First slowly....then all at once.

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March 20, 2023
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The key March options expiry last week coincided with the revelations that one of the US's fastest growing banks had collapsed, leaving markets that were poised to break one way or the other to head down. Meanwhile, one of Europe's longest running troubled banks, Credit Suisse, also appears to have finally succumbed, leading to the macro bears pushing crisis narratives everywhere. However, it is worth noting that these are issues around risk management and in SVBs case a regime change that no longer fits their (recent) business model. This is not about tightening credit conditions blowing up a risky lending book, it is about the new New Normal of normal levels of interest rates and a flat (or even inverted) yield curve that does not suit the model of bond fund masquerading as a Bank. There are many business models that will be challenged in this new normal, but there are an equal number that will prosper. As markets give up all their year to date gains, investors have the opportunity to work out which ones to buy on the dip.

Last week's events at SVB fit Ernest Hemmingway's description in 'The Sun also Rises' of going bankrupt perfectly; "first slowly, then all at once", but it is important to recognise that this is happening because things are getting better, not worse. SVB was one of, if not the, fastest growing banks in the US between the start of Covid and the end of QE, when its Silicon Valley VC/IPO pipeline business model was turbo-charged by the $5.4trn of new deposits that flooded the US banking system as the Fed allowed the US money supply to explode.

SVB grew rapidly under Zero Interest Rates and dangerously so under Zero Covid when it essentially turned into a Bond Hedge Fund, albeit one apparently ignoring both duration risk and liquidity (funding) risk. Its problem was more deposits than it knew what to do with.

SVB was not alone in not having any actual loan business in which to deploy its vastly increased, low cost, deposits, but it was relatively unique in that almost all of its deposits were from corporates. Instead of having millions of people with thousands of $s, they had thousands of people with millions of dollars, almost none of it Federally insured. This was actually a feature not a bug in its business model, which loaned money at VC stage in return for post IPO banking (including a lot of mortgages for newly minted multi millionaires). SVB effectively deployed the money into the fixed income markets, generating some very healthy carry trade profits, but as the Fed started raising rates at the short end that could only remain profitable by 'reaching for yield', essentially taking more long dated positions, thus increasing both duration risk (increasing sensitivity of asset prices to further rises in rates) and of course funding mismatch of on-demand funding for longer duration assets - borrowing short to lend long. As such, SVB started to go ex growth last year and as the yield curve inverted, started to lose money. As zero Covid and Zero Interest rates ended, so did its business model. It started going bankrupt slowly. No surprise that the share price peaked around the time the Fed started to tighten and short positions started to grow around the time the yield curve inverted. However, unlike the actual Bond funds that blew up in 2022 using similar strategies, SVB did not face redemptions and the need to become forced sellers. Accounting rules and regulations were generous, allowing for almost $100bn of assets to be marked as Held to Maturity (HTM) leaving both the regulators and the bank praying that there would not be any deposit flight, the equivalent of fund redemptions, given that the, at that point unrealised, losses of around $15bn on the bond book would effectively wipe out all the Tier 1 Capital.

Of course the company knew the problems, which is why they tried to raise more capital and it was this that finally woke the markets up to the issues at hand. Part of the reason for the 'shock' of SVB in our view is that everyone appears to have assumed that everyone else was doing the due diligence (shades of FTX) and much of this was due to the dominance of passive funds in the shareholder list who owned the stock simply on the basis of its position in assorted indices. Brokers analysts meanwhile seemed as asleep as the regulators, with only one sell recommendation and even though a number of active managers were short, the issues with SVB were below the general radar. Until they weren't and the depositors took note and took flight. It was then that SVB went bankrupt all at once.

We see it as no coincidence that the turmoil in markets came the same week as the March options expiry, for while the troubles at Silicon Valley Bank and a number of others may have been the catalyst, the equity markets had been sitting right in the uncertainty zone, looking to break either to the upside or the downside on technicals and the news flow simply determined which way things went at expiry. The result has been that all the gains year to date were given back in a week, leaving investors wondering once again which way the fundamentals are going.

In fact, the (mid month) options expiries have been driving the markets all year in our view, firstly with short covering and short dated options trading between mid December and mid January and then with asset allocation and rebalancing into Emerging Markets, Europe and Japan between mid January and mid February. We then noted that the roll to the March contract in Mid February had led to some tail risk hedging around the anniversary of the Ukraine war, which had left the markets poised for a directional move this last week. In terms of valuations, we noted in the March monthly that the Internal Rate of Return on most markets had moved to the expensive end of their fair value ranges, leaving them vulnerable to some profit taking. This of course has now reversed.

Following the short squeeze in January and the rebalancing in February, markets had moved from the cheap to the expensive end of their fair value ranges. This has now reversed in a week.

In terms of fundamentals, the bears are back claiming this is about their projections of a recession and calling for further falls in markets. The macro pundits who were caught in the January short squeeze, at the time mis-attributed it to the equity market being too optimistic on growth and are now equally mistaking this sell off for a 'reality check' on the macro (ie claiming they were right). We would disagree; our valuation work shows that higher bond yields and lower growth were already in the price and what has happened here is simply a shift in risk premiums. Having also missed the China re-opening story in February the macro bears are once again back to the 'China is going to blow up' memes and are now extending SVB news to a credit crunch, when evidence suggest that neither is true. The selloff last week in Global mining and energy stocks accordingly looks particularly speculative, especially as it is also based on a revisit of the 'yield curves predict recessions' modelling that the same pundits were pushing back in January. The truth is that it really is different this time and we need to be especially wary of historical analogues as a guide to markets. Raising interest rates as a precursor to tightening credit and slowing the growth of the money supply will certainly slow an economy, but that isn't what is happening. We are normalising interest rates after more than a decade of setting them too low and as Silicon Valley Bank discovered, raising interest rates back to 'normal' levels undercuts the business model of deposit taking bank as bond fund, while also allowing for a more efficient allocation of capital away from 'telemedicine for french bulldogs SaaS startups' as one meme had it.

Of course, Credit Suisse, which like SoftBank has never appeared to want to pass up the opportunity to mis-price risk, has added to the broader concerns around banking this week and led to some confusion that the US banking problems are extended to Europe. This is very much not the case; most European banks have too much regulatory capital, not too little and none have the depositor profile of SVB. More importantly, the European regulators have not allowed them to buy back shares or pay dividends until now and the reason that, even after a strong run this year, they were still cheap, is that the era of Zero Interest Rates and Zero Covid was as unprofitable for them as it was profitable for competitor and challenger banks like SVB. In effect, what is bad for SVB is the same as what is now good for European Banks. As the dust settles after the options expiry, we would not be surprised to see some buying on dips in these areas. Meanwhile, it looks like UBS are coming in to take on Credit Suisse, much as SBC were asked to take on the old Union Bank of Switzerland over twenty five years ago to create UBS. Even then CS was regarded as in danger of going under due to its risk management issues, so it really has stretched Hemmingway's description of slowly, before it too appears to have gone all at once.

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