The Perils of Skinny Dipping at Ebb Tide

03.14.2023 The combination of higher interest rates and an inverted yield curve represents an ebbing tide for the banking business. And to paraphrase Warren Buffet, we’re now learning which banks are wearing bathing suits and which have been skinny dipping. Last Friday, the nation witnessed its second-largest bank failure in Silicon Valley Bank (SVB). The news sent shockwaves throughout the financial markets.  In an economy that boasts strong household balance sheets, fueled by one of the best labor markets in decades, how could a bank failure of that magnitude occur?

Bank profits are mostly derived from their net interest margin – the interest rate differential between the interest they earn on loans less the interest they pay on deposits. In most environments, that business strategy is simple. But when interest rates rise at a pace not seen in 40 years, the strategy gets more complicated. In SVB’s case, the bank collected large deposits from a small number of borrowers and invested the proceeds in long-maturity government securities. Recent withdrawals forced it to sell some of its assets that had declined in value due to higher interest rates, which in turn prompted SVB to book a loss. The bank attempted to make up the shortfall by raising equity and selling shares. That tactic backfired when their corporate customers sensed trouble and liquidated their deposits, sending SVB into a tailspin. Meanwhile, the stockpile of assets held at US banks over the FDIC’s $250,000 guarantee limit has mushroomed to nearly $8 trillion – up from a bit over $2 trillion during the financial crisis.

Most bank failures occur due to credit defaults on loan assets. That wasn’t the case with SVB; the credit quality of their bond portfolio was superb. It was a simple mismatch between loans and deposits that tripped management up, suggesting that the problems Silicon Valley Bank faced were unique to a handful of financial institutions, including Signature Bank, the other FDIC casualty. It should be noted that SVB had quadrupled in size in the span of four years, thanks to its venture capital connections.  Moreover, the bank had a concentration of large, rate-sensitive deposits, with 88 per cent of the bank’s deposits being uninsured.

For well over a decade, banks feasted on low interest rates, enabling them to pay virtually nothing for their deposits. Thanks to tepid rates across the entire bond market, banks had little competition for assets. That changed when the Federal Reserve started hiking overnight interest rates last year.  Chairman Powell & Company ratcheted up their benchmark rate from zero per cent to 4.5 per cent in a year’s time, its steepest hiking cycle since 1980.

Bank profits got squeezed by rising short-term rates, which increased the cost of deposits, and an inverted yield curve, which crimped the yield on their loan opportunities. A few weeks ago, the yield differential between 10-year and 2-year notes inverted to its biggest yield deficit in over 40 years. The industry’s net interest margin, at 3-3.5 per cent, is situated at the bottom quartile of its historical range as of December.

As a result of the failures, bank regulators, including the US Treasury and the Federal Reserve, announced deposit backstops for the account holders of both failed banks. The Fed authorized a borrowing program for banks needing to address deposit outflows without having to sell underwater assets. The Fed’s program announced over the weekend, incidentally, would have saved Silicon Valley Bank had it been in force last week. The announcements were generally welcomed by investors.

Investors’ reaction to the failure news has been strong, as worried depositors are stuck in a prisoners’ dilemma, worrying their bank could be next and wondering whether to withdraw their deposits. The S&P Banking Index was dragged down 7 per cent on Monday by First Republic Bank, which plunged over 60 per cent for the day.

Seven of the S&P 500’s 11 sector groups gained ground on Monday, with interest-rate-sensitive real estate up 1.6%. Bond yields plunged at a pace not seen in decades. The 2-year Treasury yield slid more than 0.6 per cent, its biggest one-day yield slide since the Volcker era. Bond investors essentially wiped out the possibility of a Fed rate hike at the March meeting. As recently as last week, traders were bracing for a half-point hike.

We believe the Fed will follow through with a quarter-point increase at its March meeting to maintain credibility, and will likely characterize the recent banking failures as solved. Moreover, February  inflation data released this morning suggests the Fed’s work on taming price growth continues. That said, the Fed bears some blame, and perhaps guilt, for the magnitude and veracity of their tightening program and its impact on the banking sector. We note that last year at this time the Fed’s benchmark rate was zero. The first quarter-point hike took place on March 16, 2022.

The skies are clearing for equities, as we expect Powell & Company, after their March move, to take a wait-and-see attitude on tightening further. We expect a weaker dollar and stable rates to set the stage for equities, particularly non-dollar equities, to advance. That said, equity investors should be rooting for the banks. History shows that the S&P 500 does well when financials are outperforming.