Our investment thesis since early 2022 has been that the Federal Reserve will continue to raise rates and keep them at a high level until either inflation returns to target or “something breaks” in the form of a major financial crisis. The failures of regional banks Silvergate, Silicon Valley Bank (SVB) and Signature Bank earlier this month may be a warning sign that something has broken, though it is still too early to tell. All three of the banks had exposure to crypto or venture capital. Silvergate’s failure is most directly related to the crypto industry and fallout from the collapse of FTX. SVB and Signature Bank found themselves under pressure from depositor withdrawals that were first caused by weakness in the VC or crypto industries and then exacerbated by panic-driven bank runs. Most of the deposits at these banks were above the FDIC insurance limit and depositors were reasonably concerned they could lose access to cash. The banks were forced to sell low-yielding long-term Treasuries and/or Agency MBS that were valued below par as a result of higher interest rates in order to raise cash to meet those withdrawals. SVB was placed into receivership by FDIC on Friday March 10th and Signature Bank followed over the weekend. The FDIC, Treasury and the Federal Reserve issued a joint statement on March 12th detailing a plan to limit contagion to other regional banks. Depositors at the failed banks were made whole above and beyond the FDIC insurance limits. The cost of this will be borne by FDIC and its member banks, not the government or taxpayers. A new facility was created that would allow other banks to borrow from the Fed against the par value of the Treasuries and Agency MBS on their balance sheet to meet withdrawals rather than be forced to sell those bonds and risk falling into a similar spiral as SVB and Signature. If the issue with regional banks is limited to a simple mismatch between the duration of their assets (Treasuries/MBS) and their liabilities (deposits), the depositor guarantee and new Fed lending facility may be enough to contain the damage and prevent contagion. If depositors are assured they will not lose access to their funds and banks are able to access liquidity to meet withdrawals, then future bank runs become a lot less likely. In that case, the Fed may continue to hike rates at the March 22nd FOMC meeting given inflation levels that remain above target. The new program will not solve the problem, however, if the issue runs deeper than a duration mismatch. One of the systemic risks we have been focused on is the commercial real estate (CRE) market, particularly offices, multifamily and retail. Unlike single-family residential mortgages, CRE loans tend to be leveraged at variable rates and are more vulnerable to the steeply rising interest rates we have seen in the last year. Adding to the risk, the cultural shift towards remote work has resulted in rising vacancy rates in offices across the country, particularly in New York and California. Reports of defaults involving major asset managers like Blackstone and PIMCO have been hitting the headlines in recent weeks. According to a recent Bloomberg article,[1] the banking industry’s exposure to CRE rose dramatically during the pandemic from approximately $4.5 trillion in 2021 to $5.3 trillion today. Large banks have only about 6% of their assets in CRE loans but smaller and foreign banks have over 20% of their assets in CRE as of March 1st.[2] Signature Bank issued more CRE mortgages against New York City buildings than any other bank since 2020 and had about a third of its assets in real estate loans as of the end of 2022.[3] SVB was a California-domiciled bank, as is First Republic, another regional bank that has come under pressure. There has been no official indication that CRE distress contributed to the bank failures but we are watching developments in this space closely. Complicating matters, the financial instability that began with regional banks in the US has spread to Credit Suisse Groupe AG (CS). CS has been struggling since the blow up of its client Archegos in 2021 and we have discussed its issues in prior commentaries. As of this writing, its stock is trading at an all time low and its credit default swaps (which represent the cost of insuring its bonds against default) are trading at record highs. Unlike the failed regional banks, CS is a systemically important financial institution whose woes are not primarily about rising rates. The situation is rapidly evolving but a failure of CS would almost certainly meet the definition of “something breaking”. Lessons from SVB Collapse for Bond Investors The near-term cause of the SVB collapse was that the bank was forced to sell Treasuries and Agency MBS at prices well below par in order to meet withdrawals, even though those bonds would have matured at higher values had they been held to maturity. Their experience is a lesson to bond investors as well as other banks. Investors who get their fixed income exposure through pooled investment vehicles like mutual funds or ETFs are subject to a similar risk if rate volatility causes other investors in the vehicle to redeem their funds and the portfolio managers are forced to sell bonds at a discount to raise cash. This is not a risk for investors who own bonds directly, as in a separately managed account (SMA). Rate increases can cause the value of a bond to decline on paper but, barring default, those bonds will pay back at par if held to maturity. For clients with sufficient investable assets to meet minimums, an SMA can reduce the risk of locking in paper losses on bonds as a result of the decisions of other investors. SVB and ESG SVB is a case study on the outcome of four major decisions: 1) The effects of mismanagement; senior management made the mistake of investing short-term deposits into long-term fixed rate assets at a significantly higher proportion than the average bank. 2) Interest rate hikes occurred quickly and at a significant enough magnitude to elevate short-term rates dramatically and invert the yield curve. This effectively made SVB insolvent when it was forced to sell its longer duration yet lower yielding bonds to meet withdrawals. 3) Legislators and politicians relaxed core banking regulations by rolling back Dodd-Frank protections in 2018. To lessen the regulatory burden on banks with balance sheets of less than $250B.[4] The original provisions of Dodd-Frank may have stopped SVB from enacting such as aggressive deposit investment strategy. 4) The misuse of ESG scores to accelerate investment in SVB. Silicon Valley Bank was scored highly by most of the major ESG data providers and unofficially known as the “climate” bank by founders due to its involvement in financing renewable energy projects and climate technology start-ups. The details underlying SVB’s topline rating contradict its reputation as an ESG leader. Using MSCI data, SVB was an industry laggard on environmental scores. It was in the bottom quartile of consumer banks for financing environment impact, a data point that considers the bank’s credit policy as it relates to agriculture, biodiversity, fossil fuel, mining, and ESG risk management. SVB also scored in the bottom quartile for consumer banks in Access to Finance, which evaluated their efforts to expand financial services to historically underserved markets. MSCI notes that “the bank lags its industry peers in adopting ESG risk management policies and systems. We found limited evidence of sector-specific environmental credit policies and ESG due diligence and risk escalation processes.”[5] It appears that the topline scores and SVB’s inclusion in major indexes were enough to dupe mainly US ESG investors. According to Morningstar Direct, the US ESG fund universe (after controlling for domicile and share-class duplication) includes 628 funds, of which 49 or 7.8% held SVB as of January. The average weight for SVB among US ESG funds was 0.36% and included passive and active managers. The ESG globally domiciled fund universe includes 8,393 funds (after controlling for share-class duplication), of which 265 funds or 3.15% held SVB as of January with an average weight of 0.35%. Globally the overall fund universe includes 117,954 funds, of which 1,557 funds or 0.98% held SVB at an average weight of 0.24%. Idiosyncratic stock events such as this one highlights the risks of investing in broadly labeled and generic ESG funds. As this banking crisis continues Credit Suisse Group AG (CS) seems to be the next major bank struggling with liquidity issues. We are happy to state that only 2 US ESG funds hold CS (at an average 0.03% weight) and 48 globally domiciled ESG funds hold CS (at an average 0.39% weight). A vast majority of the CS ownership within ESG funds is held in passive index funds.[6]
