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deBelow are our thoughts on the broader implications of SVB. This is a fluid situation, so it is worth mentioning that our views will likely evolve in real time.
Our view is that SVB has some company-specific features that made it particularly vulnerable, but there are also systemic issues for all banks and the broader economy. The initial catalyst that sparked the crisis was the sharp and rapid decline in T-bills held by SVB and many other banks. Deposit growth at banks has outstripped lending over the last few years and this gap accelerated during the peak pandemic period as stimulus money permeated the economy and the savings rate increased rapidly. Since it takes time to lend these excess deposits, banks placed this capital in what they perceived to be safe medium and long-duration U.S. treasuries, not realizing that the shift to the new inflationary and rising interest rate regime would negatively impact the value of these securities beyond what most risk managers were modelling.
Treasuries of this duration declined about 20-25% in value over the past 30 months. Most modern-day risk managers have not experienced this kind of market (last seen in the late 1970s/early 1980s). By categorising (or recategorising) these securities as held-to-maturity rather than available-for-sale, banks could avoid marking down the balance sheet carrying values. The value gap is clearly disclosed in financial statement footnotes, and we approximated potential writedowns based on T-bill trading values for a sampling of banks. Some banks like SVB had very large potential writedowns relative to book value (shareholder’s equity). We found a range of 100%+ at one extreme to negligible writedowns at the other extreme, with plenty of large and mid-sized banks in the 10-30% writedown range as a percentage of book value. If this T-bill valuation problem were the single issue, then the vast majority of U.S. publicly traded banks appear to have sufficient equity to withstand the writedowns and continue to hold the T-bills until maturity and suffer primarily just a partial compression in the valuation targets for their stocks.
However, the larger problem is one of confidence. Bank customer confidence has eroded with the writedowns and falling stock prices and they have begun to fear for the safety of their deposits. Even if the banks have sufficient capital to absorb the writedowns, the fears can become a self-fulfilling action if enough customers pull deposits, since deposits are a major source of bank funding that can be even larger than the magnitude of the treasury writedowns. The SVB situation is exacerbated since it holds substantial deposits for many young tech startups that have been burning cash for years and must rapidly draw down their cash balances to keep their businesses operating since equity capital markets have been largely closed to raising new capital. Banks are now faced with the classic problem that has threatened them throughout history: a mismatch in terms between assets and liabilities. Impaired long-duration T-bills would potentially have to be sold at a realized loss to fund deposit losses, which are a short-term source of financing. The Treasury Department and the Fed had no choice but to step in and backstop all deposits, including those in excess of the $250k FDIC insurance.
The risk of a cascading crisis of confidence was too great, particularly in the age of social media which was not as influential during the 2008 crisis. Their goal is to demonstrate that depositors will be made unequivocally whole in these early highly-stressed cases in order to prevent runs on the broader group of remaining banks, even those that do appear to be sufficiently capitalised for the markdowns (e.g. First Republic). One scenario is that this works, the fears are calmed, SVB and SBNY are reorganised in an orderly fashion and depositors remain calm. Another scenario is that trust is broken and even greater government measures (and funding) will be required to backstop more individual banks and/or provide much larger general platforms to backstop all banks as was required in the financial crisis (e.g. TARP). It is rather notable that toxic loans (e.g. NINJA loans) were the problem in the GFC, whereas the “toxic” asset in the crisis would be government bonds! If intervention is required on a mass scale, that could lead to the massive creation of new money which is inflationary, but it could also spark a severe recession via a collapse in consumer confidence and hiring, which is deflationary. Fed interest rate policy could also be impacted with less inclination to raise rates in a skittish environment which could actually favour riskier assets and the hyper-growth/leveraged equities that have underperformed so severely in the past few quarters. Economically sensitive equities would be the most vulnerable. It is also conceivable that inflation could continue to be a problem even with a weakening economy or recession (stagflation).
Crawford believes the portfolio remains well positioned for both the general macro scenarios we weigh most heavily in our continuous scenario analysis as well as the US banking-specific crisis that has now emerged. Crawford has had relatively little direct portfolio exposure to commercial banking overall this year (e.g., ~4% in early March), exposure was reduced further last week by exiting a position in one of the regional banks we held. We continue to hold one small regional bank (~2%) whose attractive footprint and very conservative balance sheet remain compelling to us, particularly after the stock’s slide along with banking peers last week. That small gross long bank exposure is largely offset by gross short exposure to several other commercial banks, resulting in net long banking exposure of fewer than 50 bps.
The balance of our portfolio exposure to financials (~13%) comprises a mix of exchanges, investment banks, and asset managers; all positions with less direct interest-rate exposure and deposit reliance than a traditional commercial bank. As we have communicated regularly in recent quarters, Crawford believes that the risk of recession remains relatively high, a result of the confluence of rising interest rates, protracted inflation, and the growing wave of white-collar layoffs; thus, our portfolio continues to combine long exposure to companies that we believe are generally better positioned to ride out a recession and short/put protection focused on highly-levered companies which we believe are most susceptible to higher rates and demand erosion.
Adam Turberville
Director
+44 1481 742380
a.turberville@ericsturdza.com
The views and statements herein are those of Crawford Fund Management, LLC in their capacity as Investment Advisers to the EI Sturdza Strategic Long Short Fund and are valid as at 13/03/2023 and are based on internal research and modelling. Please click on Disclaimer Page to view full disclaimers.