A major bank collapses in the US

Stock markets have seen little wobble after the second-largest bank failure in history in the United States fell into the hands of the authorities. This event practically dominated the news over the weekend and that's why I decided to publish this post quickly on Monday as an exception. There's also a bit of talk in this post about share buybacks and China's economic ambitions.

A major bank collapses in the US

Last week ended in the red on the stock markets after the troubled Silicon Valley Bank went bust on Friday.

Events unfolded at lightning speed. On Wednesday, the bank said it had suffered losses worth a couple of billion when it had to liquidate safe bonds to cover customers' spate of deposit withdrawals.

There is no smoke without fire. On Thursday, the bank attempted a share issue to cover these losses. The bank assured its solvency, as banks should always do. Just take a look at this impressive slide of a corporate press release on the share issue. It says, "strong capital position", no?



Customers realized that they would soon be unable to get anything out of the failing bank. Confidence was lost and everyone rushed to withdraw their deposits in a panic. The share issue collapsed as the bank run intensified, and on Friday the bank fell into the hands of the authorities.

Over the weekend, the authorities tweaked the situation and all SVB deposits were protected beyond the normal $250,000 deposit guarantee. In addition, the Fed provides expensive funding for banks in a difficult liquidity situation in exchange for bonds. This should prevent the bank run from spreading to the wider system. Fortunately, the problems of the money world are always solved with money. At the same time, SVB's management was fired, and the shareholders deservedly lost their money, so in addition to the carrot, a bit of stick was utilized.

I’ll attempt to explain in layman’s terms the collapse of a Californian bank specifically dedicated to serving start-ups, more commonly known as SVB.

One thing to understand about banks is that they don’t have all the deposits of businesses and people in cash waiting to be withdrawn. The assumption is that not everyone runs to the bank at the same time to withdraw their money. This next comment cuts several corners and is technically wrong, but in layman's terms you can imagine that the bank is effectively lending that money straight away to other customers. (Actually, the bank creates the loan money out of thin air, but let's not into that this time.) Or the bank invests them. In practice, your and my deposits in the bank are the bank's debt to us.

Another point: Banks are already forced by regulation to park some of their money in safe places, such as the central bank, government bonds or other fixed income securities.

The SVB has seen a large inflow of deposits in recent years as the bank has grown at rocket-speed. An exceptionally large amount of that money was invested in securitized mortgages, which are also considered safe. If interest-bearing securities are held on the balance sheet until maturity, the bank earns the interest. If you sell fixed income securities, you can either make a profit or a loss, depending on how the value of the securities has developed.

Due to the sharp rise in interest rates, these investments were heavily in the red. Surely everyone understands that if you bought a bond that yields 2% a couple of years ago, no one wants to pay full price for it today, when the market is now yielding 4-5%. In particular, the value of long bonds falls when interest rates rise. In this case, you would just want to hold the bond until its maturity date, so that the loss is not realized, and you could get away with taking too much risk.

But when the bank run hit, the SVB had no choice but to start liquidating papers at a loss.

The SVB had invested obscenely in low-interest investments, while its deposit base of start-ups and technology companies was very slippery. This was conscious yet stupid risk-taking by the bank.



In other words, this speculative bank financing speculative start-ups collapsed when the outward flow of deposits accelerated into a bank run and the bank, which had failed to manage risk, could not respond. As I understand it, banks should manage their interest rate risks and the sensitivity of their deposit base, but SVB clearly missed the mark here.

No matter what buffers a bank has in place, leveraged banking is ultimately always a business of trust. No bank in the world can withstand a loss of trust from customers and authorities.

SVB was the 16th largest bank in the US and the second largest bank failure in history. Banks failing from time to time is in itself normal. It just hasn't happened for a couple of years in the US, as you can see from this WSJ visualization. During the financial crisis, several hundred banks were failing every year. And the SVB is by no means the only similar case in history of a failure to manage interest rate risk. The rise in interest rates in the 1970s and 1980s wreaked similar havoc on many banks back in the day.

The bigger concern for the market is how other banks are doing. Even if other banks manage their interest rate risk better, as one would hope, they will be squeezed if customers panic and withdraw their deposits. This graph, showing the unrealized losses of more than $600 billion in US banks' bonds, spread like wildfire in the populist investment social media.

 
In addition to bank runs, there is another problem. As I have often said, the inverted yield curve is making life difficult, especially for small banks. They must compete for deposits, while people get a return of almost 5% on fixed income investments. At the same time, longer-term loan rates are below these deposit rates. It’s difficult to make a profit if you have to pay, say, 5% on deposits when you only get 4% on loans to customers. This is just a rough example, so that everyone understands the problem. The index of small banks has fallen sharply.

Of course, the banking sector is the most watched sector in the world, and I would be genuinely surprised if another financial crisis started there while the last one is still fresh in our minds. In practice, the Fed's efforts to stabilize the banking sector should calm the situation. It also remains to be seen whether regulation will tighten for smaller banks, which have not been under as much scrutiny as the big banks in the US.

Market interest rates are reacting rapidly downwards. Similarly, expectations of future Fed rate hikes moved slightly lower.

As they always say, the Fed will keep raising interest rates until something breaks. And now there’s at least a rattling in the system. The strong employment data for February released on Friday was completely overshadowed by the SVB mess. The data effectively suggested that red-hot labor market will continue, which will push the central bank to tighten monetary policy unless the economy starts to suddenly melt.

The SVB won’t necessarily be the only victim of this rate hike cycle.

Share buybacks at record level

Despite investors' endless worrying and public company fundamentals being shaken by cost pressures, equity buying in the US is at a record high. Or at least this is the case if you look at the announcements of companies’ share buyback programs. This Bloomberg graph shows the number of planned buybacks announced by companies since the beginning of the year.

This data could be interpreted as companies’ high level of confidence in the future, but in practice the five largest buyers account for 2/3 of the total declared 260 billion. These include, for example, the $75 billion buyout program of oil giant Chevron and the $40 billion buyout program of Meta.

According to JP Morgan strategists, actual equity buybacks fell by 20% year-on-year in the fourth quarter and have continued to fall since the beginning of this year. Buying back shares is usually the first thing that companies start to bargain on, as it's a bit more inconspicuous than more symbolic dividends or investments.

This graph from Yardeni Research, in which the data unfortunately ends at the third quarter, shows the number of completed purchases of own shares. On an annual basis, almost a trillion dollars’ worth of shares are bought back, meaning that half of the collective $2 trillion in earnings of all the companies in the S&P 500 is returned to shareholders in the form of share buybacks.

As you can see, these fluctuate wildly with the cycle. Most own shares are bought when prices are rising, least when they are bottoming out, which somewhat dims the tax-efficient brilliance of this form of profit distribution.

This can also be interpreted to mean that if companies reduce their share buybacks, it will put downward pressure on prices, as there will be one less significant hand to take a bite out of falling stocks. Of course, for disciplined companies and investors, a fall in share prices is an excellent opportunity to benefit from the shares of good companies.

China's economic growth target is reflected everywhere

Just over a week ago, the Chinese Communist Party announced a 5% GDP growth target for the current year for the world's second largest economy. Even in the Nordics, the aims of the command economy nomenclature shouldn’t be dismissed with a shrug, as the momentum of the Chinese economy is reflected everywhere in the world, from raw material prices to inflationary pressures.

Comments on China's growth target have been cautious, as last year's target was missed due to COVID lockdowns, and missing the target twice isn't desirable.

China is also trying to avoid a huge increase in debt, although the country's self-imposed budget limit allows a total public sector deficit of 5.9% in relation to GDP. So, in practice, the fragile economy can be supported by a big debt splurge.

Although the Chinese economy is showing signs of picking up in many areas after the end of the COVID lockdowns, as indicated by the purchasing managers' indices I talked about a while ago, exports and import data at the beginning of the year still speak in favor of the economy being fragile. Weak exports reflect sluggish demand in the rest of the world, while import data reflect sluggish domestic demand in China.

The authorities repeated in their familiar style how private consumption growth is an important component for achieving healthy economic growth.

As I have often underlined in these posts, China's economic growth is heavily skewed towards investment and its transformation into an advanced economy would require a shift in focus towards consumption. However, much of the economic decision-making would then take place outside the coffee and pastry (or for China, tea and nut) tables of local government. Therefore, transformation has been politically difficult to achieve. China's investment-led growth was a decades-long success, as a new motorway or airport increases the potential of the economy. But that tenth new motorway lane next to the old ones no longer increases productivity in the same way, but rather wastes resources.

The weakness of private consumption in China is well illustrated by the fact that the average standard of living in the country is similar to that of Mexicans, but the level of household consumption is on par with Peru. Households have been forced to over-save, and these over-savings have been channeled into investments that haven’t been very profitable for years. Several countries that have used the same economic model have eventually run into problems, most famously Japan in the 1980s.

The Communist Party has concentrated more power under Xi Jinping in the past week, which could speed up reforms. However, dictators that maximize their power haven’t generally been very good economic rulers for a long time.

If the Chinese economy recovers through services and private consumption, this shouldn’t feed inflation terribly in the rest of the world. Raw materials such as copper or oil have not reacted to China's mild growth target.

Thank you for reading the post! Read analysis and make good stock picks!