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QD view – A Silicon Valley bust?

230317 svb chart

Silicon Valley Bank (SVB) was, I’m sure, a largely unknown financial institution for many of our readers. Though they would be forgiven for their past ignorance, given that SVB was focused on servicing clients in a specific sector, usually in another country, who were, more often than not, headquartered down the street from the bank. Though with assets of over $210bn prior to its collapse, it was once counted amongst the US’s top 20 banks, by asset size. SVB is now no more, and serves as an important reminder of the necessities of good risk management. But does today’s chaos offer any interesting opportunities for investors, or at the very least vindicate the philosophies of closely linked managers? As the famous financier Nathan Rothschild once said: “buy where there is blood on the streets”.

At the very least, SVB is a lesson for our readers about the merits of diversification, and the hubris of overly aggressive return-chasing. For those who have not kept up with the news, we offer a brief timeline and explanation of SVB’s collapse:

  • SVB’s primary clients were US technology firms, and associated venture capitalist funds.
  • Flush with clients’ cash deposited from the earlier surge in US technology investing (think pre-2022), SVB invested over $90bn in what it thought were safe, often long-dated government bonds, eking out a mild return but losing liquidity in the process.
  • Fast forward to 2023 and – thanks to rising interest rates – the tech bubble burst, with depositors increasingly drawing down their cash deposits to fund their operations, unable to raise new money externally.
  • These declining deposits were coupled with a decline in the value of SVB’s bond investments, again thanks to rising interest rates.
  • In order to remain solvent and meet its withdrawal requests, SVB had to sell some of its bond investments, which crystallised a $1.8bn dollar loss.
  • SVB had not marked-to-market (regularly revalued based on market prices) its investments.
  • The bank attempted to raise capital via an equity sale.
  • This announcement had reverberations through the banking sector, with the US mega banks losing over $50bn in market cap last Wednesday alone.
  • Once SVB’s losses were made public, it devolved into a standard bank run, as depositors realised their bank was facing possible insolvency and raced to get their cash out before the bank’s liquidity dried up – customers tried to withdraw $42bn in a single day.
  • And dry up it did, requiring the Federal Reserve (Fed) to intervene on 12 March to protect depositors
  • SVB collapsed, with its shares suspended trading from 13 March.
  • Don’t expect a bailout for SVB shareholders however, SVB Financial Group, SVB’s parent, has filed for Chapter 11 bankruptcy. Thankfully for UK customers, HSBC has come to the rescue, swooping up SVB’s UK branch for £1.

The Fed would also be forced to come to the rescue of Signature bank, another depositor which was facing outflows having been heavily exposed to crypto currency firms. Another crypto-focused bank, Silvergate, has placed itself into voluntary liquidation. Most recently, another West-coast bank – First Republic – had to be bailed out to the tune of $30bn by a consortium led by JPMorgan Chase, Wells Fargo and Citigroup.

The sad thing is that SVB’s collapse was avoidable. Its depositors and borrowers were of high quality, and its investments were in credit worthy bonds. Instead, its collapse was largely due to its failure to account for its interest rate sensitivity, with both its depositors and investments highly sensitive to rate rises. With a little bit less greed, or a bit more diversification, I might have needed to find another topic for my article.

Yet the fates have seemed to conspire against banks, or simply decided to remind them of their hubris, for while writing this article, I am also watching Credit Suisse being bailed out by the Swiss central bank to the tune of $54bn after its shares were suspended from trading, having fallen 30% in a single day. Are we on the precipice of another 2008, or is the SVB debacle shaking out the weakest banks?

And what does this mean for the world of investment trusts? The fallout from SVB would certainly give Polar Capital pause for breath, as the asset manager currently runs the only trust in the financial sector, Polar Capital Global Financials (PCFT), and Polar Capital Technology (PCT), one of only two truly dedicated global multi-cap technology firms within the Technology and Media sector (the other being Allianz Technology Trust). Given their direct exposure, the PCFT team has given us some insight into how to they are looking to navigate this debacle, as well as reassuring investors around the future of the banking industry.

A bad apple doesn’t have to spoil the bunch

PCFT could have been right in the firing line of the bank sector sell off, with its portfolio being dominated by US banks and other financial institutions. JPMorgan Chase is its biggest holding (as of its last published factsheet). PCFT does, by its very design, offer investors the most direct way to trade a possible overreaction by the markets, as investors’ fears of further weakness in the banking sector, or possibly even the terror of wider contagion, weigh on the sector.

Thankfully, the response from PCFT seems to be one of pragmatism, and seemingly more courageous than the wider market, which should be reassuring to not only its shareholders but also the wider investment community.

While not completely sanguine, the PCFT team have highlighted four key aspects which they are assessing in determining the strength of US banks: balance sheet liquidity, percentage of the bank assets held in treasuries and mortgage-backed securities (MBS), capital strength, and commercial real estate lending as a percentage of assets (a detailed explanation of these can be read in their update here).

The result of their assessment isn’t entirely doom and gloom for the US banking sector, with the team actually increasing their exposure to certain banks in the current climate, such as JPMorgan Chase, highlighting the advantages of its more conservative position. Though they have reduced their exposure in some of the more ‘exposed banks’, i.e. those who are less able to generate liquidity in the event of a true crisis.

The current chaos may actually be a long-term boon for the sturdiest of banks, as fearful depositors ‘fly to quality’, and place their money with the safest banks. Huge, diverse balance sheets, like those of JPMorgan, coupled with mega-cap banks’ much more diverse revenue streams (such as asset management services) give some sense of comfort to depositors.

Yet the most important factor here, and arguably the best reason as to why one may wish to ‘buy the dip’, is that we may not need to fear the spectre of contagion, as – helped by the timely rescue of Credit Suisse – the toppling of the SVB and Signature dominoes, may not be sufficient to collapse the rest of the stack.

Arguably more important than the quality of banks in the current climate is the commitment of government bodies to ensure the stability of the banking sector. For example, the US immediately announced support measures to provide emergency liquidity to banks following the collapse of SVB, whereby they will make loans of up to one year to banks pledging US Treasuries, MBS and other qualifying assets as collateral. This means that US banks won’t need to realise the losses on their investments in the same way SVB did. If there was to be a contagion super-spreader it was more likely to be Credit Suisse, given its asset size. Yet even here the Swiss authorities have moved mountains to ensure the stability of their financial system, causing its shares to rebound 18% at Thursday’s open.

At a more fundamental level, global banking is in a generally healthy place, compared to the pre-2008 situation. As the PCFT team point out, European bank ratios are operating with balance sheet metrics well in excess of their regulatory requirements, with an average liquidity coverage ratio of 162% for example , well above the 100% minimum the regulator requires. The banks in Asia look equally as robust, with the PCFT team commenting that “the ‘sympathy falls’ in European and Asian bank stocks [on Wednesday] look excessive in the context that rate rises have been more subdued.” Given that a banking apocalypse seems to be a very unlikely outcome, maybe now is the time to follow PCFT’s example. With a bit of bravery, and an intelligent view to allocation, the bank sell off may offer a seldom found entry point into what remain fundamentally strong institutions.

A silicon lining

Given that this entire situation came about as a consequence of rising interest rates, it does raise the question around the capacity for central banks to sustain a hawkish approach to monetary policy, as the cure may end up being worse than the disease. There is no point in trying to contain inflation if you end up bringing down the banking system in the process. While it may not be a watershed moment, it does reinforce the notion that we are approaching, if not at, the peak of the interest rate-rise cycle.

There is no greater beneficiary of decelerating interest rates than the growth-stock sectors, who have been hung out to dry by the rising rate cycle, as SVB can attest to. While PCFT may be a near-term opportunity to capitalise on skittish investors, its sister trust, PCT, may be the long-term beneficiary of recent events. If the rate hiking cycle has indeed been nipped in the bud, then there should be greater certainty around the future value of cash flows, making high-growth companies like those in the technology sector more viable, as much of their value is based on projected future earnings.

The PCT team have highlighted that despite almost exclusively servicing the technology sector, SVB’s collapse will have little direct impact on PCT or the wider tech sector. If any subsector is likely to be directly impacted, it will be fintech, as market sentiment towards the sector deteriorates further. However, the PCT team points out that spending on innovative new technologies within the financial sector is heavily skewed to larger banks, who may be able to continue their investment.

Additionally, most publicly traded technology companies remain well-capitalised, with technology being the only S&P 500 sector to hold net cash in aggregate. Since those cash deposits are safe, tech firms may end up being the least likely to suffer in this mini banking crisis. While, in the March crash PCT’s NAV has been impacted far less than PCFT’s, it still offers the more attractive discount opportunity, with a 15.4% discount compared to PFCT’s 6.1%, reflecting the long-term headwinds growth stocks have faced.


Update, as of 23 March 2023

The necessity of this update is in part my fault, having chosen to write on developing news. Over the weekend the Swiss authorities deemed it prudent to force UBS to take over Credit Suisse, buying the company for the paltry sum of $3.25bn. UBS’s bid values Credit Suisse at SFr0.76 a share, less than half its closing price of SFr1.86 on Friday. The Swiss National Bank will offer $108bn in liquidity to USB, to help reduce the impact of any losses on the assets UBS has purchased.

This development effectively draws a line under what has been a tumultuous few years for Credit Suisse, with the bank losing $7.9bn last year, whereas UBS made $7.6bn. This outcome is arguably the least damaging way to deal with Credit Suisse, as the losses from this transaction will be felt by Credit Suisse’s investors, not the public. It also attests to the notion of strong banks becoming stronger, as this transaction will cement UBS as the world’s largest wealth manager, as well as removing one of its major competitors. Expect Credit Suisse’s loss-making assets to be wound down however, as UBS’s conservative approach to banking will likely not mesh with some of Credit Suisse’s more risk-loving divisions (perhaps we will say goodbye to its investment bank). While we remain in the grips of a market scare around global banks, with the regional US bank First Republic also in the firing line, once this episode is over, we may find that the largest, more rationally managed banks only end up cementing their leadership, having gobbled up competitors’ assets in a moment of weakness. These episodes are also testing the metal of banking regulators, though they have been successful in holding back any genuine contagion so far. Yet this time around regulators appear to favour placing the losses on shareholders, rather than coming to their aid via a bailout. This ‘winners vs losers’ market we are currently seeing further supports the need for good stock picking, not only to pick those companies that can outperform, but more importantly to avoid some of the truly painful losses some investors are facing.

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