March 2023
IN THIS ISSUE
TARA, TAPAS, and TIARA
Be ‘business pickers’, not ‘stock pickers’
We’ve heard this one before
Suddenly Volatile Balances (SVB)
Seemingly everyone has a take on Silicon Valley Bank’s collapse, so here’s my take through the lens of an investment manager.
Silicon Valley Bank (SVB) did not have sufficient liquidity for a bank run of spooked VC-backed depositors. SVB used deposits to build a portfolio of 10 year bonds with now-measly 1.6% yields that crashed in value with interest rates’ almost-unprecedented rise. SVB liquidated their “available for sale” bonds at significant losses to meet withdrawals but that was not enough. They tried raising capital to meet the rest of the withdrawals but that spooked depositors. And just like that, their Suddenly Volatile Balances were taken over by regulators.
If it weren’t for a critical mass of depositors withdrawing all at once, SVB would have been fine. Hold the 10 year bonds to maturity, keep collecting the 1.57% yield (albeit with a tinge of buyer’s remorse over missing out on higher yields), but then let the mark-to-market losses decay away to $0 losses at maturity, boring old banking. But boring old banking does not include concentration risk of depositors of VC-backed startups exhibiting herding behavior by all withdrawing in unison because a few VCs-in-common suggest getting their funds out before a bank run materializes.
But this problem has been solved already! Hedge funds!
When hedge funds execute long-term and/or illiquid investing strategies, liquidating those strategies to meet redemption requests is harmful to the fund’s strategies and to other fund investors. So hedge fund managers enact liquidity restrictions to forestall “runs on the fund”. Whether through lock-up periods, gate provisions, limiting redemptions to x% of an account balance per quarter, and countless other structures, fund managers have advance notice both on time and magnitude of redemption requests so they can plan accordingly - an advantage that SVB executives did not enjoy.
Sure, liquidity provisions aren’t exactly popular at banks. But maybe liquidity provisions would be preferred to bank runs?
Investment managers also know the metaphor of “picking up pennies in front of a steamroller”, the notion of investing for small profits with high Likelyhoods but that risks massive losses with low Likelyhoods. Here’s Bloomberg’s Matt Levine:
“Yesterday Bloomberg reported that “in late 2020, the firm’s asset-liability committee received an internal recommendation to buy shorter-term bonds as more deposits flowed in,” to reduce its duration risk, but that would have reduced earnings, and so “executives balked” and “continued to plow cash into higher-yielding assets.” They took imprudent duration risk, ignored objections, and it blew them up.”
Well, this was a bank run steamroller for those penny-like 1.6% bond yields.
As for banking clients who want the freedom to induce bank runs - err, I mean to withdraw the entirety of their deposits at any time - several leading investors and policy makers think they should indirectly start paying for that right. Systemically risky behavior doesn’t come free you know! Hedge-fund manager Nelson Peltz says the government should insure all bank deposits — for a price.
I actually like this idea. Bank depositors - and investors - do not like uncertainty. Particularly in the wake of how regulators handled Bear Stearns versus Lehman Brothers and others amidst the global financial crisis, this year’s fears of banking instability has caused considerable uncertainty as to whether the government will backstop some banks that “pose the risk of contagion” but not others.
Here’s Janet Yellen testifying to a Senate Appropriations subcommittee:
"I have not considered or discussed anything having to do with blanket insurance or guarantees of deposits," she said.
When a bank failure "is deemed to create systemic risk, which I think of as the risk of a contagious bank run...we are likely to invoke the systemic risk exception, which permits the FDIC to protect all depositors, and that would be a case-by-case determination."
Look, bank runs are symptoms of a loss of confidence. Instead of the uncertainty of “case-by-case determinations”, why not let the Fed insure all deposits for an appropriate fee and formalize the confidence in the financial system that will prevent these kinds of bank runs in the first place?
Discounting noise
J.P. Morgan Asset Management’s David Kelly recently shed light on a concerning reality:
“...confidence in recent years has likely been further eroded by political polarization. Since 1980, the University of Michigan Survey of Consumers has occasionally asked respondents whether they consider themselves to be Republicans, Democrats or Independents. Almost always, supporters of the party controlling the White House have felt better about the economy than their opponents. However, while from 1980 to 2016, the absolute consumer sentiment gap between Democrats and Republicans averaged 17 index points, since then it has averaged 38 index points. In December 2022, the Consumer Sentiment Index was 79.8 for Democrats and just 40.0 for Republicans.
This suggests that both sides are forming biased views of the economy, egged on by highly partisan cable news stations and amplified by an even more biased social media feed. This likely undermines confidence in general as well as leaving investors even less educated on the true state of the economy and thus true investment risks and opportunities.”
Here’s Likelyhoods in July on disconnects between peoples’ perceptions and objective realities:
With all the attention around an impending inflation-induced recession, inevitably the causes of inflation include consumer expectations. If consumers expect prices to increase, one way they may respond is by tolerating those price increases and not actually changing their buying behaviors, like downshifting or other inflation-suppressing actions. Here’s Paul Krugman pointing out this “immense disconnect”:
Thinking in Likelyhoods, one of the most challenging tasks for investment managers is determining how to discount recent news, particularly when there are so many conflicting perspectives and data points. For example, consider this catchy piece from NPR Despite high inflation, Americans are spending like crazy — and it's kind of puzzling:
“The economic lines are particularly zig-zaggy at the moment. Some, like the strong job market, point to continued growth in spending. Others, like the rising number of overdue car loans, point to a looming slowdown.”
Should investors significantly change their base rates, or would doing so mean falling victim to Base Rate Neglect (the tendency to judge an event’s likelihood by new, readily available information rather than its more stable long-term probability) and its cousin Recency Bias (overweighting recent information relative to their objective long-term probabilities)?
With both the sheer volume of news content and also the increasingly polarized nature of that content, it is becoming increasingly difficult to parse signal from noise…
… which is why Nate Silver’s book The Signal and the Noise is more important than ever. He advises:
“So you will need to adopt some different habits from the pundits you see on TV. You will need to learn how to express - and quantify - the uncertainty in your predictions. You will need to update your forecast as facts and circumstances change. You will need to recognize that there is wisdom in seeing the world from a different viewpoint. The more you are willing to do these things, the more capable you will be of evaluating a wide variety of information without abusing it.”
ONE MORE THING…
TARA, TAPAS, and TIARA. New acronyms for your reading pleasure. Wall Street Concedes There Is Finally an Alternative to Stocks.
Be ‘business pickers’, not ‘stock pickers’. Buffett’s annual letter does not disappoint. Warren Buffett's 'secret sauce' for investing success: Be 'business pickers' not 'stock pickers'
We’ve heard this one before. “It may take some time, but once the interest rate-related uncertainty settles, it will be a stock pickers’ environment again.” A One-Way Market Foils Stock Pickers as Fed Trounces Everything
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