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Lehman Brothers 2.0 Or Massive Overreaction?

To start, I would like to let everyone know that we had no exposer to SIVB or the banking sector in general, and we do not own any cryptocurrency.

Kurt S. Altrichter

Over the past several weeks, I have emphasized the likelihood of higher volatility and credit events, and recent events have confirmed my warnings. The Ivory Hill RiskSIGNAL has weakened over the past week, and we are closely monitoring it for any breakdown. The market's performance has mostly followed our expectations, with a strong surge in January followed by a pullback and consolidation phase. While we expected a credit event, we did not expect a bank failure this early in the cycle. This triggered a sharp two-day decline. Despite this setback, the overall conditional trend remains intact, though precariously so. Prepare for head fakes in both directions.

Silicon Valley Bank (SIVB) went belly up in just about 30 hours. How did this happen?

Kurt S. Altrichter

This story can be attributed to a funding base that is excessively concentrated, inadequate risk management practices, and what I think will come out as a significant amount of moral hazard.

Inadequate Risk Management Practices:

Post 2008, regulators forced banks to own enough high quality liquid assets (HQLA) at least big enough to meet a stressed outflow of deposits for 30 days. This means their Liquidity Coverage Ratio (LCR) must be above 100%.

Makes sense, right? Have enough high quality liquid assets to give people their money back.

Not so fast.

What qualifies as HQLA? Reserves at the Central Bank, Treasuries, but also corporate bonds and mortgage backed securities to a certain extent.

Kurt S. Altrichter

As a result of LCR regulation, banks have been investing trillions in bonds to bolster their balance sheets, but this comes with risk. One of the primary risks is interest rate risk. When bond yields rise, bond prices drop, which results in a loss for bond investors. Banks hedge against this risk through interest rate swaps. However, SIVB did not hedge any of its interest rate risk, leaving their investors and deposit customers exposed to significant risks.

SIVB had an enormous investment portfolio that was 57% of their total assets. This was significantly higher than the average US bank's investment portfolio, which is 24% of total assets.

SIVB's $120 billion bond portfolio had a 5.6-year non-hedged duration, which meant that every 10-basis-point increase in the 5-year interest rate resulted in a loss of $700 million.

SIVB's risk management practices were inadequate, and they did not follow basic risk management practices. This led to the bank's demise when depositors started withdrawing their money, and SIVB was forced to realize billions of dollars in losses on their bond investments to service the outflows of deposits.

While I have analyzed this situation since Friday, I believe that this is most likely an isolated incident, and it is unlikely to be a trending issue across all banks. However, there is a possibility that we may see more banks fail if they have been using similar risk management techniques as SIVB (aka no risk management).

Larger banks tend to be more stable, as they do not engage in high-risk lending to ventures such as Bitcoin and tech startups, which Silicon Valley Bank (SIVB) had done. Furthermore, larger banks are typically well-diversified, unlike SIVB. This has resulted in some attractive buying opportunities in the banking sector, although, I would wait for things to stable before buying anything.

Kurt S. Altrichter

An old saying suggests that the Federal Reserve continues to hike rates until something ultimately breaks, and in this case, it appears that things are now breaking. The Federal Reserve has implemented a 450 basis points rate hike in less than a year, and the repercussions are becoming apparent. Three banks have already failed, which led the Federal Reserve to intervene and backstop depositors. To calm the markets and prevent further bank runs and potential contagion, regulators devised the Bank Term Funding Program (BTFP) on Sunday night.

The BTFP outlines a plan to cover all deposits at Silicon Valley and Signature banks. Additionally, the Federal Reserve has created an emergency liquidity facility for other banks, and it has pledged to address future liquidity issues. The goal is to prevent further panic among investors and depositors and to instill confidence in the banking system.

SIVB, which was the 16th largest bank in the US, had a significant presence as a lender in the tech industry. Recent media reports suggest that VC and PE firms were advising their clients to move their funds away from SIVB, fueling a panic among banks that continued until regulators intervened and shut down the bank.

The failure of SIVB has brought to light the significant losses that banks are collectively facing on loans due to the increase in interest rates. The FDIC reported that the total unrealized losses at the end of 2022 amounted to $620 billion, a sharp rise from the $15 billion reported in 2021. Liquidating these portfolios would substantially deteriorate the book value of banks.

Investors and depositors have been rattled by the troubles at SIVB, leading to a tightening of financial conditions. This, in turn, may result in a reversal of the hawkish stance expected from the Federal Reserve. Restricted lending induced by banks amplifies the impact of the current Fed hikes and could reduce the need for future hikes.

Kurt S. Altrichter

Even though the NFP jobs report is important for the Federal Reserve, the inflationary risks may be somewhat minimized by the SIVB bank scare. Even if the jobs report for February is good, the second-order effects of the SIVB problems will likely make it harder to get money. This means that the Federal Reserve might not have to raise rates as quickly as it has been.

I am not calling for a Fed pivot but this combined with the fact that a solid portion of the US government's debt is set to rollover into higher interest debt in 2024 could possibly make the Fed at least think about a less aggressive interest rate policy.

If you are worried about your bank or are wondering how you can increase your FDIC coverage, please reach out to me.

And remember—the one fact pertaining to all conditions is that they will change.

Best regards,

Kurt S. Altrichter, CRPS®

Fiduciary Advisor | President

Direct: 952.828.5336

—Written 03.13.2023


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