Moral Hazard

It is ironic that investors’ first port of call for their savings in times of crises is the bank. Banks operate on very tight margins so they need to leverage up to make a decent return. However, this means a modest decline in asset prices can wipe out a bank’s equity making it insolvent.

No bank has enough readily accessible cash to pay back all their depositors and since depositors put money into banks in pursuit of safety and liquidity, in return for a low return, faith in the bank’s ability to meet withdrawals is paramount. It only takes fear and sentiment for depositors to cause a run-on a bank’s assets to exacerbate an already precarious position even if that bank is not insolvent. Easier now with the immediate power of social media to heighten and spread hysteria. Gone are the days when nervous savers queued down the street to access their money; now they just click on their banking app to do so.

A day does not go by without news of another bank failure, mainly in the form of regional US banks. It is important to recognise that this crisis is far removed from the Global Financial crisis of 2007/08 or the “Credit Crunch” as it was then known.

Back then banks forced massive amounts of money into the mortgage market and offered it to subprime borrowers who did not have to disclose their ability to repay those mortgages.  They did not anticipate that the lowering of lending standards could precipitate massive numbers of mortgage defaults and ignored the fragility of the structures securities built out of those mortgages.

Today the current bank failings are largely due to mismanagement. Too much money was lent to a single concentrated sector, tech start-ups and the huge sums of capital subsequently deposited by said startups, meant the bank could not earn interest from lending money as the startups did not need it. This required the bank to seek another source of income. They turned to Treasury bonds on the misplaced assumption that interest rates would never rise from their historic lows!

Should governments ride to the rescue every time a bank fails? If they do there is a danger it allows management to take undue risks knowing that they will always be rescued if they make a mistake and invest into high-risk ventures. How can depositors be expected to fully understand what their bank gets up to? The solution in the case of SVB was that the government protected the depositors but left the management and shareholders with their loss. In this way they hope to ensure managers and investors apply greater prudence in their future decision making.

When investors think things are flawless, optimism rides high and good buys can be hard to find.  But when psychology swings in the direction of hopelessness, it becomes reasonable to believe that bargain hunters and providers of capital will be holding the better cards and will have opportunities for better returns.  We consider the meltdown of SVB an early step in that direction.

An article by James Scott-Hopkins using abridged comments from a memo produced by Howard Marks, Oaktree Capital Management who manage the St. James's Place Global High Yield Bond fund.

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