April 13, 2023

WHEN THE TIDE ROLLS OUT

by Jeffrey R. Miller, CFA

Warren Buffet once famously stated, “when the tide goes out, we find out who is swimming naked.” This is an appropriate metaphor for the Silicon Valley Bank fiasco, led by the rapid series of US Federal Reserve rate increases over the past 12 months. One may refer to this as “The Fed Tide” (with all due respect to the toxic algal blooms which plague warm climate coastlines during summer months).

If ever there was a pointed confluence of misbehaviors by a set of hapless characters, this was another one for the books. Seriously folks, everything that could go wrong did go wrong. The damage to the financial sector has been significant, with three banks (and counting) having gone or going down. We do not yet know how far this goes. Fortunately, early predictions of a 2008 apocalypse appear premature.

I find much of the fault with the Fed and the abrupt rise in interest rates driven by their actions. They are proving relentless in the effort to correct a couple of decades of loose monetary policy in a compressed time frame. It’s like slamming the brakes on a 200 mph Ferrari and expecting a smooth stop. Not going to happen, all hell will break loose.

The effect of rapidly rising interest rates on bank balance sheets challenges them to correct the imbalance, in a very short time period. At its core, this is what happened to Silicon Valley Bank, aided by massive withdrawals by depositors via smart phone apps. There were also multiple examples of bad management and lack of responsibility to depositors and shareholders. In the weeks and months prior to bankruptcy, insiders were 1) selling their own shares in the bank while planning to issue more shares in a capital raise, 2) personally increasing borrowing from the bank, tripling their outstanding loans to $219 million, and 3) the president of Silicon Valley Bank was a director on the board of the Federal Reserve Bank of San Francisco, their chief regulator. This is the fox managing the hen house.

We think the banking sector will manage through this, but much blame can be placed at the feet of the Federal Reserve. A slower, more thoughtful rise in rates would have let markets, especially the banking sector, adjust more prudently. Instead, everyone is swimming on the beach. We have yet to see what damage will be wreaked upon the broader economy.

Yesterday, OPEC announced a substantial cut in oil production. Prices will rise, and the Fed has no control over this decision. Nor do they control the massive deficit spending being engaged in by the Federal government. It is with increasing concern that the probability of a harder than necessary recession may be ahead of us. The rate actions by the Federal Reserve are pushing risk into the economy. Is this prudent? OPEC’s cut in oil production will drive oil and other energy prices up, stoking inflation—this has nothing to do with monetary policy.

So as the tide rolls out, let’s hope you have your suit on.—J. Miller