Headlines this month all over the financial world, were about bank blowups. First, there was Silicon Valley Bank (SVB), a bank closely associated with tech startups all around the world. Then came another regional US bank, Signature Bank. And then the news spread across the pond to Credit Suisse (CS) which was forced into a shotgun wedding with UBS.
Silicon Valley Bank’s problems seemed to stem from an asset-liability mismatch, or what is also called a duration mismatch. A very large percentage of SVB’s liabilities were deposits, which were short-term in nature in the sense that the depositors could pull them out, at short notice, while it had invested a bulk of these funds in long-term US treasuries and mortgage-backed securities (MBS). Most of these long-term investments were bought when interest rates were very low and the average yield on their MBS portfolio was 1.56%.
Once the US Fed recognized that inflation is not ‘transitory’ and began raising the Fed funds rate aggressively over the last year, it pushed up bond yields across the tenure spectrum. From the price at which SVB bought the MBS which was 1.56%, the yield on the mortgage backed securities index reached a peak of 5.12% and is currently at 4.33%. As bond yields go up, bond prices go down. As a result, SVB had mark-to-market losses on its bond portfolio which when it became apparent to the market, caused a run on the bank as all depositors, particularly those above the $250,000 insurance limit rushed to withdraw their money. Uninsured deposits constituted 88% of SVB’s total deposits.
SVB’s problems seemed to spill over to Credit Suisse, the second largest bank in Switzerland with $575 bn in total assets. SVB by comparison had $212 bn in assets as of Dec-22. Credit Suisse has a long history of problems and has been fined by regulators on a regular basis over the last many years. Clients began to withdraw their money from CS at a rapid pace and on 19th Mar 2023, the Swiss authorities announced a merger of CS with its larger rival UBS. To ensure that this gets done before markets open on Monday, the Swiss authorities in an unusual move, said that this would not require approval from shareholders of the two banks.
The genesis of these events is the extremely loose monetary and fiscal policies during the covid pandemic. Interest rates were brought to zero and along with that, the US Fed did significant Quantitative Easing (QE). QE refers to the Fed buying US government securities and mortgage-backed securities from the market and the Fed balance sheet eventually reached $8.9 trillion at its peak. Trillions of dollars were also spent by the US government as a fiscal stimulus to help the millions cope with the pandemic. The net result was that all these measures stoked inflation when demand returned to normal after the pandemic. This is true not only of the US but also of Europe where inflation readings have been very high over the last 22 months. The playbook was the same here too with a huge amount of monetary and fiscal stimulus during covid.
In India too, inflation has been on the higher side over the last 14 months. In India, the RBI has the mandate to keep inflation within a corridor of 2% to 6%. India’s latest inflation print was 6.4% in Feb 2023. On the other hand, the US Fed is on record saying that they want to keep inflation near the 2% mark and the latest inflation print in the US came in at 6.0%. As we can see, while in India too, we are suffering from high inflation, it is not nearly as acute as it is in the US in the context of their respective histories of inflation. As a result, while interest rates in India have increased since the covid lows, they are lower than levels in 2018. In September 2018, the India 10-year government bond yield was at 8.2%, while currently it is 7.3%. As a result, losses on bond holdings are less of a concern in India as compared to how it has been for US and Europe, where inflation is way above historical norms. As such we do not foresee an interest rate risk led issue for banks in India.
We have been saying for a while that opportunities are hard to find. However, over the last few months the market has corrected a little and that has widened the opportunity set for us as investors. We are reminded of the words of Benjamin Graham that we must use the manic-depressive nature of Mr. Market to our advantage by being greedy when others are fearful and vice versa. Many investors treat volatility as something to be worried about. However, if you understand well the value of what you own, volatility can be a friend for the intelligent investor.