Mar 16, 2023

Meritage Current Market Update

The news of the failure of Silicon Valley Bank (SVB) and accompanying turmoil in the banking sector is worthy of a brief note of explanation and perspective. There will be more that we will know and address in our upcoming quarterly correspondence.

Aside from the specifics that befell the collapse of SVB, most current on investors’ minds is (1) whether this failure is an event that evolves into a broader financial crisis, and (2) does SVB’s failure have a direct impact on their own investments.

To the latter point, Meritage clients do not have exposure to the shares of SVB, nor Signature Bank, a financial institution that was also taken over by the Fed this weekend. This activity, however, has weighed on the entire banking sector and it is premature to suggest these pressures have run their course. Unlike the focus on banks in the 2007-2008 Global Financial Crisis, this event was not triggered by leverage and credit concerns. That said, we would not be surprised to see increased scrutiny around these risks in the current environment.

To the former concern about systemic risk to the financial system, this story has moved quickly from warning signs around Silicon Valley Bank earlier last week to being taken over by the Federal Reserve on Friday. Here are the key points as they stand this morning:

• Regulators at the Fed, Treasury, and other agencies have moved quickly to calm fears by assuring depositors of SVB, Signature Bank, and any other bank that they will have access to their cash, even if over the $250,000 FDIC limit. The clear intent here is to curtail panic of a broader financial contagion. This also provided the liquidity to the customers of SVB and Signature Bank to meet their payroll and other liquidity obligations.
• The aggressive response by the Government seems to be the right step to restore some semblance of order to the financial sector. Like previous federal backstopping initiatives of this kind, there are significant longer-term consequences that will affect the banking system and the broad markets in general. Calls for new regulation to prevent future occurrences are already in the works. Issues of moral hazard and accountability for taking risk will undoubtedly be a part of this. For now, the Fed has said that tax-payer funds are not being used in the SVB and Signature Bank restructuring.
• The rise of SVB to the 16th largest US bank was distinguished with regards to its niche catering to tech start-ups and venture capital firms. SVB’s fall was typical of a traditional bank run. Over 90% of its deposits exceeded FDIC insured levels. A loss of confidence about a bank’s ability to meet liquidity needs will translate to depositors withdrawing their funds. Since no bank maintains enough liquidity to pay everyone off at the same time (most deposits are used for credit-worthy loans), banks rely on the confidence of their depositors. Any cracks in the story, legitimate or not, can quickly shut the doors of any bank, especially in the age of social media.
• SVB was the beneficiary of the massive inflow of cash into the tech sector, resulting in a ballooning of bank deposits. It wasn’t the funneling of these deposits into high risk/low quality investments that undermined the bank’s balance sheet. Instead, they purchased longer-maturity Treasury bonds and found themselves in a position where they had to sell at a loss (before they matured at par) to meet withdrawal requests. The underlying catalysts to this chain of events were the bank’s mismatching of the maturity of their assets and liabilities, the sharp rise in interest rates, and the cash from tech start-ups drying up – a risk that potentially could arise in other financial institutions.
• It is important to remember that investment assets held in custody with a financial institution are not a part of that institution’s capital and thus not exposed to their business risk. Aside from the inconvenience of finding a new custodian, custodial client assets of SVB are not at risk to the insolvency of their business.
• The response from federal agencies has provided some near-term relief to the broad stock market. More significant is the rally in bonds, as investors reassess the Fed’s willingness to proceed with additional rate hikes in the face of this increased risk to the economy. Short-term bond yields have tumbled over the past several days as the market has absorbed this unexpected development.

The irony of this latest unraveling is that conventional wisdom believed the banking sector was in much better shape to withstand a shock to the financial system due to increased regulatory initiatives following the 2007-2008 financial crisis. In many ways, that is true.

From another perspective, the failure of SVB was more about building an entity on the back of historically low interest rates and unlimited access to liquidity and not taking precautions for the inevitable reversal of those conditions. SVB also had a high concentration of customers in the tech industry. Investors will naturally be on guard for other potential risks in the financial sector and the economy at large. SVB and Signature Bank won’t be the last casualties of unwinding the Fed’s easy money policies.

At the same time, panic-driven investment decisions can also create attractive investment opportunities.  That’s always been the case for long-term investors and there is no reason to believe it’s different this time.  In times of elevated risk, investors will pay more attention to strong business fundamentals. This is consistent with our process of focusing on companies with strong free cash flow and reasonable valuations. We believe good management teams should already be prepared for an increasingly volatile operating environment.

As we mentioned at the outset, there is much more to assess from the events of the past week, particularly from an economic, regulatory, investment, and sentiment standpoint.  We look forward to reporting back to you soon.

The Meritage Investment Team