March 12, 2023 – “I have not seen it like this since I went $5 bid for half a million shares of Citi group and got hit in 1990!” said Jim Cramer on live TV, quite hilariously, in the fall of 2007 as the Global Financial Crisis entered its first inning.
Seven months later, there was a bank run on Bear Stearns, leading to its bailout by the Fed and J.P. Morgan. Then, within fourteen months, Lehman Brothers failed, which set off calamity within the global economy and the worst recession in nearly one hundred years.
A banking crisis occurs when a significant number of banks and financial institutions face sudden financial distress or insolvency, leading to a widespread loss of confidence in the banking system. A banking crisis can result from a variety of factors, including poor management practices, excessive risk-taking, economic downturns, financial bubbles, or political instability.
During a banking crisis and the accompanying loss of confidence by depositors and clients, banks can experience a sudden surge in customer withdrawals, which can quickly deplete their reserves and lead to a liquidity crunch. A bank run occurs when a large number of customers withdraw their deposits simultaneously because they fear the bank may become insolvent or unable to fulfill its obligations. Even a rumour regarding a bank’s financial health can set off a devastating bank run that can spiral out of control, solidifying a bank’s demise.
From a depositor’s perspective, a bank run resembles the game of musical chairs – when you hear the music stop, you want to be first. Those who are slow to react, lose. When you are the CFO of a company, and you lose the company’s cash, that’s a problem. During a bank run, the quick survive.
A run on the bank can lead to losses for depositors, creating a potential negative feedback loop as panic sets in and markets go haywire. During a banking crisis, bank runs can occur more frequently because of the widespread fear and uncertainty about the financial health of the banking system. As a result, bank runs can quickly escalate and become contagious, spreading from one bank to another and leading to a widespread collapse of the banking system, with severe negative ramifications for both markets and the economy.
To prevent bank runs and stabilize the banking system during a crisis, governments and central banks may intervene by providing emergency liquidity to banks, guaranteeing deposits, or implementing other measures to restore confidence in the banking system. In more severe crises, the central bank can flood the system with liquidity and ease financial conditions, using tools such as low interest rates and quantitative easing to calm markets and help the system recover. This government bailout occurred in 2008 and ultimately led to the recovery of the banking system, markets, and the global economy.
Over the past several days, we saw a stunning run on Silicon Valley Bank (SVB), ultimately leading to its failure and subsequent FDIC receivership.
SVB was the 16th largest bank in the United States, with $209 billion in assets at the end of 2022. Its demise was the second largest bank failure in U.S. history, after Washington Mutual in 2008. The bank was home to cash belonging to approximately half of all venture-backed startups in the U.S. and was the default financial institution used within the startup community (per the direction of Silicon Valley venture capitalists).
SVB’s demise was swift. Its stock crashed on March 9th, when rumours of its financial issues swirled and investors and depositors tried to withdraw $42 billion in deposits from the bank. By the next day, the bank failed, and its stock became worthless.
U.S. bank stocks dropped more than 12% last week, the most significant weekly drop since early 2020. The bank run on SVB and its quick failure led to the loss of investors’ confidence in other banks. Smaller financial institutions will lose deposits, threatening their viability.
Investors were rightly so to sell their bank stocks. There are several reasons for lower stock prices:
- Increased existential risk, particularly with regional banks whose deposits can dissipate quickly. This increased risk should result in lower valuation multiples (i.e. higher risk premia) for the sector.
- Lower book values as banks are forced to sell underwater held-to-maturity fixed-income securities, which were purchased when interest rates were much lower, to shore up their liquidity. The sale of liquid assets at a loss will lead to lower equity book values.
- Reduced profitability as banks are forced to increase deposit rates in a bid to hold onto client funds and stem the migration to higher-yielding money market funds.
Nevertheless, Silicon Valley Bank failed due to two unique issues that may not carry over to other financial institutions.First, SVB’s deposit base was very risky. Most of its deposits came from Silicon Valley startups, which went through an unprecedented boom over the past several years. During this period, with so much cash coming in the door, its long-term securities portfolio grew from $17 billion to $98 billion over a short period. The bank could not lend the funds as quickly as they came in, so it bought billions of long-term, low-interest-rate mortgage-backed securities and Treasury bonds.
As interest rates rose, SVB’s portfolio of high-duration fixed-income securities suffered devastating mark-to-market losses of more than $15 billion (nearly equal to its entire equity value). The bank’s major mistake was having such a significant portion of its assets in fixed-rate securities, especially with effectively no interest rate hedges. When interest rates rose, the decision to have a much higher concentration of its assets in low-yielding fixed-income securities proved to be its Achilles heel. Each 1% rise in interest rates led to billions of dollars of losses.
SVB bet the farm on a highly risky interest rate gamble, and as rates rose, it suffered devastating losses that decimated its balance sheet.
In an attempt to shore up its liquidity, SVB was forced to sell some of its fixed-income securities, crystalizing a nearly $2 billion loss. Once the bank disclosed the large realized loss and a subsequent attempt at a $2.25-billion capital raise through an equity offering, its fate was sealed as depositors lost confidence, and a bank run commenced.
The asset side of SVB’s balance sheet was vulnerable to higher interest rates given its above-average exposure to low-yielding fixed-income securities. Compounding the issue, on the liability side of its balance sheet, the bank’s deposits were heavily concentrated in one sector and were very easy to withdraw, creating a significant vulnerability. In addition, only 2.7% of SVB deposits were FDIC insured. Non-FDIC-insured deposits, which accounted for nearly 98% of SVB’s deposit base, will be the quickest to leave at the first sign of trouble.
In comparison to its interest-rate-sensitive assets, SVB’s deposit base was also highly sensitive to interest rates (specifically, reliant on low interest rates). Out of all the major banks, SVB had by far the riskiest deposit base.
Cash came flooding in the door at SVB over the past several years as startup companies’ coffers filled with VC funds, itself a product of the previous zero-interest rate environment.
As interest rates rose, money market funds became quite attractive to Chief Financial Officers as a home for their companies’ cash. Why hold funds in a 0% yielding checking account when money market funds now yield over 4%?
Given the low-yielding nature of its assets, and the desire to maintain profitability through a positive net-interest margin, SVB was unable to raise the rates it paid depositors. It could not compete with more attractive yields found elsewhere.
Money began to find a better home in short-term cash funds. As a result, the assets held in cash savings ETFs boomed, to the detriment of banks.
Given its low-yielding assets, and commensurate low-yielding deposit base, SVB’s capital position was weakened throughout 2022 and into 2023. Its declining capital position forced it to sell securities at a loss, which destroyed the market’s confidence.
SVB’s hasty attempt at a $2.25 billion share sale caused a -60% one-day drop in its share price, which started a death spiral. Venture capitalists compounded the problem by encouraging their portfolio companies to withdraw their money from Silicon Valley Bank, effectively shouting fire in a crowded theatre and inducing a bank run.
Just as venture capitalists created SVB’s success, they also destroyed it.
In a banking crisis, the thing that markets fear most is contagion. It is impossible to know all the implications and knock-on effects as the dominos fall.
For example. reserve-backed stablecoins were once viewed as safe. Essentially, they are tokenized money market funds.
Shortly after SVB’s failure, the second largest stablecoin issuer, USDC, announced that it had $3 billion, or approximately 8%, of its $40 billion reserves at the bank.
This revelation caused a severe bank run on USDC, as it swiftly “broke the buck” and traded from 100 cents on the dollar to 91.
Aside from potential runs on smaller regional banks, the subsequent main risk to be aware of is money market funds.
If one of these “break the buck” as USDC did, then all hell may break loose. Credit markets could freeze, leading to a significant loss of investor confidence and widespread panic.
Is this a potential redux of 2008? Only time will tell, although it is looking unlikely. One important distinction is that in 2008 the banking crisis was caused by toxic assets related to subprime mortgages. In today’s banking crisis, the “toxic assets” are innocuous – long-term Treasury bonds and mortgage-backed securities. While of the highest quality from an investment perspective, these fixed-income securities are only “toxic” in that they were purchased at far too high prices (given previously ultra-low interest rates).
In the Great Financial Crisis, it was a credit quality issue. In the current banking crisis, it is a duration issue.
In 2008, the toxic subprime mortgages were sold off, causing a death spiral that compounded reductions in asset values. It was a negative feedback loop.
In contrast, some of today’s “toxic” assets (long-term Treasury bonds) are anti-fragile. On Friday, as SVB failed and was placed into receivership, Treasury yields plummeted and bonds rallied significantly. Long-term Treasurys were up +3.3% this week.
As the current banking crisis worsens, long-term, high-quality fixed-income securities can rally in value and function as an airbag, cushioning the blow. This market reaction creates the opposite of a death spiral – a positive feedback loop. The failure of SVB caused Treasury bonds to surge in value, ironically dramatically improving the health of other banks. Contrary to the crisis in 2008, the current banking crisis dynamic and its cause appear to be less systemic in nature.
Nonetheless, SVB was not the only bank with substantial mark-to-market losses on its held-to-maturity bond portfolio and without sufficient interest rate hedges. Across all FDIC banks, there were approximately $620 billion of unrealized losses on banks’ securities portfolios as of the end of last year.
What will happen next? Much of this depends on the U.S. Government’s response. It has developed a system to monitor, regulate, and potentially bail out financial institutions to nip bank runs in the bud and prevent banking crises from occurring, or at least spiraling out of control.
Moral hazard arises when market participants no longer feel the need to make careful choices and manage risk because they expect others, including the Government, to bail them out when bad things happen. It is the Government’s job to carefully balance the stability of the system and potential bailouts using taxpayer funds, against mitigating moral hazard.
We all know what happened when the Government failed to bail out Lehman Brothers.
They say that capitalism without bankruptcy is like Christianity without hell. While SVB’s stockholders and creditors should lose their investment and not be bailed out, hopefully, the Government will act to ensure the continued operation of the thousands of businesses with cash stuck at SVB. Thankfully, $250,000 of its depositors’ cash is insured and will be available on Monday.
What are investors to do? First, for businesses and individuals, make sure you do not have a cash balance above the insured amount at a potentially vulnerable bank. Keeping cash safe is of the utmost importance.
For investors, market volatility will likely ensue. Risks will rise. We may see more bank failures as isolated runs hit vulnerable banks. That being said, the large banks should be fine. Thus far, credit default swaps on the big banks have barely budged.
Nonetheless, investors should be prepared before systemic risks arise. The best way for investors to be prepared is through thoughtful portfolio diversification.
Adequate portfolio diversification includes at least six uncorrelated asset classes within a portfolio, including assets that may be negatively correlated with stocks. When an asset is uncorrelated or negatively correlated, it can do well as markets tumble.
“Going to cash” is likely the wrong approach to risk management for several reasons. First, if allocators sell their investments, they’ll crystalize a taxable event. Second, if an allocator is spooked into selling everything, they are likely taking far too much risk than they are comfortable with. Third, most choose to go to cash after a material drawdown in their portfolio, more often than not selling near the bottom. Fourth, even if an investor liquidates their portfolio before a significant decline in asset values, it is highly unlikely that they will buy back below where they sold. They are more likely to fight the last battle and only panic buy back in once asset values recovered significantly (and higher than where they sold).
Harvard’s endowment takes an astute approach to risk management within a long-term asset allocation framework.
Notably, Harvard’s endowment has twice as much of its portfolio in hedge funds as compared to public equities.
Harvard allocates more to hedge funds than public equities to generate higher risk-adjusted returns.
The SVB failure and the accompanying banking crisis proved two investing mantras:
- Diversification works.
- Risk management matters.
If investors incorporate these two important investing mantras into their asset allocation framework, they should attain satisfactory long-term investment results without too much consternation.
Accelerate manages five alternative ETFs, each with a specific mandate:
- Accelerate Arbitrage Fund (TSX: ARB): SPAC and merger arbitrage
- Accelerate Absolute Return Hedge Fund (TSX: HDGE): Long-short equity
- Accelerate OneChoice Alternative Portfolio ETF (TSX; ONEC): Alternatives portfolio solution
- Accelerate Enhanced Canadian Benchmark Alternative Fund (TSX: ATSX): Buffered index
- Accelerate Carbon-Negative Bitcoin ETF (TSX: ABTC): Eco-friendly bitcoin
ARB declined -0.2% in February and remains up 0.3% year-to-date. The benchmark S&P Merger Arbitrage Index fell -0.4% in February and is down -2.5% thus far in 2023.
Lately in merger arbitrage, it has been more of what you did not own than what you did own that has determined your returns. The M&A environment has been a venerable minefield of potential risks. From an antitrust risk perspective, regulators globally, and the FTC and DoJ in the U.S. particularly, have been quite aggressive regarding mergers and acquisitions. Three large-cap deals have been challenged by antitrust authorities recently, including Microsoft’s acquisition of Activision, JetBlue’s merger with Spirit, and ICE’s deal with Black Knight. In a less politically charged environment, the majority of these deals would have been cleared by regulators without issue.
While we expect that some of these mergers will be successfully defended in court, and end up closing, the effect of a lawsuit from the DoJ or FTC is a significant delay. With the current high level of interest rates, substantial delays to closing can be costly.
In any event, lately, the key to success in merger arbitrage has been to avoid the hairier antitrust situations and stick with small and mid-cap consolidations and private equity buyouts. In addition, it is best to stay away from bank deals now, given the current banking crisis.
Currently, ARB is allocated two-thirds to SPAC arbitrage and one-third to merger arbitrage. Leveraged buyouts account for 12% of the portfolio, while strategic mergers represent 22%. ARB’s gross exposure stands below 1.3x.
HDGE gained 5.2% in February as U.S. long-short multifactor portfolios bounced back after a drubbing in the first month of the year.
U.S. long-short performance was led by the trend and price momentum factors, which gained 7.7% and 6.4% during the month, respectively. In addition, the value, quality, and operating momentum long-short portfolios generated positive performance of between 1.7% and 4.9%.
The speculative surge that led to a challenging start to the year for HDGE has reversed, and then some. Thus far in 2023, HDGE has been negatively correlated to the S&P 500, falling as the market rallied and surging as the market fell. A strategy that can generate positive uncorrelated, or negatively correlated returns can serve as an effective portfolio hedge and diversifier within a long-term asset allocation framework.
ONEC fell -0.2% last month and remains up 5.5% year-to-date.
The lone positive performing allocation within the Fund’s portfolio was the absolute return mandate, which surged 5.2% during the month, proving once again to be an effective diversifier and portfolio hedge.
Detractors within the portfolio include gold, which dropped -5.2%, risk parity, which fell -4.8%, and infrastructure, declining by -4.0%. In addition, the real estate allocation had a negative performance of -3.4% during the month.
Other portfolio allocations in ONEC, including leveraged loans, mortgages, long-short equity, arbitrage, and bitcoin, were all down slightly.
After more than two years, the Accelerate portfolio management team modified the ONEC portfolio. We have eliminated the 10% allocation to bitcoin, and in its place, allocated 5% to managed futures and 5% to commodities. We believe this allocation change will improve ONEC’s risk-adjusted performance by reducing volatility and mitigating drawdowns.
ATSX fell -0.2% in February while its benchmark, the TSX 60, declined -1.6%. The Fund remains up 4.0% year-to-date compared to the benchmark’s return of 4.6%.
The Fund’s long-short overlay portfolio generated 1.4% of outperformance during the month. Most Canadian long-short multifactor portfolios attained positive performance, led by price momentum, with a 4.7% return, and value, with a 4.3% gain. The quality and trend long-short portfolios were up less than 3% while the operating momentum long-short portfolio suffered a slight decline.
As expected, ATSX’s outperformance occurs during down markets. It was designed to reduce drawdowns and volatility while aiming to participate fully in upside markets (along with paying a 7%+ yield). As a result, it will generally lag during speculative surges as occurred in January. Nonetheless, we believe the speculative fervour in the equity markets to start the year was a temporary phenomenon, and the remainder of 2023 could be a sideways and choppy market in which hedged strategies can do well.
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Disclaimer: This distribution does not constitute investment, legal or tax advice. Data provided in this distribution should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information in this distribution is based on current market conditions and may fluctuate and change in the future. No representation or warranty, expressed or implied, is made on behalf of Accelerate Financial Technologies Inc. (“Accelerate”) as to the accuracy or completeness of the information contained herein. Accelerate does not accept any liability for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on all or any part of this research and any liability is expressly disclaimed. Past performance is not indicative of future results. Visit www.AccelerateShares.com for more information.