Late Sunday afternoon the Treasury, Federal Deposit Insurance Corporation, and Federal Reserve took extraordinary measures to protect bank depositors around the country. The action was precipitated by an equally extraordinary failure in risk management at California-based, Silicon Valley Bank (SVB). Below we explain a few reasons why Silicon Valley was particularly at risk and why yesterday’s regulatory actions were taken. We’ll also discuss our approach to managing “cash deposits” and why our investments are not subject to any one bank’s health but instead the health of the underlying investment in stocks, bonds, government money-markets, and treasuries. And while a bank failure creates understandable angst, we do not believe it impairs the long-term value of these investments.
All the Wrong Metrics
The demise of Silicon Valley Bank is a significant event. It is important to note, however, that Silicon Valley Bank was unique in many respects. Over half its deposit customers were Venture Capital-backed startups and the bank more than tripled in size from 2020 to 2021 going from $60 billion to $200 billion in deposits. Silicon Valley then invested these deposits in bonds at the worst time including $80 billion of ten-year mortgages at a rate of 1.5%. The result was significant unrealized losses on the investments of customer deposits (value of the investments fell as higher rates have become available) at a time when many of its many money-losing customers started struggling to raise additional capital and thus needed those deposits. To make matters worse, 89% of Silicon Valley deposits customers had balances above the $250K FDIC insurance amount according to data submitted to the FDIC at the end of 2022. This is far greater concentration than the typical bank and only added to the fear that emerged amongst its customer base when the bank started discussing the need to raise capital last week. While all banks are struggling with the impact of the higher rates on their investment portfolios and are having to raise rates to retain deposits, it is clear Silicon Valley was particularly exposed given the pace of its growth and its now financially stressed customer base.
Regulators Respond to the Unintended Consequences
Most have recognized it would be difficult for interest rates to increase as fast and by as much as they have in the past year without something breaking. Last week, $200 billion Silicon Valley Bank broke and many of the tech-focused large and early-stage customers it supported were faced with a cash crisis. However, the actions taken yesterday by regulators were less Silicon Valley specific and more an effort to stop the fear of the safety of bank deposits from spreading. While time will tell, the regulator’s offer to accept bank investments at par value as collateral for government loans should eliminate the situation Silicon Valley Bank found itself in of having to fund deposits with a diminished bond portfolio due to the significant unrealized losses. Moreover, as time passes, we think depositors will come to appreciate how Silicon Valley Bank represented a unique set of risks that either management was not sophisticated enough to understand or just too greedy or naïve to address. Regardless, this unfortunately appears to be another instance where potential regulatory red flags were only recognized after the fact.
Our Clients Have Very Little Exposure to Bank Deposits
Most of our clients have their assets custodied at Charles Schwab. Like most all brokerages, Charles Schwab has a bank to which they historically sweep uninvested customer cash. Importantly, Woodmont clients have very little cash with Schwab Bank and in most all cases the balances are below the $250K FDIC insured amount. Instead of holding bank cash, we've invested client cash in stocks, bonds, government money markets, and treasuries. This limits Charles Schwab’s role for our clients to serving as a custodian and not a bank.
Not surprisingly, like other banks Charles Schwab’s earnings outlook is diminished as investors buy treasuries and other investments with cash otherwise held at its bank. Wall Street is tracking these metrics closely for Schwab and adjusting their earnings estimates as a result. However, while this shift may impact Schwab’s near-term stock potential, it is assuring to know we are not dependent on Schwab Bank's ability to retain deposits in today’s higher rate environment.
A Historic Rate Reversal
One implication of last week’s bank failure is a shift in investors’ expectations for Federal Reserve rate increases. Treasuries rallied and yields fell significantly Thursday and Friday as investors sought safety and recognized the Federal Reserve’s predicament. Specifically, if the Federal Reserve continued increasing rates that would only add to the pressure that would be placed on bank investment portfolios. We have sought to take advantage of the higher rates in recent months by modestly extending fixed-income duration. And while the two-year treasury could fall to the low 4% range this morning from its recent peak near 5%, we still think 4% is an attractive yield for risk-averse investors, especially in the context of what was available a year ago.
We recognize the technical aspects of this market brief and the unsettling developments of the past few days. Thus, please do not hesitate to email or call with questions or if we can assist you in any way. Thank you for your continued confidence and trust.
The Woodmont Team
March 13, 2023