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Morningstar Insights: What’s Next for Investors After the SVB Collapse?

Philip Straehl is the global head of research for Morningstar’s Investment Management group. In his role, he oversees the group’s capital markets research and chairs the asset allocation committee.

Tyler Dann, CFA, is head of research, Americas at Morningstar Investment Management, LLC.

Key Takeaways

  • The closure and wind-down of Silicon Valley Bank SIVB has led to considerable stress in equity markets, particularly among shares of regional banks, as well as fear of contagion.
  • There are unique elements to SVB that contributed to its demise, including its client base and risk controls.
  • While we are likely not fully “out of the woods” yet, we view the regulatory response as appropriate and likely adequate, which should head off contagion fears.
  • As long-term, fundamental, wisely contrarian investors, we’re exploring ways to benefit from a potential dislocation in banking stocks, while being mindful of the risks.

What Happened?

Silicon Valley Bank, one of the 20 largest banks in the United States in terms of assets, has collapsed. It was the second-largest bank failure in U.S. history. A second (slightly) smaller bank, Signature Bank SBNY, also folded in similar fashion. In the case of both banks, the FDIC—an independent agency of the U.S. government that provides insurance to bank depositors—was appointed as the receiver. Put simply, FDIC took over these troubled financial institutions, with the intention to create the best outcome for bank depositors.

The SVB/Signature story has a lot of components, but ultimately boils down to an old-fashioned bank run. A flood of withdrawals from depositors destroyed these banks. How could this happen? This type of situation, while complex-sounding, is fairly simple: There were not enough cash and liquid assets available that could be sold to fund deposit outflows, without wiping out the bank’s equity capital base. That’s in part because banks are not required to carry enough cash to fund 100% of their deposits. According to regulations, they’re allowed to invest multiple dollars (think $10, in round numbers) for every dollar of deposits. These investments, which could be in the form of loans to customers or invested in marketable securities such as U.S. Treasuries or mortgage-backed securities, are generally longer-term in nature, and are not always able to be sold or otherwise harvested at a profit.

Some people have made comparisons to gym memberships. If every gym member showed up at the same time, not everybody would be able to work out. Banks are similar: If every depositor wants to pull their money at the same time, not everyone can get their money back.

Why Is SVB Unique?

For SVB in particular, the growth trajectory of its deposit base, the concentration of its customers, the peculiarity of its portfolio, and the relative lack of risk controls around the portfolio are unique factors. Per public filings, SVB’s deposit base jumped from $49 billion at the end of 2018 to $189 billion at the end of 2021. Venture capital funding was at all-time highs during this period and startups receiving funding often put the proceeds into SVB bank accounts. Putting that growth in perspective, SVB’s deposit base grew by approximately 57% per year in this period while industry deposit growth was only 12% per year, according to Morningstar’s research. As well, close to half its deposit base originated from technology companies, and most of those were early-stage technology companies. Traditional retail deposits, which tend to be stickier and tend to be smaller than the $250,000 insured by the FDIC, composed a relatively small portion of SVB’s depositor base, making it more prone to a bank run.

As deposits grew rapidly at SVB, the bank increasingly purchased fixed-income investments. The bonds they purchased (predominantly mortgage-backed securities) were high-quality, but were long in duration, with the weighted average maturity over 10 years. Shortly after making these investments, the Federal Reserve began one of its most aggressive rate-hiking periods in history. As interest rates rose, the value of these bonds fell. While in theory, the bond losses only existed on paper (if SVB held the bonds until maturity, it would get all its money back, plus interest), the “mark-to-market,” or unrealized, losses from these investments were significant, exceeding the company’s tangible equity capital. Observing this, depositors became skittish, started redeeming their money, and SVB became a forced seller of many of those bonds to meet redemptions. The paper losses turned into actual losses and laid the foundation for the rush to the exit by SVB’s depositors.

Is This a Lehman Moment?

While the collapse of another bank (Lehman Brothers) was at the epicenter of the global financial crisis in 2008, we believe that the recent bank failures are significantly less likely to trigger a global banking crisis. The speculative excesses that caused the financial crisis of 2008-09 were rooted in an economywide bubble in the real estate market, propelled by a large amounts of cheap debt funding that flowed into real estate securities. These leveraged and insufficiently capitalized owners of real estate securities created a fault line in the financial system, causing a global banking crisis as the price of real estate assets started declining and leveraged investors faced margin calls.

This time around, the speculative excess appears to have been in concentrated in niche segments of equities and alternative asset markets such as companies related to cryptocurrencies. Unlike the economywide debt binge that dominated the period leading up to the global financial crisis, venture capital tends to be equity-funded. Consequently, if venture companies fail, the loss typically ends with the investor, rather than being transmitted through the financial system as a bad debt. Additionally, bank balance sheets are largely a function of the regulatory response to the global financial crisis, and are significantly stronger than they were in the period leading up to 2008.

We would argue that while the rapid rise in Treasury yields has caused some short-term losses for the banking industry that are substantive, industry capital levels are better positioned to weather the storm. We also believe the regulatory response from the Fed, the FDIC, and the Treasury Department has been quick, unified, and substantive. The addressing of insured and uninsured depositors at SVB and Signature, as well as the opening of a borrowing window for short-term collateralized funding available at very attractive interest rates and terms should head off any concerns around systemic risk of a collective “run on the bank” moment.

Investment Implications

First, let’s cover portfolio exposure to SVB. This stock was listed on the Nasdaq stock exchange and thus was held by many investors. Some indirect exposure is therefore likely for investors that hold a diverse portfolio using mutual funds or exchange-traded funds. In the case of Morningstar’s managed portfolio range, we expect the maximum exposure to be less than 0.5%, often far less, depending on the strategy used.

Regarding knock-on effects, in the short term, we would not be surprised to see market volatility remain elevated, reflecting the increased uncertainty around potential outcomes. In particular, the financial services sector, most notably regional banks, could remain under strain for some time. However, as long-term, valuation-driven, fundamental, and wisely contrarian investors, this type of setup is one that we would use to begin searching for opportunities. We would look for our valuation work, coupled with our assessment of fundamental risk and investor expectations, to be our guide in determining whether, when, and by how much to increase our investment in the banking industry, as well as other sectors that could be affected.

We currently have a balanced viewpoint of U.S. financials, with a “medium” conviction rating assigned. From a valuation perspective, the sector looks relatively cheap (the second cheapest, behind communication services) but recent events have increased uncertainty, so careful portfolio construction is warranted. One issue is that the earnings can be quite volatile and cyclical, but bargain prices can present themselves as investors flee from uncertainty. Armed with research, we stand ready to adapt, and will monitor both the opportunities and risks very closely.

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