Centre Street Cambridge Corporation - April 2023 - cscc101 meta name="keywords" content="Commentary April 2023

e have long felt that the next financial crisis would emanate from the fixed-income arena, which is why for many years we have talked repeatedly about the dangers of buying long-dated bonds. “Never a short-term borrower or long-term lender be,” is a maxim worth remembering. This is emphatically the case during periods of low interest rates; low rates are the product of high prices, and it is never wise to pay an inflated valuation for any financial asset. Nevertheless, people are tempted (usually at the worst time) into extending maturities, since even a tiny return from a historical standpoint may represent a significant premium over short-term alternatives, which, in the years since the Financial Crisis of 2008, have frequently offered little or no return at all.

Skepticism towards fixed-income was a tough stance to take when long bonds offering 2-3% with little credit risk looked positively lucrative compared with 0% for money-market funds (historically, 5-6% would have been more the norm). But it was the price risk that scared off serious investors from lending money for more than a few years at a time (note: lending money is what you do when you buy a bond). The needs of individuals to increase their income and some institutions to meet distant financial obligations proved irresistible to many who “reached for yield” despite the risks. A long period of relatively stable rates at low levels inured investors to the fact that they were paying top prices for financial assets that could react violently to any change in the market interest rate structure.

While “we told you so” is a phrase rife with potential embarrassment when used in connection with Wall Street, the risks we have often warned against lie at the heart of the latest blow-up in banking. The collapse in March of Silicon Valley Bank (SVB) in California, the second-largest bank failure in US history (in nominal terms, at least), has rattled financial nerves worldwide. To call the current turmoil a “crisis” seems overblown, but when financial markets and emotions mix, anything can happen, which the rapid actions taken by central banks and regulators in the US and Europe demonstrate.

Before commenting further on SVB, we should explain that banking is essentially an elaborate confidence game, in which an impressive building with columns in front creates an aura of stability and permanence masking a fragile reality. Behind those columns a magical transformation takes place: something that people may need at any time (their cash) becomes something that might not be liquidated in a hurry without penalty. Thirty-year mortgages or long-term bonds are good examples of this. With bank deposits this arrangement normally works because depositors have confidence that they can get their money promptly if needed; indeed, loss of the belief in access to ready cash was associated with numerous banking and economic crises in early US economic history, and an important reason for establishing the Federal Reserve system in 1914. Having requisite cash on hand to meet demand requires bank managements to act responsibly to maintain adequate liquid reserves and invest prudently. In this year’s banking turmoil, depositors lost confidence in only a few institutions, but many others were tainted through association, raising the danger of a negative feedback loop that could swamp the industry; indeed, many small banks saw deposits flee to large financial institutions in the aftermath of SVB. Regulators’ and central bankers’ swift response appears to have halted further contagion and panic.

SVB is a regional bank with about $200 billion in assets. The bank had experienced rapid growth since 2015 and saw a big influx of deposits in 2021, 95% of which were not covered by deposit insurance (its customers included a lot of technology startup companies which had raised cash in a hot market for initial public offerings during the pandemic period). Instead of using those deposits to make loans, management unwisely invested in long-term securities (treasuries and mortgage bonds) that have, it is important to note, very low credit risk, and which offered a larger “spread” over the bank's funding costs than other investments. Indeed, before its troubles began, the bank held more money in such bonds than it had out in loans to customers.

This stance was in effect a big bet on interest rates, a wager that paid off for a while, quickly generating higher profits for the bank. Last year, however, the Federal Reserve acted to counter unexpectedly high inflation, and interest rates rose rapidly; the two-year treasury note, for example, yielding only 0.2% in 2021, at one point in March 2023 paid over 5%. Rising rates drove down the market value of long-term bonds (this is what we mean by price or market risk.). At the same time, SVB’s high-tech depositors, facing challenges in their own businesses, suddenly needed to access their funds. The withdrawals depleted the bank's liquidity and forced it to sell some of its bond holdings at a significant loss. Adding to the pressure, well-known venture capitalists warned others to pull their money from SVB. A classic run on the bank ensued, an attempt to raise new funding failed, and the rest is now part of the sordid history of bank mismanagement.

How could this happen at a “well-capitalized” bank in a highly regulated industry? One answer is that it wasn't as highly regulated as it could or should have been. Smaller institutions such as SVB are not subject to the sort of strict “stress tests” imposed on the industry following the Financial Crisis in 2008 as part of the Dodd-Frank Act. Executives, including SVB’s, engaged in a successful effort to obtain this exemption; SVB itself spent $500,000 on lobbying in the three years leading up to deregulation in 2018. Had SVB been subject to the same oversight as the leading mega-banks (with trillions of dollars in assets), its disastrous course might well have been averted.

Another force at work at SVB was well illustrated in a Financial Times piece after the bank’s collapse. After the surge in deposits in 2021, SVB’s long-term bond buying spree eventually totaled about $125 billion. Its bond portfolio’s “duration” (a measure of price sensitivity to changes in interest rates) rose to 4 from 2.5 in 2016. “Reaching for yield ” worked; the bank's profitability, as measured by its “return on equity” (“ROE”), climbed markedly to over 20% in 2018-19 from about 12% in 2017. Not surprisingly, executive compensation, which was tied to that ROE figure, rose sharply to $14 million in 2019, from $8 million in 2017, and only fell slightly to $13.5 million in 2022. Executives (not just at SVB, we hasten to add) who had lobbied hard for softer regulation used the advantage gained to roll the dice on interest rates and boost their own fortunes. The bank’s shareholders and the banking industry in general (through higher deposit insurance fees) have and will pay dearly for these shenanigans; we have yet to see if the decision-makers will be required to shoulder any costs themselves. Given the history of such schemes, we suspect they will get off lightly.

For us, the takeaway from this latest banking mishap is that these institutions require tight regulation, perhaps to the extent of turning them into quasi-utilities, because the societal cost of their failures is too high. Many would say that such strictures would cause talented individuals to turn away from the industry, but perhaps making banking “boring” would not be such a bad thing. Talented individuals, or at least the aggressive and greedy ones, can always start their own businesses and pile risk on their own heads in the hope of a big pay-off, instead of stiffing taxpayers, who have suffered as the ultimate backstop for banking misdeeds.

If effective regulation of banking seems a challenge, any remedy for excessive compensation of managements seems positively far-fetched. After the 2008 Financial Crisis, the heads of some major banks, including the ones that failed, walked away with enormous fortunes, putting paid to the universal boast among corporate executives that their interests are “aligned” with those of shareholders through ownership of their company›s stock. Yet when their shareholdings come from stock grants or options instead of from market purchases like everyone else’s, how does that constitute “alignment?” Their shares can be sold (subject to some restrictions) usually without penalty, and unlike the aggregate ownership of a company, former executives can walk away with fortunes intact. SVB executives, for example, sold $3.6 million of their own stock a couple of weeks before their bank was seized.

We have always advocated a “skin in the game” approach to “alignment,” tying management wealth to their companies until well after their retirements — in other words, subjecting them to the risks that partnerships face. (Weaker Wall Street partnerships got wiped-out during the Depression — a proper disincentive to take on undue risk.) Some believe that jail time is the answer, but few of the most egregious activities involving corporate management are in fact criminal. Years ago, we paraphrased remarks from an observer who stated that banking, like the airlines, has never made money. In the aggregate — including write-offs, fines and other penalties, liquidations and all the rest — the industry has probably been marginally profitable, at best, over time. Unfortunately, this does not seem to apply to bankers themselves.

We have observed that the designation “market guru” often results from making one correct forecast, when the forecast happens to involve a big event, such as the 1987 October crash, or the real estate collapse that led to the 2008 Crisis. Subsequent soothsaying attempts by said guru usually fall flat. This happened recently when a hedge fund manager famous for “calling” the housing collapse of 2008 tweeted a “sell” early in the first quarter. At the end of March, he recanted and admitted his early assessment had been wrong. Fortunately, we don’t pay attention to soothsaying or use it in decision-making, and neither should anyone else.

Once again markets have turned the gurus’ predictions on their heads. A double-digit decline in 2022, a Federal Reserve tightening cycle, a downturn in housing, weak earnings outlooks, and, finally, a banking scare all combined to create negative sentiment in the markets this year. Nevertheless, trading has been relatively stable overall, and the averages finished the quarter on a positive note: the NASDAQ average, for example, saw its best quarter since 2020, an advance of about 17%. In fixed-income, the two-year treasury note’s yield had the biggest monthly drop in March since 2008. Technology stocks had an outsized positive influence on the indexes in the opening months of the year, returning to vigor after last year’s rout. When a headline such as “second biggest bank failure in US history” produces only a tepid reaction among investors, it says a lot about the underlying strength, or foolishness, of the markets and market participants.