Silicon Valley Bust

Especially from the Credit Bubble perspective, it was a troubling week. A more hawkish Fed Chair in the face of escalating systemic risk. Two bank failures, including a spectacular bank run dooming an institution with assets exceeding $200 billion – the largest failure since Washington Mutual’s September 2008 collapse – and the second largest in U.S. history. There was also this week confirmation of slowing system Credit growth. And from a global perspective, Xi Jinping directly blamed the U.S. for China’s problems.

History doesn’t repeat itself, but it rhymes. Silicon Valley Bank (SVB) is not Lehman Brothers, but we can make uncomfortable comparisons. Both failed institutions were central players in their respective Bubbles. Lehman was a key player in risky mortgage loans, while SVB is the dominant financier for Silicon Valley startups. Lehman fatefully compounded its risk profile by aggressively leveraging a portfolio of high-risk securitizations. SVB ended 2022 with a $120 billion securities portfolio, the vast majority mortgage securities (MBS and CMOs). Lehman falling into distress had a major negative impact on the underlying securities on its balance sheet. SVB’s spectacular collapse will have a major negative impact on its $74 billion loan portfolio. Lehman’s collapse unleashed “the great financial crisis.”

March 10 – Bloomberg (Lynn Doan, Hannah Miller and Katie Roof): “Startup founders are beginning to worry about whether they’ll be able to keep paying employees following the failure of Silicon Valley Bank. Payroll service provider Rippling notified customers on Friday that some payroll processing had stalled because SVB helped process its payments. The company, a startup itself, switched to JPMorgan Chase, but not soon enough: Paychecks were already ‘in flight’ with SVB and have yet to be paid out — and the firm is still trying to understand what the bank’s collapse on Friday will mean for them… Startup founder Brad Hargreaves said some firms may not be able to make payroll next week. And because boards are incredibly sensitive to employing workers they can’t pay, he said, ‘Expect mass layoffs later today, Monday at latest…’ More than half of tech companies ‘keep the lion’s share of their cash at SVB,’ said Greg Martin, founding partner of the investment firm Liquid Stock. ‘They all need to make payroll early next week.’”

A tangled web… Apparently, SVB startup borrowers were required to keep their cash deposited at SVB. By their nature, startups generally operate negative cash-flow operations. If they lose access to new cash, they’re in trouble. While finance tightened markedly last year, SVB still expanded its loan portfolio at a double-digit (12%) rate. Now scores of companies that require new financings to survive have in 48 hours lost their key lender, along with access to their cash.

How could it have ever made sense to run a risky startup loan portfolio simultaneously with a huge portfolio of risky mortgage securities? Because it worked miraculously during a protracted cycle of zero interest-rates, a surefire Fed liquidity backstop, bubbling market and venture capital environments, and generally ultra-loose “money”.

This one will not be easy to explain. With assets below $250 billion, SVB was able to avoid the more onerous post-GFC regulatory regime for systemically important financial institutions. At least that’s the excuse we’ll hear. Unfortunately, bank regulators for way too long looked the other way. Worse yet, the Federal Home Loan Bank advanced SVB $15 billion last year, a liquidity backstop that surely contributed to complacency and deeply flawed risk management.

The Fed’s Q4 Z.1 “flow of funds” Credit report was released Thursday. The data help provide some clarity on today’s most unusual backdrop. I’ll attempt to interweave the Z.1 with the mounting systemic risk illuminated late this week with SVB’s crisis.

Importantly, Credit growth slowed markedly during Q4. And while booming markets surely spurred a Q1 pickup in Credit in some areas, the underlying backdrop is one of a faltering Credit Bubble.

Non-Financial Debt (NFD) growth slowed to a 3.00% pace in Q4, the slowest rate since Q1 2017. Household Mortgage Debt growth slowed to 4.39% (from Q3’s 6.66%), while non-mortgage consumer debt growth increased to 6.96%. Growth in Total Business Borrowings dropped to 2.16% from Q3’s 4.00%, the weakest expansion since Q3 2020. In what will surely reverse soon, federal debt growth slowed to a five-quarter low 3.98% annual growth rate.

And while system Credit growth slowed, cooling had yet to materialize in bank lending data. Bank Loans expanded $361 billion, or 10.5% annualized, during Q4 to a record $14.054 TN. This pushed 2022 Loan growth to an annual record $1.424 TN, or 11.3%. Bank Mortgage lending slowed to a still robust $142 billion, or 9.0%. At $541 billion, 2022 growth in Bank Mortgages was the strongest since 2004. Bank Consumer loans expanded $87 billion, or 13.5% annualized, boosting 2022 growth to a record $303 billion, or 12.8%. Q4 business “not elsewhere classified” Loans rose $131 billion, or 11.0%, to an annual record $584 billion, or 13.6%.

Curiously, Financial Sector borrowings expanded at a 10.0% pace during Q4, up from Q3’s 6.71% and Q4 2021’s 6.25%. GSE (government-sponsored enterprises) Assets expanded $241 billion, or 10.7% annualized, during Q4, to a record $9.224 TN. Last year’s record growth of $921 billion, or 11.1%, exceeded previous record 2020 by 54%. The pre-pandemic record was $301 billion set in 2007. Over 12 quarters, GSE assets surged $2.094 TN, or 29.4%.

In my analysis of the Q3 Z.1, underscoring the rapid expansion of GSE assets, I asked “Why?” Clearly, there has been a major push to sustain a historic lending boom. FHLB advances/loans expanded $163 billion during Q4 (100% annualized!) to a record $824 billion, the strongest quarterly growth since the Q3 2007 subprime blowup. For 2022, FHLB Loans surged an unprecedented $477 billion, or 138%, more than double the previous record set in 2007 ($226bn). This is crazy-time late-cycle growth by a highly levered institution in a rising rate and faltering Bubble backdrop.

From the Federal Home Loan Bank of San Francisco’s February 22nd press release: “At December 31, 2022, total assets were $121.1 billion, an increase of $67.0 billion from $54.1 billion at December 31, 2021. Advances increased to $89.4 billion at December 31, 2022, from $17.0 billion at December 31, 2021, an increase of $72.4 billion, as member demand for primarily short-term advances increased.”

I’ll assume the San Francisco FHLB advanced the $15 billion to SVB last year. It’s worth noting that this institution has “Total Capital” of $7.7 billion to support its Advances of $89.4 billion and Investments of $30.3 billion.

The combined FHLB system ended the year with Total Assets of $1.247 TN, having expanded $524 billion, or 72% over the previous 12 months. Total Capital ended September at $67.8 billion. A Friday evening Bloomberg headline: “White House Offers Assurances on Banks, Says 2008 Lesson Learned.” We clearly didn’t learn the right lessons from the bursting mortgage finance Bubble crisis. Unfortunately, another learning opportunity beckons.

Regional bank stocks came under heavy selling pressure this week. I’ll assume the SVB fiasco proves an inflection point for egregious FHLB growth, lending that has surely provided major support for the historic late-cycle bank lending boom. With system Credit growth already weakened, the financial system fragile, and the economy highly vulnerable, a tightening of bank lending will have major ramifications.

There is every reason to expect an especially brutal downside to this historic Credit cycle. Many will ask how trouble at a regional lender could rock global bank stocks and markets more generally. Well, a tightening of financial conditions in the U.S. banking system at this stage of the cycle will unleash powerful down-cycle dynamics – at home and abroad.

Bank of America CDS surged 11 bps Friday (to 86bps), the largest daily gain since March 20, 2020. The 17 bps jump for the week was the biggest since June 2020. Citigroup’s 8.4 bps Friday CDS increase was the largest since June 2022, with the 16.5 bps gain for the week the biggest since last September. Morgan Stanley’s 18.8 bps Friday CDS surge was the largest since March 18th, 2020, with the 28.3 bps gain for the week the biggest since the panic week March 20, 2020. JPMorgan’s 13.4 bps gain for the week was the largest since September 2022.

The KBW Bank Index sank 15.7% this week, the largest weekly decline since the 18.8% drop during covid panic week March 20, 2020. The Nasdaq Bank Index dropped 16.1%, and the NYSE Financials Index this week fell 7.5%. The Broker/Dealer Index (XBD) lost 9.3%. The European STOXX 600 Bank Index dropped 5.0%, and the Hang Seng China Financials Index fell 5.1%.

High-yield CDS jumped 23 bps Thursday, the largest daily increase since December (up another 19bps Friday). The 65 bps gain for the week was the largest since June 2020. Investment-grade CDS rose 12 bps this week, the biggest gain since September.

Rate markets believe SVB will have a significant influence on the Federal Reserve’s tightening cycle. Two-year Treasury yields traded up to 5.07% in Wednesday trading, the high since 2007. Two-year yields then reversed 48 bps lower to end the week at 4.59%. Market expectations for (what was “peak”) Fed funds at the September 20th FOMC meeting touched 5.70% late Wednesday, before reversing sharply lower to end the week at 5.18%. The probability of a 50 bps rate hike during the March 22nd FOMC meeting dropped from about 70% Wednesday to 33% to close the week.

March 10 – Bloomberg (Paige Smith): “The ripple effects of one of the biggest US bank runs in over a decade are reaching a wide variety of businesses, as companies from startups to vineyard owners raise alarms. Silicon Valley Bank, once a darling of the California financial system, fell swiftly on Friday, a day after investors and depositors tried to make $42 billion in withdrawals. Roku Inc., LendingClub Corp. and Eiger BioPharmaceuticals Inc. were among dozens of companies that revealed they have deposits stuck at the bank. The stranded funds show that SVB’s troubles are spreading throughout the Silicon Valley ecosystem and pose a risk to the economy at large.”

March 10 – Bloomberg (John Gittelsohn, Margi Murphy and Hannah Miller): “The shocking collapse of Silicon Valley Bank rippled across California Friday to industries far beyond the technology community that it played a major role in shaping. From wealthy founders to Napa vineyard owners, clients were scrambling to secure funds or find out basic information about what would happen to their deposits. Anxious customers formed lines outside branches across the Bay Area and fears grew that some companies will struggle to make payroll next week. The sudden implosion… delivered a deep blow to a Silicon Valley ecosystem already struggling with a rapid tech downturn, thousands of layoffs and the lingering economic effects of the Covid-19 pandemic. In a region that exploded over the past decade to generate massive wealth and become an engine of economic growth, the bank had extensive and far-ranging roots. ‘The reach into Silicon Valley is at the high level,’ said Louis Lehot, a partner at Foley & Lardner, a law firm that advises startups and public companies, who said thousands of bank clients will be affected. ‘It’s deep and broad at all levels of the ecosystem from big companies to startups to VCs, private equity firms and everything in between.’”

Friday’s intensely anticipated payrolls data – stronger-than-expected 311,000 jobs added, though the 0.2% gain in Average Weekly Earnings and the 0.2 increase to a 3.6% unemployment rate were on the weaker side – were completely overshadowed by SVB. And suddenly next week’s inflation data hardly seem life and death.

Early in the year, I posited that the big squeeze and resulting loosening of financial conditions would on the margin bolster lending and system Credit growth, somewhat extending the cycle. Post-SVB, I’m adjusting the analysis. I now see a market “risk off” tightening of conditions, coupled with a tightening of bank lending, inducing a problematic Credit slowdown. At this point, I don’t see a Lehman-style crisis of confidence in the “repo” market and seizing up of money and debt markets. But for scores of startups and negative cash-flow enterprises, the unfolding tightening of lending poses an existential threat. Contagion effects will be far-reaching, including residential and commercial real estate markets.  There will be greater concern for uninsured deposits throughout the banking system.

The Fed now faces the predicament that has been galvanizing for the past year. It’s got a serious inflation problem, along with acute system fragility. Further tightening risks pushing the markets and economy over the proverbial cliff. Not tightening, with bond yields sinking in anticipation of rate cuts and more QE, risks underpinning inflationary pressures. Markets are now pricing in 40 bps of rate cuts between June and December FOMC meetings. Months of “risk on” have exacerbated fragilities.

For months, markets have been sniffing out an accident. It’s anything but clear how this all plays out. But SVB sure appears to be the start of a gigantic multi-vehicle pileup.

Meanwhile, I found this week’s comments from Xi Jinping and his new foreign minister alarming. It appears consistent with a major shift in strategy. I had assumed Beijing’s decision to play nice in the sandbox was a temporary measure seen as constructive for their focus on stabilizing the deflating Chinese economic Bubble. The U.S. wasn’t willing to play along, and now Beijing will play hardball.

Xi Jinping: “Western countries, led by the United States, have implemented all-round containment, encirclement and suppression against us, bringing unprecedentedly severe challenges to our country’s development.”

I’ve feared that when China’s Bubble inevitably collapsed, Beijing would blame the U.S. and its old nemesis Japan. Now Xi is finger-pointing directly at the U.S., as state media aggressively disseminate Cold War anti-American propaganda. It appears Xi is preparing the Chinese people for eventual conflict.

Foreign Minister Qin Gang: “If the United States does not hit the brake, but continues to speed down the wrong path, no amount of guardrails can prevent derailing and there surely will be conflict and confrontation. Such competition is a reckless gamble, with the stakes being the fundamental interests of the two peoples and even the future of humanity.”

Interjecting “even the future of humanity” strikes me as too close to Putin-style nuclear threats.

March 7 – Washington Post (Christian Shepherd): “China and the United States are careering toward an inevitable collision, Foreign Minister Qin Gang said Tuesday, a day after Chinese leader Xi Jinping made a rare direct accusation that Washington was trying to contain China. Together, the statements underscore the dire state of bilateral ties between the world’s two biggest economies, a month since a rogue balloon brought a sudden and surprising end to efforts to ‘put a floor’ under the relationship. In a news conference on the sidelines of the National People’s Congress, Qin, who was previously Beijing’s ambassador in Washington but became foreign minister in December, deployed a range of often colorful — and occasionally off-color — metaphors to describe the severity of tensions.”

Week by week, Beijing (now Foreign Minister Qin Gang) is increasingly sounding like Moscow.

March 7 – Bloomberg: “The US Indo-Pacific strategy, which purportedly aims at upholding freedom and openness, maintaining security and promoting prosperity in the region, is in fact an attempt to gang up to form exclusive blocs to provoke confrontation by plotting an Asia-Pacific version of NATO…”

March 7 – Financial Times: “‘Why talk big about respecting sovereignty and territorial integrity on the Ukraine question but then not respect the sovereignty and territorial integrity in the question of China’s Taiwan?’ he said. ‘Why on the one hand demand China not provide weapons to Russia, but on the other hand sell weapons to Taiwan in long-term violation of [joint communiqués]?’ In a snub of Washington’s warnings not to provide weapons or munitions to Moscow, Qin praised China’s close partnership with Russia for blazing a trail of trust between major powers and creating a ‘model’ for international relations. ‘With China and Russia joining hands, the move towards a multipolar world and more democratic international system has gained momentum and global strategic balance and stability have gained a guarantor,’ Qin said. ‘The more turbulent the world is, the more China-Russia relations should keep moving forward.’”

A collapsing Bubble fixing Beijing’s sights on Taiwan. It’s a scenario I’ve feared for years. I just never imagined China and Russia as “partners without limits” in a fragmenting world of economic and military alliances. As I wrote to begin this analysis, a troubling week.

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Categories: Doug Noland