Update on Silicon Valley Bank & the Investing Landscape

• Details are still emerging from the collapse of Silicon Valley Bank (“SVB”). SVB is the second largest bank in US history to collapse (behind the collapse of Washington Mutual during the Great Financial Crisis). 
• The FDIC also took over Signature Bank this weekend, and Silvergate Bank announced voluntary liquidation earlier in the week (Silvergate’s demise was more related to cryptocurrency business than Signature or SVB).
• The FDIC has stepped in to insure all of SVB’s deposit base in an attempt to mitigate further bank runs. Other regional banks, including First Republic, are experiencing substantial declines in their equity values.
• While details are still a little murky, it appears that SVB experienced a classic, 1930s-style run on the bank. In just two days, nearly $50B of redemptions were requested by its depositors.
• It appears that SVB mismanaged their balance sheet with a substantial amount of their assets tied up in longer-term U.S. treasuries and mortgage-backed securities that were purchased before rates began to rise. These securities lost value as rates rose.  As news of these losses began to become apparent (first from a disclosure in the most recent filing and later when news of asset sales and an equity raise came to light), depositors grew worried and removed capital.  SVB’s clients had large average balances and thus many clients were not fully protected by FDIC.  This exacerbated the outflows.
• Notably, SVB is one of the largest lenders to venture capital-backed startups. For many years, startups and venture/growth private equity portfolio companies have experienced a huge tailwind.  Much of this tailwind came from historically low interest rates which allowed investors to justify repeated, increasing equity fund raises at very high levels for companies that had not yet reached a self-sustaining maturity level (meaning they burned cash each year and would have failed without new capital investment).  SVB’s client base is closely tied to the financial and tech industry, with a wealth management business that is heavily reliant on lending to technology professionals, and a commercial bank that lends to tech startups and private equity firms.
• It is possible that the SVB episode is isolated to just a couple banks that took too much risk and experienced a loss of confidence. If so, this will be a one-off incident and a sign that capitalism is at work.  However, if other banks begin to experience a run, we could see substantial economic fallout.
• Unlike the Great Financial Crisis, the large money center banks are extremely well capitalized. We do not believe that we are going to have a similar experience to the 2008 crisis.  SVB’s business is heavily concentrated in areas of the market that experienced the greatest excesses over the past 15 years.  Further, SVB’s management of their assets and liabilities is indicative of poor risk management, not systemic risks.  Their investments and their clients were extremely levered to a historically low interest rate environment and rising rates ultimately led to their demise.  A small percentage of their assets were FDIC insured.  While contagion is a real risk and could have meaningful impacts on the economy, we would be most concerned about regional banks who took on similar risks as SVB.
• In addition to the risk of bank runs at specific regional banks, we don’t yet know the impact of the SVB failure on the private equity and private debt sectors, particularly in venture capital or growth equity. Relative to the stock market and capital markets, many private equity-like investors have yet to mark down their investments.  Meanwhile, we are seeing a steady outflow of capital sources as bank financing retreats and certain poorly structured open-end debt funds deal with redemptions.  According to a March 9^th study from Pitchbook, venture capital-backed companies demand or need 2.1x the capital that is currently available in the market.  Notably, this figure is before the collapse of SVB.  While good ideas will continue to receive financing, we do not yet know how much damage we will see in this particular area of the market.
• The Federal Reserve has continued to raise their key interest rate, the Fed Funds Rate, in an attempt to bring inflation down. Numerous indicators show that inflation is indeed coming down from its peak.  Other indicators such as wages, unemployment rate, housing costs, and money supply levels suggest that inflation could remain higher than the stated 2% target.
• The Fed’s actions and rhetoric suggest that they will be unwilling to pause until they know they have succeeded in their mandate to bring inflation down to 2%. It is unclear, however, whether the Fed will change its mind after the fallout from the failure of multiple regional banks, including SVB’s collapse last week.
• The bond market has reacted to the Fed’s actions and comments so far. Short-term interest rates now approach 5%.  Meanwhile, longer-term interest rates remain much lower than short-term interest rates.  This scenario is often referred to as an “inverted yield curve.”  Historically, inverted yield curves are precursors to recessions. 
• One interpretation of an inverted yield curve as a recession indicator is that the Federal Reserve has more control over short-term rates, but free markets ultimately dictate long-term rates. In most scenarios free markets demand higher interest rates for longer-term rates to compensate for locking up capital for a longer time.  A steeply inverted yield curve could be an indication that the Fed is making a policy mistake.
• While we have no way of predicting the future, Verum’s Investment Committee believes that the prospects of a Federal Reserve policy error sparking a recession are elevated.
• The pain of the previous 15 months in both the bond market and the stock market has led to higher future expected returns. We now expect a balanced portfolio of stocks and bonds to earn more over the next decade than we did at the beginning of 2022.  Most of this increase is due to higher interest rates enabling a steady stream of income for investors.  While the stock market has fallen nearly 20% over the last 15 months, stock market valuations remain near average historical levels.  Further, the earnings yield on the stock market now pays a comparable rate to the bond market for the first time in well over a decade.  The concept of TINA (“There Is No Alternative”) is no more.  There is now an alternative to stocks, and it’s bonds – particularly short-term bonds.
• As we noted in past communications, rising rates and reduced liquidity have historically led to breakage in the real economy. Monetary tightening works on a lag and is not linear.  Importantly, the Fed has raised rates more aggressively and at a faster pace than they have in modern history.  We don’t know the results yet, but we have been expecting to see damage in the real economy.  Until Friday, we had only seen pockets of distress, for example crypto, and high equity asset prices in the frothiest markets.  Last week’s events may be the beginning of the Fed-induced pain in the real economy.  There is no telling how much damage will be inflicted.  For now, our Investment Committee believes it is important to have ample “Defense” in portfolios and that highly liquid short-term bonds present a reasonable rate of return as potential opportunities in “Offense” emerge.

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