From an email sent to IIM investors on March 21, 2023…
The banking crisis that began in the U.S. spread to Europe late last week. Concerns over the solvency of Credit Suisse, Switzerland’s second largest “global systemically important bank” (G-SIB), were due in no small part to recent runs on U.S. banks. What made Credit Suisse particularly vulnerable was that it had been plagued by reputational and financial difficulties over the past decade – including issues with financial reporting, exposure to the failed companies Archegos and Greensill, and a criminal conviction over money laundering, among other things.
On Sunday, UBS agreed to buy Credit Suisse in a $3 billion deal brokered by regulators, reminiscent of JPMorgan’s takeover of Bear Stearns in 2008. The situation is still evolving and, in the U.S., regulators continue to monitor banks for signs of contagion.
These banking system concerns add to the long list of challenges investors have faced the past few years. Over just the past 12 months, we’ve seen inflation, Fed rate hikes, Russia’s invasion of Ukraine, and a bear market. In 2021, many were concerned over the sustainability of the economic recovery and excessive stock market valuations. In 2020, the pandemic and nationwide shutdowns threatened the economic and financial system, in addition to public health.
Many of these events occurred seemingly out of left field, catching investors off guard – in both stock and bond markets. Below you can see the impact of recent bond market distress represented by the normally stable MOVE index – an indicator of Treasury market volatility – on both U.S. and European banks.
Banking system concerns spread to Europe last week
While there are unique circumstances behind the failures of Credit Suisse and Silicon Valley Bank, banking crises are not as unexpected as global pandemics and military invasions. Recent bank failures mirror other collapses over history. The history of financial markets is full of similar incidents that have been well documented in classic books like Manias, Panics, and Crashes by Charles Kindleberger.
One theory is that the common thread in these incidents is the availability of money, the expansion of credit, and the eventual tightening of financial conditions. Like a sugar rush, the supply of credit and the flow of funds through the global financial system can drive asset bubbles, appreciating currencies, and risk-taking in a particular market, asset class, or entire country.
Sooner or later, however, that sugar rush turns into a sugar crash – as returns dwindle, sentiment shifts, and conditions tighten. This not only occurred leading up to the 2008 housing crash and financial crisis, but in numerous other episodes, too – most famously the 1997-1998 Asian currency crisis, when the hedge fund Long-Term Capital Management required a bailout, as well as the savings and loan crises from 1980 to 1994 – when 1,600 U.S. banks failed.
This suggests that while failed banks are not innocent bystanders – they often involve poor risk management and excessive risk-taking – they are also subject to macroeconomic trends just like any other company. When both the supply and demand for money by individuals and businesses is expanding, banks have strong incentives to extend more and more credit. As this compounds, it can lead to asset bubbles in real estate and the stock market, among other areas, which in turn further increases the appetite for credit. Thought that can continue for longer than expected, eventually it grinds to a halt.
Central banks have tightened conditions over the past year
So it is probably little coincidence that this crisis is occurring just as the Fed, the European Central Bank, the Bank of England, and other monetary authorities are removing liquidity from the system today – by shrinking their balance sheets and raising interest rates. On the right side of the chart above you can see the recent rollover in the size of central bank balance sheets across the world over the past year – after numerous years of growth. Coupled with lower asset prices across the broader stock market, the tech sector, and areas like cryptocurrencies, there is historical precedent that those recent declines would increase financial stress.
That does not mean, however, that we will see a repeat of 2008 – when the largest banks were significantly levered up with what were believed to be safe securities – but which really were not safe at all. Today, these banks are much better capitalized and have broader deposit bases. For better or worse, regulators also now have playbooks to be used at the first sign of trouble, as we have seen over the past few weeks.
The nature of this crisis – a lack of confidence – should also in theory be easier to isolate among a relatively small number of banks than back in 2008, which featured broader, systemic risk. The most prominent issue banks have faced over the past year is one of rising interest rates and falling bond prices leading to dramatic declines in the market value of assets held by banks. This specifically led to liquidity and solvency problems for Silicon Valley Bank as deposits were pulled – due to a sudden lack of confidence in the bank.
However, context is important. Specifically, the asset side of most bank balance sheets remains in good health. As a percentage of total loans, non-current loan balances held by banks are near historical lows – and could deteriorate modestly further without a significant impact on bank capital. In addition, nearly half of the value of U.S. bank deposits is already insured.
So, while unrealized losses at banks are noteworthy, it’s also important to understand they are due entirely to an increase in interest rates, not a significant deterioration in credit quality – like in 2008. Furthermore, U.S. banks do not currently have an uncomfortably high uninsured deposit ratio, nor unrealized losses on Held To Maturity securities in excess of capital. And in the event of a bank’s need to raise cash, a new Fed facility is also now at the ready, which will minimize the need for banks to realize further Held To Maturity losses.
To be clear – this does not mean the crisis is over. But it might mean we are through the worst of it.
Towards that end, rating agency S&P Global put out a report last week on banks, noting that they “view the risks from unrealized losses as manageable” and that “most banks have the capacity to hold their (non-trading) fair-valued assets to maturity, and in doing so neutralize the impact of unrealized losses over time.” That’s a key distinction that in my opinion has gone missing in too many of the more hyperbolic media reports of late.
Waiting for market pullbacks often results in missed opportunities
For long-term investors, all this underscores the value in staying patient. The S&P 500 continues to trade at a relatively attractive valuation – at least compared to recent years – and interest rates have been notably more stable. Mixed stock-and-bond portfolios have already performed better this year, preserving capital and benefiting from stronger bond performance.
The irony is that some investors are always waiting for an opportune time to invest in the market. However, when markets do temporarily fall, these same investors may be hesitant to take advantage, since markets usually pull back for a good though temporary reason. What inevitably happens is that investors miss these opportunities before markets recover, forcing them to wait for the next pullback.
History shows that it’s better to simply stay invested. The accompanying chart shows the effect of waiting for different sized one-day pullbacks. For instance, an investor that waits for a 3% pullback would have to wait 68 trading days on average, missing a 2.3% gain that would have been achieved if they simply invested and held on. These historical returns are even larger for bigger pullbacks, since markets tend to rise over time.
Additionally, investing does not need to be all-or-nothing. Even beginning with a strategy like dollar-cost averaging can help investors take advantage of attractive valuations while spreading risk over time. So, while the past is no guarantee of the future, history is pretty clear on how investors should take advantage of market environments like the current one.
The bottom line?
This current banking crisis is still evolving – but is already quite different from 2008. Remaining patient and taking advantage of attractive opportunities is still the best way to achieve long-term financial goals.
Please let me know if you have any questions.