The Boot Is On The Other Foot

Reflecting on the Kami-Kwasi Budget

In September of 2022, the UK sovereign bond markets, or gilts, suffered a dramatic collapse in prices when two-way liquidity in this large and important market dried up. As the then short-lived British prime minister, Liz Truss, and her finance minister announced plans to stimulate growth by a sharp reduction in overall tax rates at a time when inflation was soaring and the nation’s debt levels were sharply rising, so the external value of the pound sterling went into dramatic decline. At the same time, the prices of gilts melted away, as did market participants. There was a notable absence of buyers to meet wave upon wave of forced sellers.

Behind these sellers were primarily liability-driven derivative insurance programmes subjected to margin calls by their brokers and banks to counteract the sharp drop in gilt prices. To meet margin calls on their derivatives, these institutions were obliged to sell ever-more gilts, thus exacerbating the acute liquidity crisis. In the end, the Bank of   England stepped in as buyer and market-maker of last resort, but at a time when the Bank’s monetary policy was aimed at increasing interest rates and tightening liquidity in financial markets. The sudden bout of contrarian quantitative easing in such an important market segment during a time of rising inflation caused eyebrows to be raised in consternation across the world.

Collapse and Contagion in the US

Six months later, the collapse in the US of Silicon Valley Bank (SVB), Signature Bank and First Republic Bank (FRB) during the month under review has been no less dramatic. Much uncertainty remains with the stress spreading to other regional institutions such as Keycorp, Comerica, Zions Bancorp and Truist Financial, all for similar reasons. And there are others. The ramifications of the failure of SVB, the US’s sixteenth largest bank, at a time of Federal Reserve hawkishness have reverberated across financial markets and the banking industry around the world. It soon became clear that SVB’s balance sheet and interest risk management was far from optimal and that the bank had re-invested massive amounts of their customers’ deposits in various types of fixed-income securities, of which US treasuries with long maturities formed the core. As so often in the field of banking, the institution had borrowed from its depositors on a short-term basis while reinvesting these deposits in long-term maturities. During periods of normal yield curves in which longer-term risk was rewarded by a higher coupon than short-term investments, borrowing short and lending long would have been common practice. However, when yield curves invert, and severely, as is the case under current market conditions, this strategy breaks down. The sharp drawdown in government bond prices eventually caught up with SVB as well as with their depositors. The bank’s last-minute attempts to shore up its balance sheet through a hastily arranged and ultimately failed capital increase was too late to prevent a run on SVB. The magnitude of the withdrawal of their deposits by the bank’s main customers was at the time reported as US$ 42 billion by Forbes magazine and this left the bank with a negative liquidity position. A staggering 25 per cent of deposits were withdrawn in short order.

Furthermore, the bank’s CEO and much of its senior management exercised their share options and sold their shares in the runup to the bank’s failure. That SVB operated in the niche area of tech start-ups and venture capital businesses makes it impossible to conclude that this is a one-off and standalone crisis. It is more than that. As the First Republic Bank collapsed, a cohort of mainstream US institutions collectively placed around $30 billion of fresh deposits into FRB. Yet, in spite of this, the share price of the bank continued to plunge after the announcement.

The crisis spread. The result was heavy pressure on the share prices of international banks across the world, even in some regions, such as Europe, where the banks remain well-capitalised following various stress tests undergone since the global financial crisis of 2008. Fingers of blame are pointed at the Federal Reserve as observers wonder whether the central bank was asleep at the wheel whilst the SVB problems grew during the past months, apparently unnoticed or unattended to. The hawkish rhetoric of Federal Reserve Chairman Jerome Powell as little as 48 hours before the SVB debacle exploded raises legitimate questions of why such rhetoric could be used moments before such an important bank failure.

This said, some of the Dodd-Frank reforms introduced after the global financial crisis in 2008 were rolled back by President Donald Trump, thereby exempting smaller banks from some of the tougher liquidity requirements their larger brethren needed to abide by. Now, the usual progressive US politicians are demanding that these tougher liquidity requirements be re-instated for smaller banks. (It is the progressives moment in the sun). This is happening at the same time as countless bank depositors are switching their savings into money market funds which play little or no role in credit creation. Although a large amount of such money market funds end up investing in US treasuries, the bond market reaction, in pushing down yields, would indicate that this trend, if it persists, would be as deflationary as the liquidation of a number of important US banks.

Interest Rate Aftershocks

Crucially, however, and contrary to what happened in the gilts debacle of last year, bond prices across mature world markets have surged because of the SVB demise. This was admittedly due, in part, to the massive covering of the generally popular short positions by hedge funds. Although moves of this size are frequently the result of technicalities before signalling fundamental shifts in financial markets, it is nonetheless noteworthy how the reaction by the US bond market was the opposite of what happened during the sterling and gilt crisis of last year.

This begs the legitimate and fundamental question of why bond prices in the UK were battered last year while US bond prices exploded after the SBV failure in a move reminiscent of the aftermath of Black Monday, the day when the US stock markets declined by 20 per cent in one session in 1987. Covering short positions and reinvesting the proceeds in perceived safe havens is the behaviour by punters that generally accompanies debacles of these kinds. And the fact that price volatility spikes as liquidity problems mount in such conditions is de rigueur.

But there is a difference between now and the fall of 2022. Back then, inflation rates and their expectations, as well as interest rate expectations, were firmly on the rise, as were world bond yields. Central banks were often perceived as “behind the curve”, resulting in hawkish tones by both the Federal Reserve and the European Central Bank. Yet, since that time, more than a dozen central banks across the world, some of them from large nations, have begun a process of monetary easing as inflation numbers, still too high, seem to have changed their trajectory. Despite ongoing hawkishness in leading central bank rhetoric, a growing number of commentators hold the view that the end of monetary tightening is in sight.

It is obvious that the magnitude of past interest rate increases introduced by central banks would indicate that most of the tightening is behind us, even if the full effects are still to be felt around the world economy. It is also well-established by statistics that stock markets look across the valley and “anticipate” what lies ahead. If inflation subsides; if economic growth falters; if corporate earnings are revised downwards by both the investment community and businesses themselves; and if tensions simmer in the interbank sphere, as well as other factors, the conclusion would indicate that the trajectory for interest rates and bond yields will be different from the past eighteen months, potentially markedly so.

If that is indeed the case, as time will tell, the behaviour of stock and bond markets in the SVB debacle cannot be compared to the gilts and sterling crisis that surrounded the liability-driven meltdown that took place in the UK last September. While many banking and financial shares have been hit at this time, and spectacularly so, share prices of longer-duration businesses such as quality growth companies have been positively affected by the extraordinary turnaround in bond markets, especially at the inflation-sensitive short end, that has collapsed yields across all markets and maturities, but also at the longer end.

Swiss-temic Failure and the Breakdown of Trust

And then there is the crisis surrounding Credit Suisse. The traditionally most venerable of Swiss banks has been grappling with scandals and mismanagement for years. Top    managers came and went frequently. The current CEO and the bank’s chairman are relatively new in office. Massive losses in 2022 wiped out any profits made in the previous decade.

As the US banks’ debacle took place at a time when bank share prices were heavily under pressure across the globe, the share price of Credit Suisse was in a freefall, reflecting, among other things, the sharp outflow from professional depositors (compared with non-professional retail depositors who are usually slower to grasp the simple fact that making a deposit means lending the bank your money). Even the bank’s own staff have lost confidence and withdrawn their deposits.

Despite years of scandal relating to Greensill, Archegos and others, Credit Suisse’s   risk-adjusted balance sheet, as measured by its Liquidity Coverage Ratio, its Basel III ratio or its Leverage Ratio all seemed in good health although question marks remain over what “risk-adjusted” may mean in today’s environment. Credit Suisse’s funding agreement of 50 billion Swiss Francs with the Swiss National Bank was, strictly speaking, both huge and more than necessary. And the use Credit Suisse was putting to these liquidity injections would have included the repurchase of its publicly-traded bonds, now heavily discounted to their par value. Nonetheless, short-selling of the bank’s shares has continued remorselessly.

All this means that what is in short supply, not only with Credit Suisse but within the banking industry as a whole, is trust. When a bank is tainted by scandal after scandal, the time eventually comes when something snaps and confidence melts away. Credit Suisse’s bonds are in “distressed” territory following the inevitable downgrade by ratings agencies.

Finally and after a frenetic weekend of negotiations between government, Finma the Swiss regulator, the Swiss National Bank, as well as others, Union Bank of Switzerland, or UBS, the largest Swiss bank, agreed to take over Credit Suisse for a heavily-discounted price, compared with that quoted on the stock exchange. UBS offered an all-share deal to Credit Suisse shareholders.

However, and in a controversial move that caused howls of protest, so-called AT1 bondholders, otherwise known as holders of Coco bonds, were swiftly disenfranchised from the legal position whereby bondholders rank higher than shareholders. Such bondholders have been wiped out and it is expected that this large market will dry up despite such instruments being created in the aftermath of the 2008 global financial  crisis. These AT1 bonds were designed as a solution to the problem of undercapitalisation of international banks, even if such instruments were popular in Europe rather than in the US.

The takeover of Credit Suisse by UBS, enforced by the Swiss government on an unwilling buyer, has transformed UBS into a de-facto Swiss state bank, not only too big to fail. In future, the state will be heavy-handed in leaning on the bank’s management in decisions that range from growth strategy to board appointments to remuneration policy and beyond. That is the price UBS was forced to pay after it, too, was saved by the state in 2008.

Conclusion

Rumours, noise and signals are bound to continue in the weeks and months ahead. But what happens behind the scenes and under the radar screen is likely more important than anything else. Interbank arrangements across the frontiers of banking are under review. For example, BNP Paribas prohibited their traders from engaging in derivatives trades with Credit Suisse. Although this is clearly one of many such examples, Credit Suisse was a major international player in derivatives trading through its US subsidiary. All this reduction of activity behind the scenes will make the outlook for inflation more benign and for economic growth more malign.

What is and has always been clear is that banks can never form part of a pure quality growth investment universe or feature in such a portfolio. By definition, none of the Ten Golden Rules of quality growth investing can apply to the banking industry. Although many banks are run by competent managers and make adequate and sometimes growing profits, they are ultimately the victims of the price of money, over which they have no control. It follows that no reliable forecasting of future growth and profits is possible. Nonetheless, quality growth investors need to keep a wary eye on the banking industry as well as bond markets. 

These two areas are closely related and their influence on stock markets is material.

In short, as Wall Street suffered sharp drawdowns in stock and bond markets in 2022 at a time when Main Street was still enjoying economic expansion, it is probable that the tables have turned. The potential for economic recession as well as for a simultaneous rally in financial markets has risen in tandem as the outlook for interest rates and inflation has undergone a fundamental change.

For now, the boot is on the other foot.

P. Seilern

22nd March, 2023

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