JPM - When There Is One Cockroach

2023-03-13 18:27:43 ET

Summary

• Equities cratered late in the week as Silicon Valley Bank (the 18th largest bank in the country based on deposits) collapsed and was taken over by the FDIC.
• The FDIC and the Treasury departments put in some investor backstops over the weekend to prevent further volatility in the financial system.
• Will these actions be enough to snuff out growing fears of financial contagion? That is the $64,000 question for investors and the market.

I sincerely believe that banking establishments are more dangerous than standing armies, and that the principle of spending money to be paid by posterity, under the name of funding, is but swindling futurity on a large scale .”? Thomas Jefferson.

Late last week, Silicon Valley Bank, which is owned by SVB Financial Group ( SIVB ), imploded and was taken over by the FDIC on Friday. It was the second largest bank collapse in U.S. history, exceeded only by Washington Mutual in 2008 during the financial crisis. Over the weekend, the FDIC and the Treasury Department announced measures to backstop deposits at SIVB and other actions intended to snuff out fears of financial contagion. Will they be enough to achieve that goal? A discussion follows below.

SVB's Collapse

The crisis started on Thursday with the stock of SVB Financial Group plunging 60% during the trading day after management announced it was selling almost all of its available for sale ((AFS)) securities. This triggered an approximate $1.8 billion loss for SVB and blindsided shareholders in the bank. The company intended to do an over $2 billion capital raise to shore up its liquidity and bolstered its balance sheet , but the events of the day and what followed last week made that effort impossible. By Friday, the FDIC took over and shuttered the bank. SVB was the 18th largest bank in the country with some $175 billion in deposits, of which just over $150 billion were " uninsured ."

Silicon Valley Bank had been a key part of the venture capital and startup ecosystem across San Francisco for four decades. The collapse of SVB was the final result of a massive bank run on Friday, where over $40 billion worth of deposits were withdrawn in a single day. The collapse triggered a huge spike in fears of financial contagion on Thursday and Friday. Famed head fund manager Bill Ackman was one the first to call for a government bailout at SVB as " The failure of SVB Financial could destroy an important long-term driver of the economy as VC-backed companies rely on SVB for loans and holding their operating cash."

Many Venture Capital funds soon followed with that call to action, and Twitter was flooded by these pleas over the weekend, all in the name of containing the fallout from Silicon Valley Bank's collapse. Of course, many of these same VCs helped cause the huge run at the doomed bank late last week by urging their portfolio companies to withdraw all deposits they had at SVB. Life, as always, contains much irony.

Silicon Valley Bank's fatal flaw was around basic risk management implementation. The bank's deposits swelled in 2020-2022 as the Fed's easy money policies had triggered a huge boom in IPOs and SPACS among SVB's primary customer base out west.

In the post-pandemic low/zero interest rate environment, SVB's risk management team chose to violate one of the core tenets of Banking 101. This is the matching of durations between assets and liabilities. SVB invested a huge portion of its portfolio in long dated treasuries, mortgage bonds and the like. All for less than a half a percent in additional average annual yield it should be noted. While this helped the bank's profitability a bit in the short run within a low/zero interest rate environment, it made SVB extremely vulnerable in a scenario where interest rates increased at a rapid base.

This is exactly what occurred starting in March of last year, when the Federal Reserve embarked on its most aggressive monetary policy in over 40 years. This quickly produced over $15 billion in " unrealized losses" on SVB's long dated bond portfolio. Combined with the outflow of deposits, this began the series of events last week that resulted in the largest bank collapse since the Lehman days. It should be noted that JPMorgan Chase & Co. ( JPM ) noted that very same asset/liability mismatch at SVB in a private report to clients in November of last year. However, the bank chose to maintained their Overweight rating on SVB Financial Group at that time.

The Government Acts:

SVP's implosion caused the entire financial sector to sell off hard on Thursday and Friday. Especially hard hit were the " not too big to fail" regional banks. First Republic Bank ( FRC ) bank has lost 75% of its shareholder value since SVB's descent into receivership began in the middle of last week. U.S. regulators shut down New York-based Signature Bank ( SBNY ) , a significant lender to the crypto industry over the weekend.

The Treasury Department then designated both Silicon Valley Bank and SBNY as " systemic risks" before the markets opened this morning. This gave the government the authority to unwind both institutions in a way that will “ fully protect all depositors .” The FDIC’s current deposit insurance fund will be used to cover all depositors in these shuttered banks, including those that were previously uninsured due to the $250K cap on guaranteed deposits.

In addition, the Federal Reserve is creating a new Bank Term Funding Program or BTFB. This effort will be targeting the safeguarding of institutions that have been affected by the huge spike in market in volatility and instability, we have seen since SVB's journey into the dustbin of history.

Will this be enough to calm investors' nerves and prevent further financial contagion?

There Is Rarely Only One Cockroach

It is important for investors to remember than whenever there is a seismic paradigm shift in the financial system, it rarely is a " one and done" deal. The collapse of WorldCom soon followed the implosion of Enron, and Lehman Brothers followed Bear Sterns that triggered the Great Recession some 15 years ago. Scores of financial firms perished in the Savings & Loan crisis of the late 80s/early 90s.

While the market has steadied so far in trading Monday, I am hardly ready to buy last week's dip in any meaningful fashion. I am maintaining an approximate 50% cash position overall within my portfolio. Any new money put into equities will be done via covered call orders for the additional downside mitigation.

I also have been moving most of my cash into 3 month and 6 month T bills in recent months as they were exceeding an annual yield north of five percent until SVB's implosion. In one week, the yield on 2-year treasury debt has dropped from 5.08% to this morning's low of 3.99%, a collapse of 21% it should be noted. This is the biggest three-day decline in the two year treasury's yield since the 1987 stock market crash, to put in perspective.

I moved some cash into one year T bills today, as I believe because of fears of financial contagion, the Federal Reserve is likely to slow/end its monetary tightening over the near term horizon. This halt/suspension of current monetary policy will be implemented despite inflation still being significantly over the central bank's target rate. What happens from there is anybody's guess. In the meantime, discretion will remain the better part of valor.

A government big enough to give you everything you want is a government big enough to take from you everything you have .”? Gerald R. Ford.

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