Swiss banking giant UBS announced several major strategic updates on Tuesday, including resuming share buybacks and increasing cost-cutting targets related to its takeover of Credit Suisse last year. The bank’s shares fell nearly 4% as investors reacted to financial results and the roadmap ahead.
UBS said it plans up to $1 billion in share repurchases in 2024, restarting its buyback program which was halted during the acquisition of Credit Suisse in March 2023. The deal, valued at nearly $16 billion, was the first ever merger between two global systemically important banks. It significantly expanded UBS’s wealth management operations and investment banking capabilities.
Integrating Credit Suisse is expected to generate major cost synergies over the next several years. UBS now estimates total savings of $13 billion by the end of 2026, up from the previous target of over $10 billion. Around half of the savings will come from headcount reductions, according to CFO Todd Tuckner.
While UBS said the initial phase of integration is complete, CEO Sergio Ermotti warned there is still significant restructuring ahead. The next few years will involve job cuts, combining IT systems, and optimizing operations. Ermotti cautioned that progress “will not be measured in a straight line” and the trickier parts of integration have yet to occur.
The bank reaffirmed its key financial targets, including for return on capital and cost-income ratios. It also set new ambitions, such as growing assets under management in its wealth management division to $5 trillion by 2028, up from $3.85 trillion currently.
For 2024, UBS proposed boosting its dividend by 27% compared to 2023. This comes as many European banks have been rewarding shareholders through dividends and buybacks.
UBS posted a small net loss of $279 million in the fourth quarter of 2023. The loss was attributed to Credit Suisse integration costs. However, the bank sees profitability improving in early 2024 amid better market activity and progress on merging operations.
Image Credit: Reuters Graphics
The wealth management unit reported $22 billion in net new money growth during the quarter. However, a change in metrics makes the figure not directly comparable to previous periods. The investment bank posted a pre-tax loss of $169 million but is expected to return to profitability soon.
Shares fell due to concerns around UBS’s near-term profitability as integration costs weigh on performance. While cost savings are substantial over the long run, analysts pointed out revenue will likely drop in the next couple years before synergies are fully realized.
There are also lingering concerns around integrating such large banking operations smoothly. Regulators are keeping a close eye given the combined balance sheet is nearly twice the size of Switzerland’s GDP. However, UBS maintains only around one-third of assets are illiquid.
Overall, UBS remains confident in achieving strategic goals from its takeover of Credit Suisse, even if the next few years involve headaches from combining staff, technology, and business lines. Execution risks remain but cost cuts could significantly boost profitability down the line. Tuesday’s announcements provided investors more clarity around buybacks, dividends, and the path forward.
JPMorgan Chase, the nation’s largest bank, reported a 15% decline in fourth quarter 2023 earnings on Friday, weighed down by a massive $2.9 billion fee related to the government takeover of failed regional banks last year.
The bank posted profits of $9.31 billion, or $3.04 per share, for the final three months of 2023. This compared to earnings of $10.9 billion, or $3.33 per share, in the same period a year earlier. Excluding the regional banking crisis fee and other one-time items, JPMorgan said it earned $3.97 per share in the fourth quarter.
Total revenue for the quarter rose 12% to $39.94 billion, slightly above analyst forecasts. The jump was driven by the bank’s acquisition of First Republic Bank in late 2023, higher net interest income, and increased investment banking fees.
“The U.S. economy continues to be resilient, with consumers still spending, and markets currently expect a soft landing,” said JPMorgan CEO Jamie Dimon in a statement. “These significant and somewhat unprecedented forces cause us to remain cautious.”
Dimon cited high inflation, rising interest rates, out-of-control government spending, supply chain disruptions, the war in Ukraine, and tensions in the Middle East as potential threats to the economic outlook.
For the full year 2023, JPMorgan posted record profits of nearly $50 billion, including $4.1 billion from its acquisition of First Republic. The deal instantly gave JPMorgan a leading position in serving wealthy clients in California and other coastal markets.
Smaller Competitors Squeezed
While JPMorgan has deftly navigated the rising rate environment, smaller regional banks have struggled as the Federal Reserve hiked rates aggressively to combat inflation. Many were caught holding lower-yielding assets funded by higher-cost deposits. This squeezed net interest margins.
The regional banking crisis came to a head in early 2023 as a wave of defaults and bank seizures overwhelmed the FDIC insurance fund. JPMorgan and other large banks were handed the bill, with the FDIC levying $18 billion in special fees on the industry to recapitalize the fund.
Specifically, JPMorgan paid a $2.9 billion fee in the fourth quarter related to the FDIC assessments. This was a major factor in the bank’s profit decline compared to a year ago.
JPMorgan Cautious Despite Solid Year
Despite posting record full-year earnings, Dimon and JPMorgan management struck a cautious tone in their earnings release. While U.S. consumers remain resilient for now, risks are mounting.
Inflation could prove stickier than anticipated, forcing the Fed to keep rates higher for longer. The war in Ukraine shows no signs of resolution. Middle East conflicts continue to elevate oil prices. And the U.S. government is racking up huge deficits, with no political will to cut spending.
For banks, this backdrop could pressure lending activity, loan performance, and capital levels. Mortgage rates are already above 7%, denting the housing market. Credit card delinquencies are edging higher. Corporate debt looks vulnerable as businesses face slower growth and input cost pressures.
All of this warrants a cautious stance until more clarity emerges later this year.
With JPMorgan having reported solid results for 2023, investors are now focused on the bank’s outlook for 2024 amid an expected shift in the interest rate environment.
On Friday’s earnings call, analysts will be listening closely to hear JPMorgan’s projections and commentary around key items that could impact performance this year:
Net interest income guidance for 2024. As the Fed cuts rates, net interest margins may compress. But higher loan volumes could offset this.
Expectations for credit costs and loan losses. While credit metrics are healthy now, a weaker economy could strain consumers and corporate borrowers.
Thoughts on impending hikes to capital requirements. Banks are hoping to reduce the impact of new rules on capital buffers.
M&A landscape. Does JPMorgan see opportunities for deals amid lower valuations?
Plans for excess capital deployment. Investors want to hear about potential increases in buybacks, dividends, and other uses.
JPMorgan entered 2024 with strong capital levels, putting it in position to boost shareholder returns even with new regulations. Investors will be listening to hear how management plans to leverage JPMorgan’s financial strength in the year ahead.
The bank’s 2024 outlook will be critical in determining whether its stock can build on last year’s big gains. JPMorgan was the top performing Dow stock in 2023, and investors are betting it can continue to drive profits in a more subdued rate environment.
JPMorgan Chase CEO Jamie Dimon is cashing out for the first time in his 17 years leading the banking giant. Dimon and his family are planning to unload $141 million worth of JPMorgan stock starting next year. The sale of one million shares marks the first time Dimon has trimmed his stake since taking the helm in 2006.
While surprising, the stock sale doesn’t represent a loss of faith by Dimon in JPMorgan’s future. According to a securities filing, Dimon “continues to believe the company’s prospects are very strong.” Even after shedding $141 million in stock, Dimon will still own around 7.6 million shares in the bank, worth over $1 billion at current prices.
Dimon timed the sale to take advantage of a rebound in JPMorgan’s stock, which is up 5% year-to-date despite headwinds facing the banking sector. With the Fed boosting interest rates aggressively to combat inflation, demand for loans has slowed. Banks are also earning less on their bond holdings as rates rise.
Yet JPMorgan has managed to deliver solid earnings this year, with profit jumping 35% last quarter. The acquisition of assets from failed West Coast lender First Republic enhanced results. Dimon has praised JPMorgan’s “fortress balance sheet” that has it positioned to weather economic storms.
While JPMorgan has excelled recently, Dimon has sounded the alarm on gathering risks. He warned the Fed’s inflation fight may tip the remarkably resilient U.S. economy into recession. Geopolitical tensions around the world are also a rising threat. “Now may be the most dangerous time the world has seen in decades,” Dimon said earlier this month.
With risks rising, Dimon seems to be taking money off the table while JPMorgan’s stock still hovers near 52-week highs. The sale allows him to lock in returns after a tremendous 17-year run as CEO. Since taking the helm, Dimon has led JPMorgan to become the nation’s most profitable bank, raking in $48 billion last year alone.
Yet even after the stock sale, Dimon maintains immense exposure to JPMorgan’s fortunes. His remaining 7.6 million shares give him a built-in incentive to keep delivering results and driving the stock higher. While handing some risk off to the market, Dimon remains invested in JPMorgan’s success.
Dimon’s high-profile stock sale could potentially have ripple effects across the stock market. Some may view the move as Dimon lacking confidence in the markets and economy, sparking wider selling. JPMorgan’s share price often acts as a bellwether for overall market sentiment. If investors interpret Dimon’s sale as a warning sign, it could drag down indices and lead to a pullback in stocks. However, most analysts believe the sale is simply prudent financial planning by Dimon rather than a market call. With risks rising, Dimon is wisely diversifying his holdings after a long run-up in JPMorgan’s shares. Therefore, while the sale makes waves in the news, it likely won’t dramatically sway broader market direction. But in jittery times, even a whiff of pessimism from an influential CEO like Dimon can impact overall investor psychology.
Some view the stock sale as a shot across the bow at the Federal Reserve. Dimon may be signaling that excessive rate hikes could stifle the economy and hurt the banking sector. By cashing out now, Dimon is suggesting trouble may lie ahead.
Nonetheless, JPMorgan insists Dimon has confidence in the bank’s “very strong” prospects. The stock sale appears to be prudent risk management rather than a warning. As a savvy leader, Dimon knows the value of diversification.
With markets on edge, Dimon’s stock sale provides a dose of foreboding. Yet JPMorgan remains well-positioned to weather any storm. As long as Dimon is at the helm, don’t expect one stock sale to derail JPMorgan’s trajectory anytime soon.
Silicon Valley Bank is Back in the News as the Fed Explains the Mess
Silicon Valley Bank’s management, the board of directors, and Federal Reserve supervisors all ignored banking basics. At least that is the determination of the Federal Reserve itself. The review and report of the situation, created by the Federal Reserve Board of Governors, relieve fears that the broader U.S. banking system is fragile. But it does highlight other problems that may need to be addressed by those responsible for a sound U.S. banking system.
Silicon Valley Bank was considered the “go-to bank” for venture capital firms and technology start-ups. But it failed spectacularly in March which set off a crisis of confidence toward the banking industry. Federal regulators seized Silicon Valley Bank on March 10 after customers withdrew tens of billions of dollars in deposits in a matter of hours. The speed of withdrawals was attributed to high levels of communication through social media.
The opening paragraph of the introductory letter by the Federal Reserve in DC said:
“Silicon Valley Bank (SVB) failed because of a textbook case of mismanagement by the bank. Its senior leadership failed to manage basic interest rate and liquidity risk. Its board of directors failed to oversee senior leadership and hold them accountable. And Federal Reserve supervisors failed to take forceful action, as detailed in the report.”
The plain-spoken letter and more formal report was critical of all involved, including regulators who are supposed to be evaluating bank management and processes for adequacy.
The lengthy report has four key takeaways:
“Silicon Valley Bank’s board of directors and management failed to manage their risks.”
[Editor’s note] Banks present-value their assets (investments and loans) and their liabilities (deposits) then report valuations at regular Asset/Liabilty management meetings. When a depositor locks in a CD and rates rise, the value to the bank of that deposit rises as it is present valued to higher market rates. The same for loans, and the investment portfolio if it is designated marked-to-market. Proper interest rate risk management for banks is stress testing for risk and profitability if rates rise or fall.
“Supervisors did not fully appreciate the extent of the vulnerabilities as Silicon Valley Bank grew in size and complexity.”
[Editor’s note] Regulators don’t tell banks how to manage their business, but regulators are supposed to check that a suitable plan is in place, it was created by competent managers considering the bank’s complexities, and that it is being followed.
“When supervisors did identify vulnerabilities, they did not take sufficient steps to ensure that Silicon Valley Bank fixed those problems quickly enough.”
“The board’s tailoring approach in response to the Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA) and a shift in the stance of supervisory policy impeded effective supervision by reducing standards, increasing complexity, and promoting a less assertive supervisory approach.
[Editor’s note] SVB’s CEO lobbied for this roll back of Dodd Frank which set ratios and loosened the reigns on regulatory scrutiny of larger banks.
In its criticism of its own lack of oversight, the report stated “The Federal Reserve did not appreciate the seriousness of critical deficiencies in the firm’s governance, liquidity, and interest rate risk management. These judgments meant that Silicon Valley Bank remained well-rated, even as conditions deteriorated and significant risk to the firm’s safety and soundness emerged.”
The Fed also said, based on its report, it plans to reexamine how it regulates banks the size of SVB, which had more than $200 billion in assets when it failed.
The Fed’s release, which includes internal reports and Fed communications, is a rare look into how the central bank supervises individual banks as one of the nation’s bank regulators. Other regulators include the Office of the Controller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC). Typically these processes are confidential and rarely seen by the public, but the Fed chose to release these reports to show how the bank was managed up to its failure.
It probably won’t be long before Silicon Valley Bank is used as a college case study in what not to do.
Will Systemic Risks to the Banking System Override Inflation Concerns When the Fed Meets?
Yes, the Federal Reserve’s central objective is to help maintain a sound banking system in the United States. The Fed’s regional presidents are currently in a blackout period (no public appearances) until after the FOMC meeting ends on March 22. So there is little for markets to go on to determine if the difficulties being experienced by banks will hinder the Fed’s resolve to bring inflation down to 2%. Or if the systemic risks to banks will override concerns surrounding inflation. Below we discuss some of the considerations the Fed may consider at the next meeting.
The Federal Reserve’s sound banking system responsibility is part of its broader responsibility to promote financial stability in the U.S. economy. The Fed does its best to balance competing challenges through monetary policy to promote price stability (low-inflation), maintaining the safety and soundness of individual banks, and supervising and regulating the overall banking industry to ensure that it operates in a prudent and sound manner.
While the headline news after the Fed adjusts monetary policy is usually about the Fed Funds target, the Fed can also adjust Reserve Requirements for banks. Along with that, the rate paid on these reserves, Interest on Excess Reserves (IOER). Another key bank rate that is mostly invisible to consumers is the Discount Rate. This is the interest rate at which banks can borrow money directly from the Federal Reserve. The discount rate is set by the Fed’s Board of Governors and is typically higher than the Federal Funds rate.
Banks try to avoid going to the Discount Window at the Fed because using this more expensive money is a sign to investors or depositors that something may be unhealthy at the institution. Figures for banks using this facility are reported each Thursday afternoon. There doesn’t seem to be bright flashing warning signs in the March 9 report. The amount lent on average for the seven-day period ending Thursday March 9, had decreased substantially, following a decrease the prior week. While use of the Discount Window facility is just one indicator of the overall banking systems health, it is not sending up red flags for the Fed or other stakeholders.
The European Central Bank Raised Rates
There is an expression, “when America sneezes, the world catches a cold.” The actions of the central bank in Europe, (the equivalent of the Federal Reserve in the U.S.) demonstrates that the bank failures in the U.S. are viewed as less than a sneeze. The ECB raised interest rates by half of a percentage point on Thursday (March 16). This is in line with its previously stated plan, even as the U.S. worries surrounding the banking system have shaken confidence in banks and the financial markets in recent days.
The ECB didn’t completely ignore the noise across the Atlantic; it said in a statement that its policymakers were “monitoring current market tensions closely” and the bank “stands ready to respond as necessary to preserve price stability and financial stability in the euro area.”
While Fed Chair Powell is restricted from making public addresses during the pre-FOMC blackout period, it is highly likely that there have been conversations with his cohorts in Frankfurt.
The Fed’s Upcoming Decision
On March 14, the Bureau of Labor Statistics (BLS) reported core inflation (without volatile food and energy) rose in February. Another indicator, the most recent PCE index released on February 24 also demonstrated that core prices are rising at a pace faster than the Fed deems healthy for consumers, banking, or the economy at large. The inflation numbers suggest it would be perilous for the Fed to pause its tightening efforts now.
What has so far been limited to a few U.S. banks is not likely to have been a complete surprise to those that have been setting monetary policy for the last 12 months. It may have surprised most market participants, but warning signs are usually picked up by the FRS, FDIC, and even OCC well in advance. And before news of a bank closure becomes public. Yet, the FOMC continued raising rates and implementing quantitative tightening. The big difference today is, the world is now aware of the problems and the markets are spooked.
The post-meeting FOMC statement will likely differ vastly from the past few meetings. While what the Fed decides to do remains far from certain, what is certain is that inflation is still a problem, and rising interest rates mathematically erode the value of bank assets. At the same time, money supply (M2) is declining at its fastest rate in history. At its most basic definition, M2 is consumer’s cash position, including held at banks. As less cash is held at banks, some institutions may find themselves in the position SVB was in; they have to sell assets to meet withdrawals. The asset values, which were “purchased” at lower rates, now sell for far less than were paid for them.
This would seem to put the Fed in a box. However, if it uses the Discount Window tool, and makes borrowing easier by banks, it may be able to satisfy both demands. Tighter monetary policy, while providing liquidity to banks that are being squeezed.
Take Away
What the Fed will ultimately do remains far from certain. And a lot can happen in a week. Bank closings occur on Friday’s so the FDIC has the weekend to seize control. So if you’re concerned, don’t take Friday afternoons off.
If the Fed Declines to raise rates in March it could send a signal that the Fed is weakening its fight against inflation. This could cause rates to spike higher in anticipation of rising inflation. Everyone loses if that is the case, consumers, banks, and those holding U.S. dollars.
The weakness appears to be isolated in the regional-bank sector and was likely known to the Fed prior to the closing of the banks.
Consider this, only two things have changed for Powell since the last meeting, one is rising core CPI. The other is that he will have to do an even better job at building confidence post-FOMC meeting. Business people and investors want to know that the Fed can handle the hiccups along the path to stamping out high inflation.
SVB Invested in the Entire Bubble of Everything Says, Renowned Economist
“SVB invested in the entire bubble of everything,” writes Daniel Lacalle, PhD, economist, fund manager,and once ranked as one of the top twenty most influential economists in the world (2016 and 2017). He explains in his article below the pathway the Silicon Valley bank took and “bets,” which it lost, that led to the bank’s quick demise. “Aaaaand it’s gone,” Lacalle says, borrowing a line from a South Park episode that originally aired in March 2009. – Paul Hoffman, Managing Editor, Channelchek
The second-largest collapse of a bank in recent history after Lehman Brothers could have been prevented. Now the impact is too large, and the contagion risk is difficult to measure.
The demise of the Silicon Valley Bank (SVB) is a classic bank run driven by a liquidity event, but the important lesson for everyone is that the enormity of the unrealized losses and the financial hole in the bank’s accounts would not have existed if not for ultra-loose monetary policy. Let me explain why.
As of December 31, 2022, Silicon Valley Bank had approximately $209.0 billion in total assets and about $175.4 billion in total deposits, according to their public accounts. Their top shareholders are Vanguard Group (11.3 percent), BlackRock (8.1 percent), State Street (5.2 percent) and the Swedish pension fund Alecta (4.5 percent).
The incredible growth and success of SVB could not have happened without negative rates, ultra-loose monetary policy, and the tech bubble that burst in 2022. Furthermore, the bank’s liquidity event could not have happened without the regulatory and monetary policy incentives to accumulate sovereign debt and mortgage-backed securities (MBS).
SVB’s asset base read like the clearest example of the old mantra “Don’t fight the Fed.” SVB made one big mistake: follow exactly the incentives created by loose monetary policy and regulation.
What happened in 2021? Massive success that, unfortunately, was also the first step to demise. The bank’s deposits nearly doubled with the tech boom. Everyone wanted a piece of the unstoppable new tech paradigm. SVB’s assets also rose and almost doubled.
The bank’s assets rose in value. More than 40 percent were long-dated Treasurys and MBS. The rest were seemingly world-conquering new tech and venture capital investments.
Most of those “low risk” bonds and securities were held to maturity. SVB was following the mainstream rulebook: low-risk assets to balance the risk in venture capital investments. When the Federal Reserve raised interest rates, SVB must have been shocked.
Its entire asset base was a single bet: low rates and quantitative easing for longer. Tech valuations soared in the period of loose monetary policy, and the best way to “hedge” that risk was with Treasurys and MBS. Why bet on anything else? This is what the Fed was buying in billions every month. These were the lowest-risk assets according to all regulations, and, according to the Fed and all mainstream economists, inflation was purely “transitory,” a base-effect anecdote. What could go wrong?
Inflation was not transitory, and easy money was not endless.
Rate hikes happened. And they caught the bank suffering massive losses everywhere. Goodbye, bonds and MBS prices. Goodbye, “new paradigm” tech valuations. And hello, panic. A good old bank run, despite the strong recovery of SVB shares in January. Mark-to-market unrealized losses of $15 billion were almost 100 percent of the bank’s market capitalization. Wipeout.
As the bank manager said in the famous South Park episode: “Aaaaand it’s gone.” SVB showed how quickly the capital of a bank can dissolve in front of our eyes.
The Federal Deposit Insurance Corporation (FDIC) will step in, but that is not enough because only 3 percent of SVB deposits were under $250,000. According to Time magazine, more than 85 percent of Silicon Valley Bank’s deposits were not insured.
It gets worse. One-third of US deposits are in small banks, and around half are uninsured, according to Bloomberg. Depositors at SVB will likely lose most of their money, and this will also create significant uncertainty in other entities.
SVB was the poster boy of banking management by the book. They followed a conservative policy of acquiring the safest assets—long-dated Treasury bills—as deposits soared.
SVB did exactly what those that blamed the 2008 crisis on “deregulation” recommended. SVB was a boring, conservative bank that invested its rising deposits in sovereign bonds and mortgage-backed securities, believing that inflation was transitory, as everyone except us, the crazy minority, repeated.
SVB did nothing but follow regulation, monetary policy incentives, and Keynesian economists’ recommendations point by point. SVB was the epitome of mainstream economic thinking. And mainstream killed the tech star.
Many will now blame greed, capitalism, and lack of regulation, but guess what? More regulation would have done nothing because regulation and policy incentivize buying these “low risk” assets. Furthermore, regulation and monetary policy are directly responsible for the tech bubble. The increasingly elevated valuations of unprofitable tech and the allegedly unstoppable flow of capital to fund innovation and green investments would never have happened without negative real rates and massive liquidity injections. In the case of SVB, its phenomenal growth in 2021 was a direct consequence of the insane monetary policy implemented in 2020, when the major central banks increased their balance sheet to $20 trillion as if nothing would happen.
SVB is a casualty of the narrative that money printing does not cause inflation and can continue forever. They embraced it wholeheartedly, and now they are gone.
SVB invested in the entire bubble of everything: Sovereign bonds, MBS, and tech. Did they do it because they were stupid or reckless? No. They did it because they perceived that there was very little to no risk in those assets. No bank accumulates risk in an asset it believes is high risk. The only way in which banks accumulate risk is if they perceive that there is none. Why do they perceive no risk? Because the government, regulators, central banks, and the experts tell them there is none. Who will be next?
Many will blame everything except the perverse incentives and bubbles created by monetary policy and regulation, and they will demand rate cuts and quantitative easing to solve the problem. It will only worsen. You do not solve the consequences of a bubble with more bubbles.
The demise of Silicon Valley Bank highlights the enormity of the problem of risk accumulation by political design. SVB did not collapse due to reckless management, but because they did exactly what Keynesians and monetary interventionists wanted them to do. Congratulations.
Lacalle was ranked as one of the top twenty most influential economists in the world in 2016 and 2017 by Richtopia. He holds the CIIA financial analyst title, with a postgraduate degree in higher business studies and a master’s degree in economic investigation.
The SVB Loss Demonstrates A Risk Investors Should Pay Attention To
Individual investors and even some institutional money managers are reminded of a helpful truth from the Silicon Valley Bank (SVB) balance sheet problem. The reminder of the investment risk stands in conflict with what many top firms have been recommending to investors. So it should be revisited because, unlike banks, individuals and wealth managers tend to have a wider variety of places to look for return.
Bank balance sheet management is tricky. I say this with some credibility. In August of 2008, I accepted a role as the Treasurer of a mid-sized bank just two weeks before Freddie Mac and Fannie Mae were placed into conservatorship, and three weeks before Lehman filed for bankruptcy. I was responsible for quickly finding solutions for a big potential balance sheet problem. It was a problem similar to SVB’s. Depositors at the bank were taking money out at a faster pace than bank investments, including loans cashflows, could cover. Money that had not been committed to loans were invested in low-risk investment-grade fixed-income securities. It was nerve-racking, at one point, I calculated if any two of the largest ten customers withdrew all of their funds, the bank would not have the ability to cover the withdrawal. The pain that SVB is faced with is not dissimilar.
SVB is a bank that serves many fledgling companies during a period when capital and investment in start-ups have weakened from the days of easier money just a couple of years ago. Banks make money by borrowing short from customers (demand deposits, checking, and CDs) and then lend long, presumably at a higher rate. Here they make the spread that a typical upward-sloping yield curve provides. The main risk is in maturity. What happens if your longer-term loans were made at Fed Funds plus 2.50% two years ago when average deposit costs were 0.20%, since today Fed Funds are 4.50%? Your loans are paying the bank less than the bank’s cost to fund them with short deposits. This is a risk that all banks manage – balance sheet risk.
As deposits ran off at SVB because of business conditions in Silicon Valley, the bank turned to its investment portfolio to fund withdrawals. Securities in a US bank portfolio, when purchased, are designated at the custodian, by the Treasurer, either “Trading” which in this department of the bank is rare, “Available for Sale,” which provides the treasury department the ability to sell if need be, but also requires the assets to be priced at market (this impacts the banks valuation), or “Hold to Maturity” where the fixed income securities appear on the balance sheet at cost.
If the securities are designated at purchase “Hold to Maturity” and the bank finds itself needing to sell any “Hold to Maturity” security, all securities marked “Hold to Maturity” become what regulators call tainted. The entire portfolio also becomes designated “Available for Sale.” This decision could dramatically reduce the bank’s book value in cases when interest rates have risen and bond values have dropped.
In the case of SVB, its securities portfolio, designed to earn more than deposits, was marked “Available for Sale.” When they sold, the market values were in such a lower position, from just a year earlier, that they recognized a dramatic loss. A $1.8 billion dollar loss which prompted its shares to lose more than half their market price.
Self-Directed Investors and Money Managers Should Note
The SVB explanation above, wernt a long way to remind that bonds, including US Treasury Notes have prices that rise and fall. They are different than equities, but price risk is real, and the $1.8 billion loss SVB recognized is front page proof. But since the beginning of the year many top-tier investment firms have recommended investors increase these fixed income investments and capture the new higher yields. Some even suggested ETFs in mortgaged-backed securities (MBS) or emerging markets (EM).
Goldman Asset Management is just one of the respected firms that have loudly suggested fixed income investments (CNBC, February 7, 2023)
Bond prices fall as rates rise. The Chair of the Federal Reserve, the same person that had orchestrated near zero rates, has clearly stated that the Fed will continue orchestrating higher rates. So while the stock market has been unattractive over the past 14 months, so have bonds. The difference, of course, is that bond math is absolute. As rates rise, the present value of any fixed-income security is calculated by the future value of future cash flow – this more or less determines the bonds price movement. For example, if an investor buys a bond that yields 3%, and later rates go to 6% for the same maturity, the present value is about halved. This is a plausible scenario currently, with inflation near 6%.
Stock indexes have taken a beating over the past 14 months, just like bonds. The difference is rising rates sink all bonds. It doesn’t sink all stocks.
So while the S&P 500 is down 17% since January 1, 2022, and the Russell 2000 small-cap index is down 20%, one doesn’t even have to get out of the A’s to find AT&T (T) is up 4.15% in the same period, and Canadian Company Alvopetro (ALVOF) is up 43.6%). You won’t find this type of disparity in performance or direction on the fixed-income side. US Treasuries were down 10.5% for the period.
So from one perspective, stock selection may provide potential upside, whereas rising rates could mathematically sink all bond portfolio holdings.
Take Away
Silicon Valley Bank is in a unique situation as its customer base is not very diversified. The challenges they face may be similar to other banks, but this does not appear indicative of the whole sector based on recent stress tests. Banks are restricted in what they can invest in, with rates having risen, and promised to rise more, fixed-income holdings are at a loss in many portfolios, SVB’s need to raise cash caused them to recognize what was already a market loss.
Investors, however, can take a lesson from the loss the bank took. While I have seen articles this year suggesting capitalizing on higher interest rates, the ten-year US Treasury Note is well below its historical average (40-yr. avg.+5.17% vs 3.73% today). And rates are not even returning a real rate of return relative to current and expected inflation. This would indicate a period of likely market losses on bond holdings put on today.
A Stock, or portfolio of stocks, of course, may also present losses, but the odds that any particular stock, or even an index, would seem less certain than bonds.
