Volatility in the Banking sector - Evermay’s view

Dear Clients,

As events in the banking industry continue to unfold, and with growing uncertainty about the banking sector leading to higher volatility for both stock and bond markets, we want to take this opportunity to briefly discuss what has been happening and, importantly, review how client portfolios are positioned here at Evermay.

While some of the news is unique to a handful of banks with atypical business models, (e.g., Silvergate Bank and its exposure to players in the cryptocurrency industry, and Credit Suisse which has long had a reputation as one of the most risk-taking of Wall Street banks), the broader issues which have plagued the banking industry are, in many ways, side effects of the Federal Reserve’s ongoing efforts to quash inflation by raising interest rates.

We have discussed the Fed’s policies before, especially with respect to our clients’ bond holdings which we position to be lower risk and have lower but more steady returns than investments in stocks. In anticipation of the Fed’s moves, we have invested primarily in short-term bonds that are less sensitive to price fluctuations when rates rise, and which enable our clients to benefit from those higher rates when their short-term bonds mature. In addition, we have invested in U.S. Treasuries, considered to be the least risky of all global assets, as we were aware that the possible extent of contractionary monetary policy could pose unpredictable risks to the financial system.

With the latest inflation numbers still well above recent historical averages, and nowhere near the Fed’s 2% target level, the Fed has threatened to keep lifting short-term rates beyond levels deemed likely – even by their own prognosticators – only months ago. And that had been a problem for many banks.

The banking business is relatively simple to understand. One takes in money (deposits) and invests it at higher rates (loans.) A portion of the deposit base is also invested in other assets, namely bonds, which is necessary for the banks to maintain healthy capital levels. When interest rates are steady, those bonds hold their value. But when rates rise as they have, those bonds decline in value. If they decline enough, the bank’s capital position becomes increasingly tenuous.

A perfect storm hit one bank in particular, Silicon Valley Bank (SVB), which was uniquely risky in the banking system. 97% of deposits were uninsured and their customers were well connected to one another, putting the deposits at greater risk. SVB had chosen to invest deposits in longer term assets including mortgage bonds. While not at great risk of default, these were at high risk of their market values falling and being insufficient to meet significant withdrawals. The bank took this strategy despite both internal and external recommendations, and the final attempt to raise money to address its shortfalls was not successful. Bank management and shareholders were wiped out.

An important point to keep in mind: not all banks are built the same. Since the mortgage crisis of 2008-9, the biggest US banks in particular have had much more stringent regulatory capital requirements, making it far less likely that current events will lead to a systemic shock. Much of the elevated scrutiny over the past couple of weeks has been on the regional banking sector where capital requirements are less robust. Evermay’s managed portfolios have limited exposure to this sector and we will continue to monitor markets and events closely.

Also important: Since the bailout of SVB depositors, the Fed has created a new facility, the Bank Term Funding Program, which allows banks to borrow against the full value of assets that are currently held at a loss. Had this been in place previously, Silicon Valley Bank would likely have been able to meet its withdrawal requests.

We further want to assure you of our confidence in our custodial relationship with Charles Schwab & Co., and the affiliated Charles Schwab Bank which holds the actual cash in Schwab’s brokerage accounts. It is worth noting that cash deposits with Charles Schwab Bank are FDIC insured up to the $250,000 federal limit. (Cash deposits are distinct from “cash equivalent” investments such as money market funds which are not held at the bank.) Indeed, in most cases as noted above, we have proactively invested excess cash in US Treasuries or a Treasury-focused money market fund as a prudent move in the current environment.

As always, we welcome your questions and encourage you reach out to your Evermay advisor at any time. 

 

Mitchel B. Schlesinger, CFA
Chief Investment Strategist
Senior Portfolio Manager

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