The Banking System & Market Volatility

“Banking is a very good business if you don’t do anything dumb.” Warren Buffett

Dear Clients and Friends,

As you are no doubt aware, our nation’s banking system has come under intense scrutiny in recent days. Last week, Silicon Valley Bank, a prominent institution amongst technology companies and venture capitalists, collapsed and was seized by the federal government. This marked the largest U.S. bank failure since 2008.

So, let me share an overview of what has happened and our outlook going forward.

In essence, Silicon Valley Bank owned mostly long-term government bonds to generate cash to cover their deposits. These bonds were purchased when interest rates were extremely low. As interest rates rose sharply in 2022, the value of these bonds dropped significantly. Furthermore, as the economy started to weaken, venture capitalists, startups, and technology companies began to need more liquidity to cover their debts and expenses. This pace accelerated dramatically as concern increased about SVB’s ability to pay their depositors. On March 10th, the bank collapsed.

Just a day later, Signature Bank, a bank heavily exposed to cryptocurrencies, experienced a similar panic amongst its depositors and saw more than $10 billion in outflows. It was shut down by the U.S. government hours later.

As a result, last weekend the Federal Reserve stepped in with the controversial move of guaranteeing 100% of deposits held at SVB and Signature Bank, over and above the $250,000 cap insured by FDIC.

In fact, it is estimated that 90% of deposits at SVB and Signature Bank did not have FDIC insurance.

Related to my Warren Buffett quote above, that is “doing something dumb.”

In its wake, investors and depositors alike are understandably concerned about the banking system as a whole and wondering if what happened to SVB will spread to other institutions, particularly the regional banks. Since last week’s news, the stock market has declined more than 2% and regional banking stocks have plummeted about 20%.

We are monitoring these events closely and our financial stocks in particular. It should be noted that you, our valued clients, have very limited exposure– if any – to the smaller, regional banks. Furthermore, we do not think what happened with SVB and Signature Bank is likely to become a contagion across the banking system. Here’s why:

• SVB and Signature Bank had unique business models, in SVB’s case catering exclusively to VC firms and Signature Bank with large cryptocurrency exposure. These esoteric anomalies are not common in the wider banking system, even among regional banks.

• The Federal Reserve has mobilized not only to guarantee 100% of the deposits at SVB and Signature but has stepped in to offer liquidity to the smaller regional banks to prevent another crisis.

• The large commercial banks must undergo “stress tests” to ensure they are adequately capitalized. These stress tests are like the last three recessions combined and the banks must pass them annually. In essence, the large banks are more stable, regulated, and well capitalized than they were in 2008.

• As far as the European banks, they are currently the best capitalized and most profitable they have ever been. On top of this, Credit Suisse, which has been in the news, has always been a deeply troubled institution – for well over a decade.

So, while investors and depositors certainly have reason to be concerned given the last week, we are confident, overall, that the broader banking system is intact and will remain stable.

In the short term, the stock market will continue to be sensitive to any further news surrounding these issues and other economic data. In the medium to longer term, we do believe there are some positive takeaways for the market heading into the spring/summer of 2023. Namely, after raising interest rates at their fastest pace in history, this last week will likely lead the Fed to rethink its pace of future rate hikes and bring into play a potential sooner-than-expected pause.

Hopefully, Jay Powell and the Federal Reserve recognize that it takes a full 12-18 months before the full effects of these interest rate increases take hold. So, I think we are coming close to the end of this unprecedented rate hike cycle. We’ll know more after the Fed’s meeting next week.

Importantly, CPI data has shown year-over-year inflation trending lower each month since July 2022. The February PPI report, released recently, showed significant drops in producer inflation. This has a three-to-five-week lag effect before it hits consumers. In short, inflation is trending down and should continue to drop.

No question, the economy still faces significant challenges ahead. Again, we may see more shoes drop in the financial sector, but, on the whole, we believe the banking system will stabilize. In the meantime, we intend to stay the course with the highest-quality businesses with fortress-like balance sheets and excellent long-term prospects.

Best wishes,

James C. Burns, CFA