Silicon Valley Bank’s meltdown this week was partly because it had been investing customer deposits in US Treasuries, considered one of the world’s safest investments, without hedging the risk of interest rates rising.
Last year was the first since 1870 that bonds and equities both experienced an annual decline, as the interest rate shock destroyed the value of assets in almost all classes.
Investors have been rushing to redesign their portfolios as the style of investing, which had worked so well in the years post-global financial crisis, somewhat fell apart.
Speaking in interest.co.nz's Of Interest podcast, Greg Fleming, head of global diversified funds at Salt Funds, said fiscal and monetary stimulus during the pandemic had created several parallel bubbles which are now deflating.
"We had an extraordinary amount of money sloshing around after Covid triggered that super-stimulus; not just fiscal stimulus but also central bank stimulus."
“That amount of money sloshing around the system had to find a home. Many markets took that money, some as solid as residential property, others as ethereal as ethereum.”
Bubbles in both dependable and speculative markets have been deflating and bringing investment portfolios with them.
Silicon Valley Bank, for example, was at the heart of the venture capital boom which occurred in 2021 as cashed up investors looked for places to invest all the excess liquidity they found themselves holding.
Deposits rushed into the bank as start-ups raised big funding rounds and Silicon Valley Bank invested that cash in treasury bonds.
But it couldn’t last, start-ups stopped depositing money when venture capitalists stopped writing them checks in 2022 and sky-rocketing rates depleted the value of the bank’s bonds.
It's a classic boom and bust story. The economy got too hot, the bank grew too fast, and it imploded when conditions suddenly reversed.
Not all assets and investments have experienced the dizzying extremes that Silicon Valley Bank has, but most have charted a similar direction of travel.
Accident waiting to happen
“If you go back three years, and were constructing a portfolio from scratch, one thing you would see was horrifically expensive bonds everywhere, that looked like an accident waiting to happen,” Fleming said.
“It is almost wearying to see people expressing surprise at the bond meltdown that happened last year, it was always going to happen and was just a question of minimizing your investors' exposure to it.”
The meltdown was the worst bear market in bonds that has ever occurred, which coincided with a bear market in stocks. These two assets have traditionally had an inverse-correlation, meaning one would fall when the other climbed.
That has not been the case in the past year and these two asset types have begun moving in the same direction, posing a challenge to traditional portfolio construction.
It is possible both stocks and bonds could rally when – or if – central banks cut interest rates, extending the correlation between the assets.
This might require investors to look for other uncorrelated assets to smooth out volatility in portfolios. Examples might include infrastructure, carbon credits, or even commodities like timber.
In its quarterly Global Outlook Report, Salt Funds said the approach of building portfolios from hundreds or thousands of individual securities was reliant on broad multi-year market rallies such as occurred after the global financial crisis.
“However, such rallies may now be found to belong to a vanished era, where central banks cushioned or prevented recessions by expanding liquidity and lowering the cost of activity through interest rate suppression”.
With central banks now focused on price stability, and willing to induce recessions to get there, the era of “wave riding investment strategies” may have passed.
“For instance, it is plausible to foresee a phase in which the main market benchmark indices move sideways in ranges, whilst individual securities within them still offer scope for better outcomes.”
Fleming said his expectation for financial markets in the remainder of 2023 was that it won’t be as bad as it might have felt this past week.
“We’re in more of a dilemma than a disaster,” he said. “It is a dilemma because the central banks do have to put a stopper in inflation, but they don’t want to break too many things that are reliant on yields not going through the roof”.
“Be satisfied with the quality and the underlying balance sheet of anything you invest in; be very, very vigilant about that."
You can find all episodes of the Of Interest podcast here.
39 Comments
Imagine a scenario where vendors incurring substantial losses in today's market approach a bank with a request to refinance their mortgage based on 2021 property values, they will be laughed at. But when it comes to the banks' own impaired assets, the situation in the US is quite the opposite. In fact, the Fed is being celebrated for stepping in and saving the system. This behaviour is completely reprehensible, and it is disheartening that our institutions are promoting poor risk management practices. As a regulator, they’re promoting a behaviour that if your risks don't work out, we will socialise your losses and make average Joe on the street to pay for it. Completely irresponsible and morally corrupt. There are costs for poor decisions in life and that is what the regulators are meant to ensure, but in this instance like in many others, the FED has failed at its basic duty.
This is exactly why the central banks need to go. They pick the winners (cronyism) and the loses. Speculation has to be allowed for the Ponzi to continue. Look at the Feds balance sheet ($9 Trllion), all toxic assets Wall Street does not want. MBS. Why has the Fed allowed to purchase assets, toxic at that. It is truly a sick system, designed to favor the elite at the expense of the productive people. When our fiat currencies collapse, the central banking system must go.
by HeavyG | 10th Mar 21, 10:09am
Unless CPI goes over 3% there's no overcooking going on.
by Audaxes | 10th Mar 21, 11:08am
The RBNZ’s Monetary Policy Committee has been clear from the onset of COVID-19 it’s taking a “least regrets” approach. It believes it’s easier to cool an over-heated economy, than to try to fire up a frozen one.
In the post WW2 period, after price controls were removed, inflation rose 18% in 1947 and 10% in 1948. And the Fed kept the 10-year pegged at 2.5% until 1951.
The Aussies are pegging the 3 yr note at 0.10% - $10,000,000 capital bank deposit to save $10,000 per annum at this rate. Are fiat currencies debased or not ?
by Independent_Observer | 10th Mar 21, 10:24am
Bill orchestrated this mess while Finance Minister - bit rich now for criticism from the sidelines.
by bw | 10th Mar 21, 10:41am
As evidenced by his handling of the South Canterbury Finance bail-out.
Treasury officials were predicting South Canterbury Finance's (SCF) collapse even before SCF was approved entry to the government's extended retail deposit guarantee scheme on April 1 last year.
https://www.goodreturns.co.nz/article/976498105/treasury-predicted-scf-s...
by Audaxes | 10th Mar 21, 10:48am
Crony capitalism at it's best.
by Millennial_Woman | 10th Mar 21, 10:31am
“I think the New Zealand public likes to see a government being careful about debt,” English said.
... What about household debt?
by Audaxes | 10th Mar 21, 10:54am
Private sector banks are responsible for that and there is a strong, irrefutable official belief that market forces will take care of it. Until they don't. Which is nearly always the case.
As New Zealanders grapple with out-of-reach house prices, Reserve Bank Governor Adrian Orr has described it as a "first-class problem" and that the alternative is "recession or depression". Link
Boom and bust economics dogma putting Adrian Orr's best foot forward.
Even a below average professional understands interest rate risk. The problem is not that people have been caught off guard, it is their belief that the institution will be bailed out and the managers will retain their bonuses. Nothing of this nature could occur if you put a couple of reckless managers behind bars and strip them off their wealth for not fulfilling their duty of risk management and put a couple of directors behind bars for not fulfilling their fiduciary duties.
My understanding is that the cost of bailing out the depositors in SVB is not paid for by the taxpayer and in terms of your comment about poor risk management practices the Federal Government is protecting the depositors not the investors. So the ‘risk taker’ aka the investors will certainly see the consequences of their ‘poor investment practices’.
I mean...where does it stop. Obviously we are all in the wrong business.
The British arm of Silicon Valley Bank has paid staff up to £20m in bonuses after it was bought by HSBC in a rescue deal.
https://www.telegraph.co.uk/business/2023/03/18/silicon-valley-bank-sta….
Not quite the same when you're taking about bonds held to maturity. So long as the bank is not forced to sell, they will eventually get back par value of the bond. Of course, they've incurred negative returns over some of the holding period and the maturity inflow is worth less in real terms than was envisaged at inception, but they get the money back. It does make sense to stave off hysterical bank runs in these cases.
Duration risk is most definitely a risk and not any lesser of a risk than credit risk. SVB thought they could simply ignore the former or bet that the former would not actualise.
It's no good to tell a creditor (depositor) who needs money now that if they wait ten years or whenever, they will get paid in full. In other words, cash flow is king - as for any other business.
It therefore does not make sense to stave off what looked like any other bank run - the mismatch of duration risk and liquidity.
Where did I say duration risk isn't a risk? It would be rather poorly named if that were the case.
Of course it's a risk, but it is most certainly different to credit risk. There's no coming back from an overwhelming proportion of non-performing loans. But given time and liquidity support, a bank can overcome a duration missmatch, albeit with a dent to the bottom line. It's clearly not ideal, but it is infinitely more fixable than a wholesale write down of lending assets.
It's a case of knowing you will get your money back if you can wait long enough, versus knowing you won't.
What kiwi's will find out and very shortly is that housing, crypto, municipal bonds, treasuries, currencies and the likes are not investing. They are not productive. Cheap money (bank issued) has mainly been used for speculation in all kinds of non-productive enterprises, forcing stock markets and assets to record highs, creating uncontrollable inflation. (Or was it Covid, or maybe Putin, damn global warming). The conspiracist's talk about the Great Reset and the first thing that should be 'reset' is the banking system.
What kiwi's will find out and very shortly is that housing, crypto, municipal bonds, treasuries, currencies and the likes are not investing.
What about gold (Buffet sees little value in gold btw)?
How do you define "investing"? Can "speculating" be considered "investing"?
"Last year was the first since 1870 that bonds and equities both experienced an annual decline..."
And what eventually came after that? The Bust of the1890s, and of course given the advances in communication networks everything happens a lot faster today. Railroads back then were the Tech Sector of today - perhaps even SVB et al?
"a seemingly minor but ominous economic event occurred: the Philadelphia and Reading Railroad, once a thriving and profitable line, went into bankruptcy. Like other railroads, Philadelphia and Reading had borrowed heavily to lay more tracks and make costly improvements, such as new stations and bridges. But over-expansion cut into revenues. Profits dwindled, and the company was unable to pay its debts. Soon, a similar issue began to emerge in manufacturing. Banks suffered too. As primary lending agents, their problems compounded when customers defaulted. The failure of the National Cordage Company set off a chain reaction of business and bank closings. 28 banks failed. By May, the number had grown to 54; in June, it reached 128."
“Be satisfied with the quality and the underlying balance sheet of anything you invest in; be very, very vigilant about that."
As a long time(over 40 years) dividend focused investor, that has always been my mantra. I have seen many market crashes and survived them all. All that has changed for me is that a combination of age-almost 78 and stage 4 cancer- has meant a rebalancing of my portfolio from shares and property, to shares, cash and government bonds.
SVB. Biden bailout according to a US congressman.
puts it in quite simple terms as far as he understands it and it is quite telling
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