15 March 2023
As we work our way through the week of tumultuous reaction to multiple bank failures in the United States we begin to fall into the trap of repeating phrases to shape a view that we might find understandable and acceptable to define and rationalise market response. Market-moving events throughout the last few decades have tended to be represented in phrases most likely to encompass what we see in front of us....in this case "Idiosyncratic" to describe the fashion of these failures in the USA; and "the canary in the coal mine" to underline SVB as a cautionary indicator to a greater adverse situation. These seem to be the most commonly repeated over the last few days. Is this the case?
What we are uncovering, now, is that in the relatively moribund rate environment following the GFC, in which fixed-income securities were justifiably overlooked, in favour of higher-yielding investment alternatives, some of us seem to have lost our way in understanding the basics of fixed-income investment and portfolio management.
We have seen some of the opprobrium heaped upon the managers of treasury operations at SVB. We have been alerted, in graphic detail, to the possible impact of unrealised losses in securities held at banks on capital ratios We are lambasted by commentators, mostly with hindsight indignation, to the foolishness of shifting the goalposts of Dodd-Frank on capital, liquidity and "systemically important" banks in the US system. Dodd-Frank was passed in 2010 as a framework of safeguards to help protect us from another meltdown a la GFC. Nevertheless, as always in finance, we have very short memories of "dark days" and in the clearer light of 2018 a bi-partisan bill was passed to shift the bar up from $50bn to $250bn to define a " systemically important" bank.
The names of Trump and Powell, as advocates of these refined rules are bandied about as the villians in the plot and Gruenberg as the unheard hero as he warned of regional banks presenting "an unappreciated risk" in October 2019. Two of the three protagonists of 2019 formed part of the rescue squad last weekend and their decisive actions can be seen as laudable in the midst of a difficult and possibly dangerous financial storm. However, beyond the mathematical calculations defining liquidity ratios was the somewhat unforeseen trapdoor that bank holding companies falling below the newly raised bar of $250bn, but sitting between $100bn to $250bn, no longer had to supply a resolution formulating plans for a possible wind up of the bank.
Taking all this into account we have seen a predictable assault on those institutions falling into this $100-250bn category. Analysts are producing tabulated lists of targets that fall into those banks with high ratios of uninsured deposits, unrealised losses on available-for-sale (AFS) investment securities and vulnerability to peer group comparison and contagion risk.
In short, the short-term downside price action from Friday to Monday is somewhat reversing in the USA. The decisive action to afford US banks specialised funding through the Fed and the offer of par value loans on securities held at bank, amongst other provisions, has allowed investors to see a path forward and douse some of the fire. With this in mind, the landscape of US banks seems a lot less tumultuous than the one presenting on Friday last week. The view of other global banks is somewhat less clear at this point in time. "Contagious" price action was primarily in the US domestic markets. We would suggest that some of the sell off in banks outside the USA ( ref Credit Suisse et al) is more truly "idiosyncratic" than SVB, Signature Bank or Silvergate.
The demise of Drexel Burnham Lambert in 1990 was ultimately a failure of the money market arm to fund the multifarious operations of the wider bank. The failure of Bear Stearns and Lehman Brothers was very much caused through somewhat similar circumstances. Closing off short-term funding in a stressed environment will always raise eyebrows, heart rates and short selling. Funding long-term investments through short-term financing has been the tightrope that banks have walked for generations and banking crises over the ages have been precipitated through imprudent treasury management by those specifically charged to ensure judicious rate curve management.
We can skip over the rather short-sighted categorisation by regulators of US Treasuries carrying "very little to zero-risk weight" in terms of capital requirements. But when the very same investments helped provoke the demise of SVB and in turn cast a maligned eye on the peer group we need to ask why? We agree that US treasuries are bellwether investments and carry little credit risk; however allowing bankers to lose sight of how to sensibly fund these investments, mismanage a changing yield curve environment and seemingly adopt a standstill approach to governing duration and convexity is not something we should ignore.
The failure of banks to fund through longer-term instruments, in favour of deposits and money market operations, has been a salutary lesson again and again. We shall follow up on this at a later date. We suggest that SVB is not an "idiosyncratic" situation, moreover a repetition of poor treasury management and a failure to understand fixed income securities. We would also suggest that this may be seen as a "canary in the mine".
The humble canary was used in UK mines until 1986, a simple effective indicator of a dangerous situation. We don't have to highlight what happened in financial markets in 1987; an amusing coincidence for certain. SVB may well be a canary in US banking system and we seem to have avoided disaster. Alternatively, Credit Suisse, for example, may be viewed as idiosyncratic risk outside the USA and near-term price action will remain volatile.
Conduit pays close attention to the basic tenets of fixed-income investing. Buyers no longer have to reach down the credit curve, or along the maturity spectrum to achieve respectable returns. There is little reward in extending duration beyond 3 years and stepping too far away from investment-grade securities. The risk-reward for high-yield securities is at unattractive levels and although we see a reversion to a normalised yield curve in time we remain cautious around key data, the Fed's response to inflation, the perception of reaching a terminal rate, and how we position our portfolio's with respect to convexity. Pay close attention to the Fed, measure where one should be on the curve, and adhere to the basics in fixed income; if so, navigating towards a strong fixed income portfolio is not as difficult as some would have you believe.
Paul Durrant
Conduit Securities
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