Consequences of Recent Bank Failures
Over the past few months I have been on the defensive. Markets have generally risen, I would argue because of the Janus-like policy of central banks, simultaneously raising interest rates aggressively and boosting their balance sheets through QE. Investors have chosen to ignore the heavily inverted U.S. yield curve, which has traditionally been a sign of an impending recession.
Lack of depositor confidence is the root cause of the very different bank failures
Then came the implosion of Silicon Valley Bank. In one sense, like the LDI crisis last autumn, it is a consequence of the yield curve inversion as rising bond yields drained away its capital. With hindsight we can all point a finger at the closing out of almost all their interest rate hedges in 2022, perhaps as a consequence of the lack of a Chief Risk Officer for much of the year. Or, if you prefer, at investors who didn’t pick the obvious red flags up in SVB’s 2022 report and accounts.
SVB’s business model was very different from a traditional bank, but the fall in depositors’ confidence was at the heart of its problems. In that sense, its fall played the same old record as the collapse of Overend Gurney, the biggest bank failure of the 19th century, in 1866. Credit Suisse is no different either: as someone said to me last week, its balance sheet is almost identical to Deutsche Bank’s, but only one of them has had to be rescued.
The implications of these bank failures have not yet worked their way through the system. There will be others, and it will be driven more by investor perception than by the reality of their financial metrics. We won’t see queues outside banks either, as most money will drain away via on-line transfers and transactions. But any bank where confidence is less than rock-solid, is vulnerable.
Implications of central bank response
To come back to what this means for investors, we need to start by looking at what the authorities are doing. Central banks, led by the Federal Reserve, have started QE again to attempt to restore financial stability. Global central bank balance sheets currently amount to around US$26 trillion, which is only modestly below the US$29 trillion COVID peak. Investors who only look at rising interest rates will see only half the picture.
At the same time, the Swiss National Bank has by their proposed rescue of Credit Suisse turned the corporate hierarchy upside down. Normally equity holders get wiped out in a failure while bond holders share the pickings, however meagre they may be. In this case, holders of Additional Tier 1 bonds will get nothing, while shareholders are receiving something. In defence of the SNB, AT1 bonds are contingent convertible (“co-co”) bonds, designed so that they can be converted into equity or written off if the bank’s survival is at stake. Any Credit Suisse AT1 holder who failed to read the small print deserves no sympathy.
The greater surprise is that equity holders are getting anything. It is not unprecedented for governments to strip equity holders of their right to decide a company’s future. The U.K. Government did it with the confiscation of Railtrack into a Railway Administration company in 2001. But for equity holders to receive compensation while bond holders do not is contrary to the basic principles of corporate finance.
Investors will have to pay more attention in the future to the legal framework and politics of where they place their money. Passive investors in particular are vulnerable to this kind of appropriation as they do not have agility to screen out countries or companies in time. Any global passive investor will have lost money on Credit Suisse, and in all likelihood through Silicon Valley Bank too.
Private markets will take a hit too
Private markets are not immune from the reverberations either. Quite apart from Silicon Valley Bank’s position in their eco-system, private equity involves very substantial leverage and their valuations have generally not yet taken the markdowns which public markets have. Their borrowing is done through floating rate loans, and since the Global Financial Crisis they have seen fit not to hedge the interest rate risk – why would you do when yields were going to stay at zero for ever?
Their portfolio of companies is clearly going to need more financing and it will be at much higher rates even without allowing for widening credit spreads. I have written before on the conflicts of interest between private equity partnerships and the private credit managers who provide much of their finance. Suffice it to say that it will be interesting to see how the pain is allocated between them.
The yield curve inversion prediction is likely to prove correct
Bringing all of this back to investors, it seems to me that the bond markets, as so often, have it right again. The very actions of central banks tell us how serious they believe the situation to be. Expect them to carry on with QE, perhaps to an even greater extent than in 2020 and 2021. But they cannot prevent the secondary consequences of higher interest rates and bank failures on the real economy. Add to that the question-marks over corporate governance, and the lack of transparency in private markets, and for me, equity markets are being far too optimistic.
Will central banks be the next to find themselves in the firing line?
We have seen the U.K. Defined Benefit pension schemes and Silicon Valley Bank brought down by the rise in bond yields. It is pertinent to ask who else might be holders of long dated government bonds purchased at the wrong price. By far the largest holders, as a result of their QE policies, are central banks, who have bought back their bonds as part of their asset purchase programmes. It is another reason why, despite my economic pessimism, I remain wary of bonds.