April 11, 2023
Wesley Chapel, FL
If I told you in my last commentary that two of the three largest bank failures in the history of the United States (plus the failure of a relatively small crypto bank and a Global Systemically Important Bank or G-SIB) would happen in March, and then asked you to guess whether the market would be up, down or flat for the month – what would you have guessed?
My bet is that you would have guessed “down.” Perhaps you (like me) would have said, “down by A LOT.”
It would have been a smart bet. And you (and I) would have both been wrong.
Despite that exact scenario playing out, the S&P 500 managed to finish the month of March in positive territory, up 3.31%.
You can “thank” your government for the short-term outcome. And then you can turn around and blame them for the long-term consequences.
It almost feels like too much time has passed to be writing about these bank failures, with so much (virtual) ink being spilled on the topic by every news outlet on the planet already. But since I only write a monthly commentary it feels like a mandatory topic. That said, Kyle and I do record the Elevate Market Chat every week and post that to YouTube. So if you want to get more current thoughts from me, you can subscribe to our channel and follow along.
The only real surprise of these bank failures is that anyone was or is surprised by them.
As I have written about for many months, the yield curve is inverted. In fact, exactly one year ago my April 2022 commentary was written just after the yield curve first inverted (this time). In it, I explained that banks basically can’t make any money with an inverted yield curve. The nature of their business is to take the money that you think is sitting in your checking account and invest it in safe but longer-term bonds that pay a higher interest rate. As long as the rate they earn on the longer-term bond is higher than the rate they are paying you on your checking account balance they keep the difference and make money.
But that isn’t quite the whole story… and although we probably don’t have enough time to get the whole story down in writing before the next chapter gets written, my goal in these commentaries to tell you what I would want to know if our roles were reversed; if you were the CFA Charterholder and I were the Real Estate Agent, Plumber, Eye Surgeon, HVAC guy, or Attorney.
I hope you’ll take a minute to send me a quick email and let me know how I am doing.
So, the second (and perhaps much more serious) level of the problem with the way banks make money is that they never actually have all your money if and when you want it. That’s all banks, too. Not just the smaller regional ones. If every single customer of JP Morgan Chase wanted every single dollar out of their checking accounts all at once there is zero chance they could all have it. The money simply isn’t there.
Elevate Market Chat 4/6/2023
And I am not just talking about not having the cash on hand. It wouldn’t work electronically either. Again, the banks must lend those deposits somewhere else to make profits. That somewhere else tends to be via buying bonds that are “safe” insofar as there is little to no risk of the borrower not being able to pay the money back on time and in full.
For example, let’s say that one day there is an outbreak of a new virus and pretty much everyone freaks out for a few weeks, afraid for their lives. But it turns out that it isn’t so bad. Sure, older people, those with compromised immune systems and folks who generally aren’t very healthy have an elevated risk but otherwise healthy people have a 99%+ survival rate. And the government shuts down the economy anyway.
And not just the local economy, or the national economy, but governments all around the world effectively shut down the entire global economy. Then they print a ton of money, more money than has ever been printed in history. In the United States they print more money in two years than they printed in the previous 200 years combined. And they give a bunch of this money away to corporations and citizens.
But the people can’t actually go out and do anything with this money because everything is closed. You might want to spend the money you got on tickets to a movie, a concert or a trip to Disney, but there is no point because you can’t leave your home anyway.
The government also uses a LOT of the newly printed money to buy bonds from itself – which doesn’t really make any economic sense – but it keeps interest rates low. Like really low. Artificially low. So low that there is effectively not much difference between leaving the cash in your bank account and “investing it” in a CD at the bank. The logical thought is “why tie up my money when I won’t be compensated for it. Better to just keep it where I can get it any time I want if I need it.”
Elevate Market Chat 3/31/2023
So, the people can’t really spend the money they have been given. And so where does it end up? It sits in their checking accounts where it is very easy to get to.
And what does the bank do with this massive influx of cash coming into the checking accounts of their customers? Well, they are forced to lend that money right back to the government that printed it. And they do so at those artificially low rates. The rates are so low that the bank decides to lend it back to the government for 30 years at a time, that way they can at least get a little bit of interest out of it and keep some profits.
A quick lesson on bond prices and interest rates. Bond prices move inversely to interest rates. If I pay full par value, or 100 cents on the dollar for a bond that yields 1% per year and then interest rates go up so that newly issued bonds similar to the one I own are now paying 2% per year – what must I do with the price of my bond in order to entice someone to buy it? I must lower the price. Remember my bond pays only 1% but a new bond pays 2%. All else equal, you’d rather get 2% than 1% per year in interest. So, in order to attract a buyer to my bond I must lower my asking price from 100 cents on the dollar to something lower that works out to a total return of 2% for the buyer.
So, for example, let’s say it is 2021 and the bank buys a massive number of 30-year bonds from the government. Because why not? Uncle Sam has never defaulted on his debt. US Treasuries are the ultimate safe asset. The bank pays full par value (100 cents on the dollar) of $1,000 per bond and will earn a yield of 1.25% for 30 years, with the expectation that rates will stay low forever.
What happens instead, is that after printing all that money inflation starts to show up in the economy and rates begin to rise. Two years later interest rates are 3.5% and that bond is now trading at 50 cents on the dollar. If the bank is forced to sell that bond, they will have turned a sure thing into a 50% loss in two years.
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This is the bond quote for the May 2020 issue that pays 1.25% coupon. Now trading down to 58.486 (par value is 100 in this pricing convention) so that the Yield to Maturity is equal to new bonds being issued for 30 years.
SOURCE: Charles Schwab
This isn’t too far off from reality by the way – I am not just making these numbers up. There was in fact a 30-year treasury bond auctioned around full par value in May 2020 at 1.25%, and as of this afternoon you can buy this bond for 58 cents on the dollar.
Purchasers who can hold these bonds to maturity will get 100 cents on the dollar for them when they mature at their full par value. But if you are a bank and all your depositors suddenly want their money back and you are forced to sell your longer-term bonds to satisfy those demands, it isn’t long before you don’t have the money to send them.
This is where the FDIC steps in.
As I said, you can “thank” your government (agency – the FDIC) for the short-term outcome we have seen over the past month or so. If the FDIC had not decided to guarantee 100% of all deposits over and above the stated FDIC limit of $250,000, there would have been absolute carnage in the markets when they opened on Monday, March 13th. Instead, we’ll likely have to face that carnage at some later time, to be determined...
Silicon Valley Bank’s stock (SIVB) dropped from $267.83 per share where it closed on Wednesday March 8th to a low of $100 the next day. Then the bank was seized by the FDIC and it didn’t begin trading again until Tuesday March 28th under the ticker SIVBQ, at $0.53. It trades at $0.58 today.
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SOURCE: Tradingview.com
So, despite the FDIC stepping in to protect depositors, the government provided no such protection to the company’s shareholders. They got totally wiped out – as they should have.
The real question is – should the FDIC have “bailed out” the depositors?
My opinion is a simple, “no.”
There must be consequences. That is how we learn. If you never had to deal with the consequence of any mistake you ever made, do you think you would stop making the mistake? Perhaps, but I doubt it.
There are really two types of depositors at any bank that have over $250,000 in an account and are thus, “swimming naked,” as Warren Buffet likes to say.
At Silicon Valley Bank, these two types can be represented by Mark Cuban and the company Roku.
In the first case, Mr. Cuban had (according to news outlets) maybe $10,000,000 at the bank. Mark knows the rules. He knows the FDIC limits. Anyone with that much money at a bank likely knows the limits or has advisors who do. They knowingly take the risk of keeping that much cash at one bank. They don’t have to. There are plenty of options.
Mark is also worth an estimated $5.1 billion according to Forbes. He probably has $10 million sitting at 10 different banks.
So, a loss of $10 million is 0.196% of his net worth. That’d be like someone whose net worth is $100,000 losing $196, or someone whose net worth is $1 million losing $1,960.
It’s a rounding error. Almost nothing.
Mark knew better. And he didn’t need the government to bail him out. (Sorry Mark if you’re reading this!)
And here’s the other thing that people forget to point out – it is not as though Mark would have lost the whole $10 million.
He just wouldn’t have had access to more than $250,000 of it for a while. He could have gotten that first $250,000 out immediately like anyone else under the standard FDIC Insurance limits. Then, the FDIC would have liquidated the “Held-to-Maturity” or HTM assets of the bank over time at more favorable prices than having a “fire sale.” (HTM by the way, is also known to mean “Hidden-to-Maturity” among analysts… I will come back to that later.)
And over time, maybe 6 months, maybe longer, as those assets were liquidated in an orderly fashion, Mark would have recouped much, if not all, of his $10 million.
I hate to say no big deal but… no big deal.
Then you have Roku…
Again according to news outlets, Roku (ROKU) had almost $500 million in deposits at Silicon Valley Bank. What’s the saying? “If you owe the bank $100 its your problem, but if you owe the bank $100 million that’s the banks problem!”
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Excerpt from Roku SEC Filing
In this case it was reversed and the bank owed Roku $500 million – and that is Roku’s problem. Roku is without excuse. They, like Mark, knew the FDIC rules and limits. They knew how much they had at the bank. If they didn’t know the rules that would be a whole different problem. But I assume they did know, and they simply didn’t care about the risks of having that much money sitting at one bank.
This is a publicly traded company worth $9 billion today. What on earth are they doing with 6% of their market value sitting at one bank? Where is the CFO? Where is the Risk Management department? Who is doing the due diligence? This isn’t the company’s money it is the shareholder’s money!
Roku has around 3,600 employees. They all depend on the executive team, including the CFO for their paychecks. And while Roku must carry a substantial amount of cash on its balance sheet to pay employees and vendors (since it tends to not make any money)… does it really need to keep 25% of its cash (they had $1.96 billion in cash as of the end of last quarter) at one bank? Isn’t one of those 3,600 employees qualified to open a brokerage account at Charles Schwab and spread the cash around between dozens of banks (yes, you can do that) and invest large sums in US Treasuries?
It reminds me of a quote from one of my favorite movies which I recommend everyone go watch or re-watch soon – The Big Short. There is a book too if you’d rather read. Anyway, the quote goes:
“They weren’t being stupid; they just didn’t care. They knew the taxpayers would bail them out.”
Here is where Roku is in a little bit of a different position than Mr. Cuban… According to Roku’s income statement, they spent $1.10 billion on Selling, General and Administrative costs over the past 12 months. This is where much of the employee compensation (that isn’t paid by issuing new shares of stock) will land. But the entire number includes other things than salary and wages. So, it’s the best proxy we can find for their annual payroll but it is far from perfect.
Just doing some simple math, let’s say that $1 billion was the annual wages number. That is probably high but play along. Let’s also say that Roku pays employees twice per month, so 24 times per year. That means the amount of cash they need to have on hand every couple weeks is $41,666,666 to make payroll. That would also mean the average employee is making $277,000/yr at Roku in case you are looking for a job!
At any rate, even if you wanted to keep one full month worth of payroll in a bank account to make sure you always have enough to cover it, you only need a little over $80 million… not $500 million. $500 million takes care of 12 payrolls, or 6 months of payrolls. And I can understand the desire to keep that much in short-term instruments but not in a checking account earning zero and exposing the company to risks like the one that played out at Silicon Valley Bank.
The point I am trying to make here is that unlike Cuban, who could probably afford to be without access to all but $250,000 for a few months – Roku would not have been able to make its payroll. But then again… If Roku had another roughly $1.5 billion of cash at other financial institutions, they would have been fine too. But the idea that Roku, without access to $500 million may not have been able to pay regular people, was one of the excuses made for bailing out the bank and guaranteeing all deposits, even those above the FDIC limits.
And of course, they say that the taxpayers won’t foot the bill, but I know they will – even if it is indirectly through moral hazard, increased fees charged, and lower interest rates paid by banks going forward.
Roku and Cuban both should have known (and probably did know) that they were taking unnecessary risk keeping that much money at the bank. They could have looked into the bank’s financial statements and found out how much risk there was of “deposit flight,” where deposits over the FDIC limit are quickly moved elsewhere during a panic.
They could have also looked to see how much the bank was holding in HTM assets vs. AFS (Available For Sale) assets. The HTM assets that were purchased with low interest rates would now be worth a lot less if marked to market prices at current, much higher rates. HTM securities are held at their cost price until they mature, even if the current market price of those assets has dropped precipitously, while AFS securities are held at the current market price.
It isn’t like nobody knew that this was a problem. In fact, if you look at the company’s share price you can see (in the chart above) it had been falling steadily since November of 2021 (along with the rest of the market). People were shorting the stock and calling out the bank for its mismanagement.
Here is a note from the financial statements the bank filed with the SEC back in November 2022:
“As of September 30, 2022, we identified a total of 804 investments that were in unrealized loss positions with 289 investments in an unrealized loss position for a period of time greater than 12 months. Based on our analysis of the securities in an unrealized loss position as of September 30, 2022, the decline in value is unrelated to credit loss and is related to changes in market interest rates since purchase, and therefore, changes in value for securities are included in other comprehensive income. Market valuations and credit loss analyses on assets in the AFS securities portfolio are reviewed and monitored on a quarterly basis. As of September 30, 2022, we do not intend to sell any of our securities in an unrealized loss position prior to recovery of our amortized cost basis, and it is more likely than not that we will not be required to sell any of our securities prior to recovery of our amortized cost basis.”
This had grown from only 4 investments with unrealized losses for more than 12 months as of 12/31/2021. And that was just in the AFS securities.
In the same filing the HTM securities showed an unrealized losses of $15.922 billion as of 9/30/2022… vs. only $1.343 billion of unrealized losses as of 12/31/2021.
So, the unrealized losses in HTM securities had ballooned by more than 11 times in only 9 months! That is crazy!
And Mark Cuban, Roku, and countless other investors either didn’t pay attention or didn’t care. Same goes for the regulators. It doesn’t take a genius to figure out that you might not want to have deposits in excess of the FDIC limits at this bank (and all the others like it).
Why didn’t the regulators step in and do something about this prior to it ending in a bank run? They knew the situation. But they decided to gamble and hope that clients of the bank wouldn’t lose faith. They were wrong.
The bank gambled by focusing too much on one geographic location (Silicon Valley) that is too heavily dependent on one industry (Tech Start-up Venture Capital) during a long-lasting bear market.
The customers gambled by keeping so much money with one bank.
The regulators gambled by not stepping in sooner when the problem was obvious.
The FED (Federal Reserve Bank) gambled by pushing rates lower and lower and holding them there for far too long, only to reverse course and hike rates thus destroying the value of low yield bonds.
They all knew that you and I would bail them out, one way or another.
Not to freak anyone out… but as many of you know, the FED regularly “stress tests” the banks to see how they can handle various scenarios of financial conditions. In the currently published “Severely Adverse Scenario” from now through 2026 shows the yield for the 3-month US Treasury never going above 0.10% and assumes the 10-year US Treasury never goes above 1.5%...
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SOURCE: federalreserve.gov
Friends, that is madness. As I type, the 3-month yield is 5.08% and the 10-year yield is 3.43%. These yields are orders of magnitude higher than the severely adverse scenario – and on top of that the 3-month yields more than the 10-year. So again, the curve is inverted.
To reiterate, the only real surprise of these bank failures is that anyone was or is surprised by them.
At the end of the day, every single bank on the planet has this same balance sheet problem. There is no escaping it. What the FDIC did for Silicon Valley Bank and subsequently Signature Bank of New York was tantamount to putting a Band-Aid on a broken leg.
These two banks were just the first two dominos to fall. And that is without even getting into Silvergate Bank which decided to voluntarily close up shop and unwind operations (the stock ‘SI’ crashed from an all-time high of $222 in November of 2021 to $1.56 today) a week or so before the other two failed.
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SOURCE: Tradingview.com
And then after those two (three, really) failed, a Global Systemically Important Bank (G-SIB) called Credit Suisse (CS) was bought by another bank (UBS) for pennies on the dollar of assets. CS crashed from a recent high of $14.45 in 2021 to $0.90. CS had $600 billion of assets on its balance sheet and was bought by UBS for only $3.2 billion! It’s a good deal if you can get it.
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SOURCE: Tradingview.com
This reminds me of when Bear Stearns failed and was bought by JP Morgan Chase (JPM) for pennies on the dollar back in 2008, and everyone was told that the crisis was contained, and that our “financial institutions are strong.” We all know how that turned out. But notice in the chart below that the market did rise for a few months after the transaction took place – only to see Lehman Brothers fail 6 months later and then the S&P 500 dropped 43% from there.
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And no, I am not predicting that this is event will be just like the Great Financial Crisis of 2008-09. What I am saying is that the bank failures we have seen recently are probably not isolated events. Across the United States banks have around $620 billion of unrealized losses according to their SEC filings. The recent failures are just evidence of something more. As they say, where there is smoke, there is fire. 🔥
What I will also say is that you better know where your safe money is. I would not keep a penny over the FDIC limit at any bank. There is simply no need. If you are in a situation where you are unsure about that or what to do about it, please call Ken or Kyle or reply to this email and we’ll help you out. There are smart ways to manage that risk.
As much as I would like to keep hammering on all the silliness I see happening in markets today, I think I am going to leave this commentary there.
Maybe the only other thing I need to mention is that we will get inflation (CPI) data for March tomorrow morning before the market opens. The market is expecting year-over-year CPI to be 5.2%, down from 6.0% in February. At the same time the market is expecting “Core” CPI (which excludes food and energy) to be 5.6%, up from 5.5% in February.
You read that right… the market currently expects the headline CPI number which includes food and energy to be lower than the Core CPI number. Just another anomaly that makes very little sense in the strange world in which we live today. 🤷♂️
Regardless of what the numbers come in at the market will probably react violently in the short term. Regular readers know that I think this is mostly noise at this point. I think inflation is yesterday’s news. We all know it is falling but also that it remains stubbornly high.
What I think is more important is the seemingly imminent recession we are facing as growth continues to slow and profits continue to decline for companies in the S&P 500. According to FactSet, the highest number of S&P 500 companies are issuing negative profit guidance since the third quarter of 2019.
Meanwhile (another quick fun fact before I go because I can’t resist), according to Susquehanna, as of 3/31/2023, Apple (AAPL), Nvidia (NVDA), Microsoft (MSFT), Meta Platforms aka Facebook (META), Tesla (TSLA), Amazon (AMZN), Alphabet aka Google (GOOGL), Salesforce (CRM), and Advanced Micro Devices (AMD), have contributed ~160% of the S&P 500 gains for the year 2023. So, the index would be negative without these stocks. AAPL, NVDA, and MSFT alone have contributed 91%.
It’s a good thing we own several of those names in the Elevate Strategies (along with a whole bunch of short-term US Treasuries)!
Clients, I encourage you to click here to access your personalized performance portal to see how your portfolio performed vs. the markets last month.
Until next time, I thank God for each of you, and I thank each of you for reading this commentary.
Shane Fleury, CFA
Chief Investment Officer
Elevate Capital Advisors
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