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Overview of Silicon Valley Bank's Collapse
As many of you know, the recent collapse of Silicon Valley Bank was not an isolated incident, with other banks also experiencing similar difficulties. For those who have been closely following this subject (myself included), many articles have already delved into the why and how. In light of the extensive coverage, our aim in this memo is not to reiterate the same information. Instead, let’s concentrate on the key takeaways and explore the implications of these events on the financial markets.
Asset/Liability Management
One significant risk that is often overlooked is the mismatch between the durations of one's assets and liabilities. This issue was the main reason for SVB's downfall.
In recent media coverage, the main explanation for SVB's collapse is the decreased value of their long-term bonds due to increased interest rates. Long-dated bonds yielding 3% became less attractive compared to overnight rates of 4.5% (Interest Rate Up -> Bond Prices Down). However, managing this risk should be standard practice for banks.
A bank's main liability is the money owed to depositors and account holders, who can request their funds at any time. As a result, banks must hold short-term assets to match their liabilities and minimize the exposure to unnecessary risk. This concept is not new and is a crucial aspect of banking regulation (Basel III), which unfortunately was not applied to SVB. The bank became greedy, choosing to mismatch durations to earn a higher spread.
When asset/liability durations are not matched, it creates significant risks associated with interest rate fluctuations, as seen in SVB's case. This issue is also relevant for other investors, particularly individual and private ones.
Even investors without debt have liabilities. We all save because we have future expenses, such as retirement or paying for our children's education. I have yet to meet an affluent investor that plans to spend all their savings within a year. They typically aim for their assets to generate income for financial independence or to pass them on to future generations. This implies that their future spending is long-term (long-duration liabilities), the opposite of a bank's situation.
However, many individual investors hold their assets in short-term deposits or cash, creating a mismatch with their long-term liabilities. This situation prevents them from benefiting from their capacity to invest and earn long-term yields. Additionally, they face reinvestment risk when their short-term deposits mature, as they are unsure about the future interest rates they will receive.
The Importance of Diversification
We have previously discussed the importance of diversification. However, the situation with SVB further emphasizes this point.
While the US Government protected SVB's depositors through the FDIC, allowing the bank to resume operations under government control, the previous equity and bondholders lost their money. It is worth noting that credit rating agencies had rated SVB as investment grade, with Moody's assigning an A1 rating for deposit ratings and a Baa1 rating for bond issuer ratings. These ratings were comparable to those of Citigroup Inc and Mashreq Bank amongst many others.
Unfortunately, many wealth advisors worldwide, particularly in this region, sell single-line item bonds without fully understanding the importance of diversifying whom you are lending to.
The key lesson here is the vital need for diversification when it comes to credit risk exposure. Both stocks and bonds can be easily diversified for minimal fees, and the benefits are well worth the cost.
For deposits, money market funds offer an excellent vehicle for diversification. A money market fund is a type of investment fund that invests in short-term, high-quality deposits/lending/debt, providing both liquidity and a relatively low level of risk.
Stock Pickers
Doing the due diligence wasn't also missed by credit rating agencies. Before the bank’s collapse, most investment houses had rated SVB’s stock as a buy (see below):
Another good reminder to avoid the fortune tellers of wealth management and rely on owning as many investments as possible to spread out such risk.
Conclusion: What now?
The collapse of SVB has revealed fault lines in the market that exist in a post-rate-hike world. It began with UK pensions, and now we are witnessing it in banks that were not managed responsibly. These exposed fault lines raise the question of where else there might be hidden areas of unforeseen risk that could lead to contagion or recessionary risk.
Speaking of fault lines, many have been exposed due to duration mismanagement (Asset/Liability Mismatches). We should be vigilant for other banks that will be scrutinized. It will also be prudent to watch out for insurance companies until further due diligence is conducted.
There are two factors currently at play in the market:
- When news like this emerges and fault lines are exposed, the risk of recession and lower earnings loom over markets, leading to lower equity and high-yield bond pricing. In such cases, funds flow to high-quality bonds like US Treasuries and high-grade corporate bonds. This is why the USD performs well during times of market stress.
- Simultaneously, with bad news comes the belief that the Fed may pause rate hikes and lower rates to support markets. This factor has had the strongest influence on markets of recently. Before the SVB collapse, market participants had priced in expectations of rates reaching as high as 5.75% by July. This number has now decreased to 4.75%. This is why the equity market performed well on Monday, March 14th.
Due to the strength of the second point discussed above, we are back to an unusual situation we've seen before, where bad news is good news and good news is bad news, all due to interest rate fluctuations.
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