Reversal of fortunes

Bottom Line 

It’s the 15th anniversary of the Federal Reserve-induced, $2-a-share fire sale of Bear Stearns to J.P. Morgan. Reminiscent of the contagion that emanated in 2008 from the global financial crisis and the collapse of the housing market, two of the three largest bank failures in U.S. history happened this past fortnight: the forced closures of Silicon Valley Bank (SVB) and Signature Bank. Unlike 2008, however, the collapse of these institutions appears a function of company-specific mismanagement. 

Focusing on SVB Founded in 1983, Silicon Valley Bank was the 16th largest bank in the U.S., with assets and deposits totaling $209 billion and $175 billion, respectively, at the end of 2022. It provided financing for roughly half of all U.S. venture-backed technology companies. We think its foundering was due to: 

• Poor management It appeared to be more focused on personal aggrandizement, political activity and non-core business decisions.
• Lack of risk controls It failed to properly manage its investment portfolio in a rising interest-rate environment. 
• Executive management avarice According to SEC filings, CEO Greg Becker and CFO Daniel Beck sold nearly $3.6 million and $600,000, respectively, in the bank's common stock nearly two weeks before the bank collapsed. Other executives had been selling stock since May 2021. President Biden has spoken about holding senior management accountable, with possible claw backs and civil penalties. Will the this situation be elevated to the level of failed crypto company FTX and its jailed CEO Sam Bankman-Fried? 
• Misaligned business priorities Management seemingly veered away from its core business of attracting deposits and making sound loans and investments.
• Lack of adequate regulatory supervision Where was the San Francisco Fed?

What happened? Silicon Valley Bank had invested a large amount of its bank deposits in long-term U.S. Treasuries and agency mortgage-backed securities (MBS) to capture higher yields, but those values fell as the Fed began to raise interest rates over the past year. When tech companies accelerated employee layoffs in recent months due to the slowdown in the economy, they began to pull out money. To meet those withdrawals, the bank sold parts of its bond portfolio, resulting in significant realized losses. When the bank announced a need for more capital, many of its 37,000 customers panicked about its potential insolvency, sparking a classic bank run. 

Government stepped in Silicon Valley Bank’s clients had large bank accounts, with deposits in 90% of them exceeding the FDIC’s $250,000 insurance limit. So the Fed, Treasury and the FDIC established a new Bank Term Funding Program (BTFP), which offered 1-year loans for eligible depository institutions pledging Treasuries, agencies and MBS as collateral. Importantly, the government agreed to value these bonds at par despite their large unrealized losses, effectively backstopping Silicon Valley Bank’s depositors in full and quelling the bank run. But the government also shut the bank down and removed its executive management team, rendering its stock and bonds worthless. 

Financial market volatility Amid this uncertainty, the S&P 500 has fallen by about 4% over the past fortnight. That extends the equity market’s decline since its overbought peak at 4,195 on Feb. 2 to about 9%. We believe stocks could retest their mid-October low at about 3,500 in coming months, as investors continue to reduce their earnings estimates. Over this same period, benchmark 10-year Treasury yields enjoyed a powerful flight-to-safety rally, falling from 4.09% on March 2 to 3.4% this week. Two-year Treasuries plunged from 5.07% on March 8 to a low of 3.71% this week. So the important 2/10 yield-curve inversion has shrunk dramatically from more than 100 basis points two weeks ago to 40 basis-points today.

What’s on tap for the Fed next week? Despite the banking-sector turmoil, we still expect three more quarter-point rate hikes on March 22, May 3 and June 14. That would take the fed funds rate to a terminal range of 5.25-5.50%, at which point we believe the Fed will pause into 2024.

Data dependent: solid economy, still-elevated inflation In our view, the Fed will discount the regional bank volatility and focus its attention on this past week’s economic data, in which the labor market remains strong, driving better-than-expected retail sales and elevated inflation.

• Labor market February’s nonfarm payrolls rose by a stronger-than-expected 311,000, well above the consensus estimate for a gain of 225,000, though slower than January’s outsized gain of 504,000 jobs. Initial weekly jobless claims remain very low at only 192,000. 
• Retail sales With the labor market strong, consumers are still spending. Nominal retail sales in February declined -0.4% month-over-month (m/m) versus a strong 2-year high of 3.2% m/m in January. But “control” results (which exclude autos, gas, food and building materials) surged by a much stronger-than-expected 0.5% m/m (consensus expected -0.3%) versus an upwardly revised gain of 2.3% m/m in January. Control results feed directly into the quarterly GDP calculation, and personal spending accounts for 70% of that, suggesting first quarter 2023 GDP estimates will probably rise. 
• Inflation Although nominal retail CPI inflation spiked from 1.4% year-over-year in January 2021 to a 41-year high of 9.1% in June 2022, it has since fallen to 6% in February 2023. Annualized core CPI (which excludes food and energy prices) fell from a 40-year high of 6.6% last September to 5.5% in February. But the monthly figures hardly budged, with headline still at 0.4% and core at 0.5%. So while inflation has peaked and is starting to recede, it remains sticky and persistent, which suggests that continued Fed vigilance is the appropriate course of action as it battles to get inflation down to its target of 2%. It should take a cue from the European Central Bank, which looked past the turmoil at Credit Suisse and still aggressively hike rates by 50 basis points.