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Understanding history is critical for understanding market cycles and investor behaviour. Factually, nothing ever repeats in an identical fashion. Mark Twain explained it best, “History never repeats, but it does often rhyme.” The past few weeks have been nothing short of chaotic and capricious, with banking stocks, bond yields, and even growth stocks experiencing extreme volatility. During market turmoil, rational investors revisit their investment thesis and if the fundamentals remain unchanged, they take a trip to bargain city. “When hamburgers go down in price, we sing the Hallelujah Chorus…” - Warren Buffet.
The collapse of Silicon Valley Bank (SVB) feels like déjà vu. One would expect management to be more aware considering that the Global Financial Crisis is still fresh in our memories. Before I draw your attention to historic parallels, let me explain how SVB came to near collapse.
SVB is a US-based commercial bank that at the beginning of the year was ranked 16th in size of all US banks and had supported roughly 50% of all startups there. Additionally, more than 50% of loans were to venture capital and private equity. This is quite staggering in the context of the wider US economy and the number of banks in the US which exceeds 4,000. At the same time, very few of us in Namibia had heard about it, before its troubles began a few weeks ago.
Over the past 4 years, SVB’s deposits had almost quadrupled (see Figure 1). This is unprecedented, especially for banks where competition for customer deposits is high and you are lucky if deposits grow along with the economy in low single digits on an annualised basis. In our view, the reason for this substantial rise in deposits was due to monetary policy initiatives brought on by the US Federal Reserve (USA Central Bank) in the last 15 years. In effect, the Fed has increased the supply of money more than tenfold, by printing money and placing it in the hands of institutions, corporates, and later also consumers at large. This ultimately resulted in US yields dropping as low as 0% in some instances. Much of the stimulus ended up in commercial deposit accounts, property markets, and stock markets. SVB was a net beneficiary of these flows.
Figure 1: SVB Total Deposits – Source: Arysteq/Bloomberg
While interest rates were at extreme lows, investors of all kinds flocked to yield by taking up more risky instruments on their balance sheets such as long-duration government bonds and mortgage-backed securities (MBS). SVB parked most excess depositors’ cash in long-duration securities (ie. MBS), with maturity profiles ranging from 10 to 30 years. This, we believe was driven by the gap between lending rates and more “attractive” looking securities (See Figure 2 US 10-Year Yield vs 10+ Year MSB Yield).
When inflation peaked in 2022 after more than 30 years of subdued and benign developed market inflation, global central banks, including the Fed, started raising rates in an attempt to curb inflation (See Figure 2 FED Fund Rate). This led to yields across the curve increasing, causing a sharp correction in the very instruments that SVB had bought earlier, thereby resulting in unrealised losses.
Figure 2: Timeline of Fed Fund Rate, 10+ US Government Bond Yield, 10+ MBS Yield & the Fed’s Reserve Bank Credit – Source: Arysteq/Bloomberg
Now, let me draw your attention to the historic parallels.
In 2008, Bear Stearns was the fifth largest investment bank in the US at the time of the collapse. Founded in 1923, the company survived the great depression to only face a much harsher reality during the Global Financial Crisis in 2008. After reaching its peak in 2006, the US housing market took a sharp turn as borrowers began defaulting. Similar to SVB, Bear Stearns had a concentrated balance sheet of long-duration securities.
Bear Stearns was overexposed to mortgage-backed securities (MBSs) and with the deflating housing bubble, management was unable to manage this risk. On 11 March 2008, Moody’s downgraded most of Bear Stearns’ MBSs to junk status. The Federal Reserve announced a $50.0 billion lending facility available to distressed financial institutions on the same day. Investors assumed these events were connected and this caused a run on the bank, leaving Bear Stearns incapable of opening its doors on the 13th of March. A bailout even with the assistance of J.P. Morgan couldn’t change the fact that the grim reaper had made his decision. After 85 years, Bear Stearns closed its doors on the 16th of March (History, 2008).
Fast forward to the 1st of March 2023, SVB received notification that Moody’s intentions to downgrade SVB Financial Group as a result of large losses on their investment securities. Management swiftly reacted with a plan to avoid a multi-notch downgrade by selling available-for-sale securities and executing a $2.3 billion in capital raise. After close on the 8th of March, SVB announced their strategic capital raise, and concurrently, Moody’s announced a 1-notch downgrade on SVB. This led to an aftermarket sell-off greater than 60.0%. The requests of alarmed depositors amounted to $42.0 billion, forcing SVB to crystallise unrealised losses on their bond portfolio. On the 10th of March 2023, SVB was seized by regulators. These events are by no means identical, but the similarities are uncanny.
A key differentiating factor in 2023 was the hasty response from the Fed to guarantee all depositors from SVB, another key differential is the ability of the Fed to step in considering the rapid growth of the Fed’s balance sheet.
Additionally, the Move Index, in Figure 3 below, spiked as volatility rose to levels last experienced over that same infamous period in history. Despite a positive outcome, investor behaviour paid tribute to the rhyme of history.
Figure 3: Move Index – Source: Arysteq/Bloomberg
Our investment team spent the week assessing the consequent impact on our portfolios. The short answer is that none of our securities have direct exposure to SVB through time deposits. We do, however, own certain securities that have experienced a sell-off – an irrational one in our view. After the 2008 crisis, new regulations aimed at reinforcing the capital adequacy of banks were implemented to avoid liquidity shortages. SVB met these requirements from an accounting perspective. However, what had been overlooked was the fact that:
Historically, most failed banks in the US since 2000 have had a substantially high total deposit-to-total asset ratio, roughly 90.0%. This relationship isn’t necessarily negative. However, it does bring into question the liquidity profile of the balance sheet. SVB only possessed 8.0% immediately available liquidity in the form of cash, which is why they couldn’t avoid crystallising their investment security losses.
Figure 4: Scatter Plot (Offshore Banks) – Source: Arysteq/Bloomberg
Figure 4 contrasts the total capital ratio with cash as a percentage of deposits, a clear distinction can be seen between most US and European banks. US banks find themselves undercapitalised and cash-strapped, which is quite the opposite in Europe. Considering our portfolios do not hold any to US banks and the banks that are in our portfolios have sufficient cash, we are confident that our offshore portfolio is not facing similar risks to SVB.
Our investment process places a substantial amount of emphasis on management quality. The oversight by SVB’s management to correctly manage the client concentration risk on their balance sheet, as well as the downward pressure on long-duration securities as the Fed rose interest rates to battle inflation is clear in this picture.
To provide some reassurance, our analysis highlighted that Namibian and South African banks have strong total capital ratios, well above the regulatory requirement of 10% (see Figure 5 below). In addition to this, we looked at the equity position in relation to long-duration investment securities (i.e., those exposed to interest rate risks), our findings proved that most of the local and South African banks can cover more than 70% of their entire investment portfolio with equity (see Figure 6). In SVB’s case, they could only cover 18.0%.
Figure 5: Total Capital Adequacy of SA and Namibian Banks – Source: Arysteq/Bloomberg
Figure 6: Equity as a percentage of Investment Securities – Source: Arysteq/Bloomberg
This time, the virus isn’t global. Even though the vitals are healthy, South African banking stocks experienced a less significant sell-off, however, Namibian banking stocks did not experience downward pressure. As mentioned previously, SVB was extremely industry-concentrated, South African banks do not face the same industry concentration risk, which gives us confidence that this bank sell-off in South Africa will be short-lived with potential upside ahead.
The robust and diligent process across all our portfolios makes us confident that an event such as SVB’s collapse is very unlikely and that the indirect impact on our portfolio will be short-lived. Our Namibian and South African banks provided a steady performance in our local funds and our offshore banks outperformed the global banking index proving to be robust despite market turmoil. In fact, we are already assessing our investment universe with the view to capitalising on opportunities that have arisen from this sell-off. A reassuring indicator was the FED hiking by 25bps, as no hike would have indicated their shared fear of contagion across the US banking sector.
Respect the rhyme of history.
