Revisiting the "Mini" Banking Crisis

We are almost at the one-year anniversary of the “mini” banking crisis that we faced in 2023.

As you may remember, we saw three of the five largest bank failures in American history happen in March of last year.

The biggest of these was the failure of Silicon Valley Bank or “SVB”. At the time it was the 16th largest bank in the country!

At the time, we wrote a note discussing how this crisis lined up against other similar crises from the past.

Our conclusion was…

“I think the demise of SVB is an unfortunate event and will create a lot of temporary volatility in an important (although sometimes too well-publicized) area of the economy... But I do not believe it's going to take down the U.S. economy or stock market.”

A year later we think we were right.

Recently, though, we have seen continued volatility around the banking sector with New York Community Bancorp, Inc. (NASDAQ: NYCB). The issues that challenged the sector a year ago have not gone completely away.

In view of this, we want to share our piece from last year on the banking crisis.

For many investors, the concept of a bank failure may seem foreign...

While there are always small banks that fail in any given year, there hasn't been a major bank failure since Washington Mutual back in September 2008 – during the heart of the global financial crisis.

The failure also happened during an incredibly chaotic period, a couple of weeks after the bankruptcy of Lehman Brothers. As a result, it didn't generate the same amount of headlines as the recent failure of Silicon Valley Bank ("SVB") did last week.

There has been a massive amount of coverage of what happened (and is still happening) so I won't go into great detail...

But here's the quick version of it: SVB brought in deposits from venture-backed startups and invested in a bunch of assets that got crushed as the U.S. Federal Reserve raised interest rates.

With the slowdown in venture funding and those startups burning through cash, SVB was feeling pressure on deposits. At the same time, it was facing a big markdown in the holdings of assets.

SVB might have been able to navigate the situation and come out OK, but management bungled the timing and messaging and created a panic – wiping it out in the process.

Remember, banks essentially hold (borrow) cash from investors that they let them get back at any time – the deposits.

They then invest that money into longer-term assets that aren't as easy to cash in...

Usually they hold back enough cash (maybe 5% to 10%) to deal with any normal situation where depositors want to cash out.

If investors lose confidence, however, they may all ask for their money at the same time and the bank won't be able to sell assets fast enough... or it will cause a lot of damage to asset prices if they do.

This classic "run" on the bank is what just happened to SVB.

So the big question is, how much should we care? Is this likely to have a BIG negative effect on the economy or the stock market?

The quick answer is, I don't think so...

Yes, SVB was a large institution going into the blowup with more than $200 billion of assets and ranked among the 20 largest banks in the U.S. Here's a table showing the 20 largest banks by assets, based on recent year-end data from the Fed...

This list puts the size of SVB into perspective.

First, it was less than one-tenth the size of the top three banks – JPMorgan Chase (JPM), Bank of America (BAC), and Citigroup's (C) Citibank.

Second, these top 20 control almost $20 trillion in assets. SVB made up only a little bit more than 1% of that total.

It's also important to understand what sort of assets that SVB is involved in and owns...

During the global financial crisis when large brokers Bear Stearns and Lehman Brothers went under, there was considerable concern about how this might affect the rest of the market.

Lehman itself was significantly larger at $600 billion in assets, but the more important factor was that most of its assets were integrally tied into the operations of other large financial institutions. Lehman was one of the largest counter-parties on Wall Street.

This meant that issues at Lehman could quickly spread to other large operators, including several of the major banks listed above – like JPMorgan, Bank of America, Morgan Stanley (MS), and Goldman Sachs (GS).

If the volatility at Lehman had spread, it wouldn't have just been its $600 billion at risk, but the top five financial institutions in the country as well.

SVB by comparison held a portfolio of bonds and venture-related investments. There's virtually no counter-party relationship with the rest of the financial world.

In addition to size, this is a big difference to consider versus prior periods.

Again, a similar example here would be Washington Mutual. Its portfolio was made up almost exclusively of mortgage securities, so its failure didn't have much effect on the rest of the financial system.

Were you personally impacted by any of the bank failures? Tell us more in the comments section below.

However, to understand what effect SVB's collapse might have – I think it's instructive to go back and look at the first real financial crisis that I faced in my career: the collapse of hedge fund Long-Term Capital Management ("LTCM") back in 1998.

I've written about this many times previously here at Empire Elite Trader, but LTCM was a highly leveraged, fixed income-focused fund created by some famous traders from esteemed bond-trading brokerage Salomon Brothers.

This fund famously went bankrupt in August 1998 as a result of various markets moving against it and its 25-to-1 leverage ratio.

To put that leverage ratio in perspective... on its almost $5 billion of assets under management, LTCM was managing $125 billion of assets in its portfolio. Considering this happened 25 years ago and adjusting for inflation, I would argue that LTCM was roughly 2 times or more the size of SVB.

Unlike SVB, however, LTCM was integrally tied into the financial system and Wall Street. Pretty much 100% of its assets had major counter-parties that made up the bulk of the financial system.

In this case, the Federal Reserve Bank of New York stepped in and arranged a $3.7 billion bailout and liquidation of the fund. And something similar is happening with SVB.

So, what was the effect of LTCM's collapse on the markets?

Take a look at this chart of the S&P 500 Index across that period...

As you can see, the market was already heading down going into this period (some of the volatility that hurt LTCM), and then it took a quick 10% move down even further.

Meanwhile, last week, the market was only down 1.5% on the day SVB went under, which I believe shows the difference between SVB and LTCM.

We can argue about the similarities and differences between the underlying environments, but both had their challenges, and the market itself is acknowledging the relative effect of SVB.

One last chart to look at is of banking giant JPMorgan during the time of LTCM's collapse...

As you can see, it acted similarly to the overall stock market. It was trading down going into the period and then got hit hard during the bailout. This is with volatility in one of its major counter-parties.

I think the demise of SVB is an unfortunate event and will create a lot of temporary volatility in an important (although sometimes too well- publicized) area of the economy... But I do not believe it's going to take down the U.S. economy or stock market.