BlackRock’s iShares US Regional Banks ETF (IAT) declined 17.4% last week. On Sunday evening, Signature Bank was closed by regulators as a result of its exposure to the crypto markets. Signature is the third largest bank failure in US history.

SVB’s failure stems from a client-base of start-ups and venture-capital firms in the tech industry. Other banks and financial institutions with significant capital problems are tied to the crypto industry. These are small segments of the US economy. Further, SVB was the 19th largest bank in the US according to a report late 2022. But it was only 5.6% of the size of the largest, JPMorgan Chase. Signature Bank was smaller than SVB.

When you read the headlines, one could think the sky is falling. But the S&P 500 declined just 3% between Wednesday and Friday in reaction to this news and the fear that ensued. Other market news in consideration were as followed: Employers added 311,000 jobs in February, according to the jobs report on Friday. It was also reported that more individuals re-entered the workforce and are actively looking for a job. This is good news for employers looking to see wage growth decline to a more moderate, healthy pace. Last week’s news also shifted investors’ expectations on the Fed’s next rate hike as it continues to fight inflation. Prior to Wednesday, the market was pricing in a hike of 0.50%. Currently, the market is expecting a hike of 0.25%. Bond prices rose on Friday, with the US Aggregate Bond Index appreciating 1.2%. Going back to an earlier comment on the safety of US Treasuries, amid the turmoil late last week, many investors attempting to time the market and shift their portfolio to safer securities purchased US treasuries. It’s interesting to note that the securities that contributed to SVB’s demise are the same securities that investors turned to for safety.

As we noted earlier, ASI is monitoring the evolving developments closely. Last night, it was announced that banking regulators and the US government are stepping in to provide a backstop to cash losses (beyond the FDIC-insured $250,000) at the failing banks. According to President Biden in his address this morning, that is as far as the guarantee will go. As always, we take a measured approach to responding to developments such as this. We do not want to overreact. Last week’s news on SVB and other related businesses is concerning, for sure, but we must remain focused on the big picture and facts.

You must be wondering how much exposure your portfolio had to the failed banks mentioned above. ASI’s portfolio is broadly diversified across many countries and market sectors, so your exposure to the banks in the current headlines is extremely small. For example, the DFA funds and ETFs we use for stock exposure had less than 0.10% in Silicon Valley Bank stock as of the end of January.

Follow this link to a comforting announcement from Charles Schwab on the financial strength of their business.