The Why and What Next of the SVB and Credit Suisse

I hope everyone’s bank deposits are safe and insured!

What a crazy few weeks it’s been.

Last week’s update about the collapse of Silicon Valley Bank (SVB) reads like an antiquarian scroll. That’s how fast things have moved since.

So fast that last Wednesday, I got to host a livestream discussion with Fat Tail Editorial Director Greg Canavan and Exponential Stock Investor editor Ryan Dinse about the upheaval stirred by SVB’s failure.

The discussion focused on the significance of recent events, particularly the implications for Aussie investors.

If that sounds interesting, you can watch the chat below:

I will be hosting another livestream discussion with Greg and Ryan this Thursday to unpack the latest revelations, including the repercussions of the Fed’s upcoming interest rate decision.

What happens to Credit Suisse after being acquired by UBS? Will we see a Fed pivot? We’ll see.

There is a lot happening and lots to talk about. So stay tuned for Thursday’s livestream!

What caused the SVB collapse?

How did we get here? What’s the dominant cause?

Ironically, one of the best explanations came from the Federal Deposit Insurance Corporation’s (FDIC) Chairman, Martin Gruenberg, — four days before Silicon Valley Bank failed!

At an industry conference in Washington in early March, Gruenberg discussed the impact of the pandemic on the banking sector and the key risks ahead.

In a key passage, Gruenberg admitted rising interest rates are posing problems to banks’ balance sheets (emphasis added):

‘The current interest rate environment has had dramatic effects on the profitability and risk profile of banks’ funding and investment strategies. First, as a result of the higher interest rates, longer term maturity assets acquired by banks when interest rates were lower are now worth less than their face values. The result is that most banks have some amount of unrealized losses on securities. The total of these unrealized losses, including securities that are available for sale or held to maturity, was about $620 billion at yearend 2022. Unrealized losses on securities have meaningfully reduced the reported equity capital of the banking industry.

‘A complicating factor for banks that hold significant amounts of longer term assets is that increases in market interest rates can cause gradual negative earnings impacts over time. Specifically, assets that were acquired when interest rates were lower are now earning a below-market interest rate. This reduces the net interest margin below what could otherwise be achieved. For that reason, some banks may choose to sell depreciated assets, realize the loss, and replace the sold asset with a new, higher yielding asset.’

SVB’s pandemic boom

It seems the regulator wasn’t caught off guard by the nature of the current crisis, flagging that ‘unexpected liquidity needs’ could pose risks:

What the FDIC underestimated was the probability of these unexpected demands (emphasis added):

‘The good news about this issue is that banks are generally in a strong financial condition, and have not been forced to realize losses by selling depreciated securities. On the other hand, unrealized losses weaken a bank’s future ability to meet unexpected liquidity needs.’

Unexpected liquidity needs…like flighty Silicon Valley start-ups shoring up dwindling cash reserves in a panic turbocharged by Twitter.

But this latent problem facing banks was flagged even earlier.

In September 2022, the Kansas City Fed released a research bulletin focusing on smaller US community banks.

The Kansas City Fed recapitulated the now familiar story:

‘Due to the increasing rate environment, securities that were purchased when the market dictated lower yields have become less desirable to investors resulting in declining valuations.’

The research note found the tangible capital equity ratio — comprising total equity capital less goodwill and intangible assets — of the US’s community banks was falling due to ‘mounting unrealized losses on AFS securities’.

I found the following finding striking (emphasis added):

‘At year-end 2021, only 4 community banks had tangible equity capital ratios below 5 percent; that number increased to 333 at June 30, 2022, indicating less ability to sustain economic shocks.’

The number of community banks with tangible equity capital ratios below 5% is likely higher now, with the Fed funds rate spiking since June 2022:

So was the intervention of the Fed and US Treasury justified then?

The Economist published a great piece on this last week. Here is a telling snippet:

‘The Fed and Treasury’s interventions were the sort which would be expected in a crisis. They have fundamentally reshaped America’s financial architecture. Yet at first glance the problem appeared to be poor risk management at a single bank. “Either this was an indefensible overreaction, or there is much more rot in the American banking system than those of us on the outside of confidential supervisory information can even know,” says Peter Conti-Brown, a financial historian at the University of Pennsylvania. So which is it?’

Which is it, indeed. We’ll be dealing with this question for a while yet.

But what does this all mean for us antipodean investors, anyway?

What does this all mean for me anyway?

During last week’s chat, Greg mentioned the importance of being a cool cucumber. Not hip, but composed and rational.

Greg thinks you need to be a true contrarian in this market.

As he said, the months ahead will be high on bad news. But if you can steady your emotions, these months will also be high in opportunity.

Energy is a sector to watch if markets continue to soften. And they are softening at the moment.

For instance, Westpac’s Commodities Index fell 5% in February, led by a 23% fall in thermal coal.

Yet plenty of commodities remain supply-constrained over the longer term.

Commodities boom — in this climate?

Now may seem like an iffy time to be considering commodities. If banks globally crack under current pressure and precipitate a recession, demand for commodities will wilt fast.

But according to my colleague and Diggers and Drillers editor James Cooper, commodities still offer value on the back of long-term secular tailwinds. James — a former geologist — thinks the tailwinds stretch beyond the current mayhem.

Consider oil.

Last week, oil posted its worst weekly loss since the early days of the pandemic as the banking crisis sours sentiment and outlook.

But look further and you see James’s point.

In its commodities update, Westpac noted that despite a strong demand outlook for crude, supply is still lagging:

‘Despite a robust outlook for crude oil demand (the EIA continues to upgrade its forecast for global crude and liquids consumption in 2023) the number of oil rigs active in the US is still some 32% lower than the pre-COVID peak in late 2018/early 2019. OPEC+ production is also still 8% below pre-COVID peaks and yet total crude supply in February was estimated to be just 1% lower than pre-COVID levels. The extra supply has come from non-US non-OPEC+ production. Both non-OPEC production outside of North America, and North American production are back to pre-COVID levels, highlighting current supply growth is coming for the more marginal producers.’

Helping the long-term case for commodities is China’s reemergence from strict lockdowns.

Last month, the second-largest economy recorded its largest gain in imports in a year. China’s recovery is advancing — despite the turmoil.

(Caveat: let’s see if this continues.)

The latest news out of China ties in nicely with James’s recent piece on misunderstandings about the country’s economy:

‘Right now, the charts of major [Chinese] steel producing firms are pricing in future growth.

‘Buying activity is strong for these companies…it’s the clearest indication we have for future strength in the Chinese economy.

‘The reasons may not seem obvious right now, but the evidence is not found in official data…it’s on the ground, tightly held by the companies’ major shareholders and management team.

‘These are the insiders that drive share prices higher or lower based on market conditions well ahead of public knowledge or official statistics.’

For James, nothing has changed about the long-term outlook — the ‘stage is set for unprecedented growth in the mining sector’.

He’s planning to capitalise by launching a new premium trading service focused on the small-cap end of the commodities market.

James will leverage his expertise to hunt exciting mining juniors.

Keep an eye out in the days ahead for more information about James’s new service.

Regards,

Kiryll Prakapenka,
Editor, Money Morning

PS: Hope to see you this Thursday for the chat with Greg and Ryan. If you want me to ask any particular question, shoot me a message here.