Boiling Frogs

As a long-time author of investment commentaries, one of the cruelest twists of fate is to have a major market event occur that renders your hard work outdated. Such was the case when I recently finished a commentary entitled, “Boiling Frogs.” I wrote how the Fed’s policy of steadily hiking interest rates reminded me of the tale which states the best way to cook a frog is to put it in a pot and steadily heat the water, as opposed to throwing the frog into a pot of boiling water. Supposedly, the frog does not perceive the danger in the steadily rising water temperature and will be slowly boiled. I hypothesized that the market may be underestimating the probability of something in the financial system getting cooked given the pace of the Fed’s interest rate hikes. It turns out that frog was Silicon Valley Bank (SVB).

To recap recent events, SVB, which was the 16th largest bank in the U.S., experienced a precipitous collapse and was taken into receivership by the Federal Deposit Insurance Corporation (FDIC). This timeline¹ of the collapse reinforces its suddenness:

• During the first week of March, Moody’s Investor Service Inc, one of the largest credit ratings firms, privately tells SVB executives that Moody’s would be downgrading SVB’s credit rating due to a $1.8 billion loss that the bank sustained in its $20 billion bond portfolio.
• On March 8th, SVB spooks investors by announcing a $2.25 billion equity sale to shore up the company’s balance sheet. The CEO states that the bank is in a strong financial position. Moody’s issues its downgrade of SVB’s long-term credit rating from A to BBB.
• On March 9th, influential venture capitalists and investors take to Twitter to urge depositors to pull their money as the bank may be in peril. According to California state regulators, depositors initiated $42 billion of withdrawals in one day. Per SVB’s annual filing, the bank had $173 billion in total deposits as of December 31st, 2022.
• On March 10th, the 40-year-old bank was deemed insolvent by mid-morning and taken over by state regulators.

There are dozens of important messages for investors to absorb from this saga, but it’s hard to pinpoint them through the stream of “hot takes” flying over the airwaves. SVB is certainly open to criticism on all fronts, but theories that try to explain a bank run based on political talking points (we’re including both sides here), don’t stand up to scrutiny as THE cause. We will try our best to bring some honest clarity to the situation.

#BankRun

The bank went bust because they failed to hedge interest rate risk in their bond portfolio and panic set in. Bond prices dropped last year by ~5-20% (depending on the type of bond) as interest rates soared higher with Fed action. Consequently, a $1.8 billion loss on a $20 billion portfolio does not seem out of the realm of reason. Yet, most banks protect against this degree of potential loss by hedging away some of their interest rate risk. SVB was unwise not to hedge this risk, and the decision proved to be a costly one.

Another key factor in the failure of SVB was its high-end client base. Over 90% of SVB deposits were above the $250k FDIC insurance limit. For context, most community banks have between 20-40% of their deposits over the FDIC limit, while most regional and mega-banks have 40-55% exceeding the limit. As such, when rumors started to fly that the bank may be in trouble, SVB’s depositors, many of them businesses, had more to lose. If the “average” SVB client had $2.5mm in a checking account (10% FDIC insured, 90% uninsured), then a bank collapse could mean that the average depositor may lose $2.25mm. Moreover, their clientele generally had access to technology and multiple financial institutions. Moving money is easy, as evidenced by ~25% of the bank’s deposits moving in a single day.

Once the bank collapsed, the contagion spread. In contrast to past banking crises where low-quality banks with bad loans on their books faced scrutiny, it was other high-end banks with the bulk of customer deposits exceeding the $250k limit that felt the market’s wrath. A new-age bank run ensued, much like the old-fashioned ones, only this time the funds flowed with the click of a digital button. Signature Bank was the next to fail, while other regional banks with similar depositor profiles sustained steep stock price declines.

Following the collapse of SVB and Signature Bank two days later, the Fed announced that all depositors would be fully covered at these two banks. We speculate that a more holistic solution by the Fed will need to be announced in the coming weeks; otherwise, the same flow of funds is likely to continue. As a high-net-worth depositor (including many businesses requiring operating balances in excess of the $250k FDIC limit), why risk the Fed deciding to not fully cover deposits during the next bank failure? Apparently, I am not the only one who thinks this way, as Bank of America (a “too big to fail” bank) reported inflows of $15 billion in the days following SVB’s failure – despite just a few weeks ago having some WORSE reported capital reserve ratios than banks like Signature, First Republic and other regional banks “in the crosshairs.”

Saving the Frogs

As for possible solutions, we should remember that the FDIC is not a government-funded program. The “I” stands for “insurance” which is a premium all banks pay to insure depositors – a premium that undoubtedly gets passed on to customers in some form. The FDIC limit can be raised to a much higher number to protect deposits at one’s bank of choice. Higher FDIC insurance premiums would be borne by all, but stability would be reintroduced to the banking system.

Without such a move, we expect the handful of “too big to fail” banks will continue to swell in size, an outcome that we cannot imagine would be desirable to many policymakers or “Main Street” individuals. To those who argue against covering depositors at these failed banks, we would caution to be careful what you wish for as a “digital bank run” could happen anywhere with a few tweets. There is also a feedback loop wherein if just one or two more banks fail due to withdrawals of uninsured balances, the breadth of this crisis could accelerate rapidly to the entire banking system even though most bank balance sheets are strong.

The trickier aspect of the crisis is to identify where other boiling frogs may lie. The Fed has hiked rates at an unprecedented pace over the past 12 months. While SVB’s bond losses were largely preventable, it would not be unexpected to see lending at banks dramatically tighten in the coming months and/or problems begin to surface in their commercial real estate portfolios. We do not expect a full-blown financial crisis, as the key ingredient of excessive leverage is missing, and we believe some degree of disruption and economic slowdown is already expected and, therefore, priced into markets. Thus, further disruption short of a banking crisis does not necessarily mean further dramatic market adjustments. Make no mistake though, the temperature of the water is rising, and SVB and Signature Bank may not be the only frogs that get cooked.