An over-arching theme for the last several quarters was whether the current fed policy would eventually break something. The Fed has made it clear it was willing to cause a shallow recession if that was the small price it took to bring long-term inflation down to more sustainable levels. For the last several months, the employment markets have been extremely resilient (last week’s February employment report showed a 311k m/m increase, much higher-than-expected), and inflation moderated from extreme levels. A crack began to form last week, when crypto-focused bank Silvergate announced it would wind down operations (due to the FTX fallout) and the FDIC taking control of Silicon Valley Bank’s deposits on Friday, after the bank had to recognize losses in its fixed income portfolio, a direct result of Fed rate hikes. The concern is whether there is contagion risk in the financial market or is this mostly an isolated issue within a niche area?
On the week, the S&P 500 weakened 4.51% and the DJIA declined 4.35%. The Russell 2000, which represents small/midsized US companies, dropped 8.03%. International markets were not nearly as bad, but they also gave back ground with developed international (MSCI EAFE) and emerging markets (MSCI EM) down 0.75% and 3.29%, respectively. Bonds had a strong week rallying 1.15% amidst the chaos as there was a flight to safety. The 10 yr Treasury ended last week at a yield of 3.70% versus 3.97% the week prior.
On Friday, Silicon Valley Bank (SIVB) was shut down by regulators who cited inadequate liquidity and insolvency. According to the FDIC, insured depositors will have access to their funds no later than this morning. While capital, wholesale funding, and loan to deposit ratios have vastly improved since the financial crisis, there are a few exceptions and SIVB was in a league of its own in relation to other financial institutions. SIVB has a high level of loans plus securities as a percentage of deposits, and very low sticky retail deposits, unlike most financial institutions. Bottom line, SIVB carved out a distinct and much riskier capital profile and had an unusually high reliance on corporate and venture capital funding (only 7% was private banking clients…).
Historically, banks have failed due to credit risk. In this case, the primary issue was a duration mismatch between high quality assets (“hold-to-maturity” securities) and deposit liabilities. Additionally, SIVB is not a systemically important financial institution that will bring down the financial system. With that said, we are monitoring the situation closely and will continue to provide our thoughts as more details become available. Markets will likely be volatile in the near-term.
“You only find out who is swimming naked when the tide goes out”. – Warren Buffett