Expecting the Unexpected
Banking is a very good business unless you do dumb things.Warren Buffett
Unexpected events happen with incredible regularity. The most recent example of this phenomenon was the failure of the 16th largest bank in the U.S. – Silicon Valley Bank (SIVB) – on March 10, 2023, blindsiding many investors. Bank runs of this sort don’t happen oft en, and we certainly don’t remember bank runs being on anyone’s list of most pressing worries for 2023.
What Happened To SIVB?
Everything at Silicon Valley Bank seemed fine until, of course, it wasn’t. Ernest Hemingway’s quote perfectly encapsulates what happened: “How did you go bankrupt? Gradually, then suddenly.”
Much has already been written about the SIVB failure, so consider this an over-simplificati on. Silicon Valley Bank saw huge deposit inflows from its customers (mainly venture-backed start-ups) in 2020 and 2021. SIVB’s management invested these deposits in long-term government-backed securities at very low interest rates. In 2022 and 2023, interest rates surged higher, resulting in mark-to-market price declines for these securities.
While this normally wouldn’t be a catastrophic issue, SIVB’s depositors were unique in that they were highly concentrated in one industry/geography and had large amounts of uninsured deposits (above the FDIC limits). All of a sudden, depositors lost faith in SIVB’s financial position and all ran for the exit at the same time, withdrawing large amounts of money. The bank’s swift failure was due to a classic bank run.
Silicon Valley Bank’s management team deserves most of the blame due to an egregious error in risk management – loading SIVB’s balance sheet with long-dated government securities at ultra-low interest rates. While these securities have no credit risk, this balance sheet structure exposed the bank to substantial losses if interest rates were to rise rapidly, also known as interest rate risk.
2023 Is Not 2008
These events immediately brought comparisons to the 2007-2009 Global Financial Crisis (GFC). On the surface, this makes sense. The GFC was relatively recent, centered around large bank failures, and left many deep and long-lasting scars in investors’ memories. For many, there is a sense of “here we go again!”
However, the banking events of 2023 bear virtually no resemblance to the GFC. There are no toxic loans or impossible-to-understand financial instruments hiding on bank balance sheets this time around. So far, the banks that failed simply made horrible risk management decisions, putting short-term earnings ahead of long-term solvency. Additionally, their concentrated depositor base with large amounts of uninsured deposits made them especially vulnerable to a crisis of confidence. These unique characteristics are not widespread across most banks.
The big question that lingers is this: Will 2023’s bank crisis create contagion across the rest of the financial sector and the broader economy, creating substantial systemic risk? At this point, nobody truly knows the answer to this. However, the uniqueness of each of the recent bank failures makes this possibility seem unlikely. Overall, the U.S. banking industry is in much better shape today than in the years prior to the GFC.
The Importance Of Management
The banking business is based on trust. Depositors must have confidence that the bank holding their money is financially sound. Once this trust is broken, even a small crack, an unraveling can happen swiftly. This is why risk management is the number one most critical aspect to the long-term success of a bank. The CEO is the ultimate steward of risk management, which is why evaluating a bank’s management team is of utmost importance prior to purchasing shares (or potentially even making a deposit).
Risk in banking can come in many different shapes and sizes – credit risk, interest rate or duration risk, concentration in funding sources, concentration in geographies or industries, among many others. As investors, we must always consider these risks as well as the risk-taking culture of the firm. Risk can never be eliminated, but banks with a culture of transparent risk management and mitigation will stand a much better chance of avoiding the major potholes that will inevitably arise over time.
Who’s Swimming Naked?
Across all industries, we at Baird Trust look to invest in companies with managers who think and act like Chief Risk Officers. We are often reminded of Warren Buffett’s saying, “You only find out who’s swimming naked when the tide goes out.” What he means by this is that in good times, many companies seemingly forget about risk management and instead start taking more aggressive risks in search of higher returns. This embrace of risk often goes unnoticed by much of the investment community. But when an unexpected event happens – a banking crisis, a recession, a pandemic, etc. – those risk management decisions become crystal clear. Those companies that took excess risk are exposed and typically suffer, sometimes catastrophically.
There are all sorts of large long-term risks a company can take in the pursuit of higher near-term earnings. Like SIVB, many companies pander to the short-term nature of Wall Street and follow this strategy. However, this approach is almost always a mistake. A business can only generate attractive long-term cash flows and returns for its owners if it actually survives over the long term. Any decision that puts survival in serious jeopardy is a bad one, even if it takes years for it to become apparent.
In today’s environment of rapidly rising interest rates, we are finding out who has been swimming naked - Silicon Valley Bank, Credit Suisse, Signature Bank, and Silvergate Capital. There may be more failures before the tide has fully receded. However, this is the normal course of capitalism. As Charlie Munger has said, “Capitalism without failure is like religion without hell.”
Risk Management Is Critical
We have written many times about the folly of trying to make predictions about the future, and the SIVB episode simply adds another piece of evidence. Using history as a guide, we must always be prepared for unexpected events that we are not contemplating. While risk always looks obvious in hindsight, it is incredibly difficult to predict when and where it will rear its ugly head next.
We approach this conundrum by ensuring that disciplined risk management is a foundational tenet of our investment process. We try to invest in companies that maniacally prepare for the bad times before they arrive. This means companies with strong competitive advantages, robust positive cash flows through cycles, and low or moderate levels of financial leverage. These companies must have CEOs who are first and foremost risk managers. Their first goal is to put the company into a position to not only survive crises, but also to thrive and grow stronger through them. Finally, we aim to buy stakes in these businesses at prices below what we think they are worth. This creates a margin of safety so that if we are wrong in our assessment, and we will be wrong sometimes, the mistake is unlikely to be a catastrophic one.
Each step in our investment process – business, management, and price – has risk mitigation at its core. We are always thinking about what could go wrong and trying to protect against it as best we can. In other words, we aim to avoid swimming naked because we never know when the tide will go out.
We know that recent events are bringing back tough memories from the Global Financial Crisis for many of you, our valued clients. We understand that this is unpleasant and frightening. But our guiding light is our time-tested investment process, which remains the same today as it has been during all periods of heightened uncertainty over the past 30 years. We may not know exactly how the current financial uncertainty will play out, but we do know we will make it to the other side. Thank you for your unwavering commitment to Baird Trust.
Baird Trust Company (“Baird Trust”), a Kentucky state chartered trust company, is owned by Baird Financial Corporation (“BFC”). It is affiliated with Robert W. Baird & Co. Incorporated (“Baird”), (an SEC-registered broker dealer and investment advisor), and other operating businesses owned by BFC. Past performance is not a predictor of future success. All investing involves the risk of loss and any security may decline in value. This is not intended as a recommendation to buy or sell any security and views expressed may change without notice. Baird Trust does not provide tax or legal advice. This market commentary is not meant to be advice for all investors. Please consult with your Baird Financial Advisor about your own specific financial situation.