March 2023

“You’re thinking of this place all wrong.  As if I had the money back in a safe…Your money’s in Joe’s house…and a hundred others.”  George Bailey

Readers who are familiar with the Jimmy Stewart classic It’s a Wonderful Life will recognize the bank run scene where George Bailey explains fractional reserve banking to customers of the Building and Loan and then proceeds to stem the tide by personally providing liquidity and giving a rousing speech that restores confidence in the institution.  We were all forced to relearn the story of bank runs in March, albeit with many more zeros attached and considerably more capital at stake than the $2,000 honeymoon kitty that George Bailey used back in Beford Falls.  Absent that, the story was exactly the same, minus the Jimmy Stewart charisma.

First up was west coast bank Silicon Valley Bank (SVB), where a badly managed asset/liability position went severely underwater with tighter monetary policy, putting the bank in a negative equity situation. Next crypto industry banker Signature Bank (SB) was in the spotlight as depositors fled fearing a collapse in the wake of the recent crypto wipe out.  Both institutions were quickly resolved over a weekend by the FDIC, according to the well-worn playbook.  Nonetheless a panic was brewing among depositors, so a bridge bank was established to guarantee all deposits of SVB, regardless of size, effectively engineering a bailout of technology VC’s and their portfolio companies as they represented the largest customer group.  A contagion to other west coast banks spread sparking a response from both the Fed (easing terms of liquidity provision) and several of the large banks (collectively depositing funds) that appeared to stem the tide by month end.  The full ramifications – both in terms of Fed policy and future regulation will play out in the coming months.  Suffice to say that very few things will lead to the end of tightening cycles quicker than bank runs and restricted credit conditions.

This all turned up to be a warmup for the main event a week later Credit Suisse (CS), succumbing to a long running outflow of deposits, was forced to first seek liquidity assistance from the SNB and then a shotgun marriage with UBS for a bargain basement price that also saw an unprecedented inversion of the capital structure with AT1s completely written down while equity holders received CHF 3 billion.  While this crisis only recently accelerated to a point of no return it is now clear that the turning point was in Q4 of last year when the strategic update misfired and led to more questions than answers, only to be followed by a never-ending series of mishaps (chairman’s misleading comments on deposits, the restatement of previous year results, doubts created about key shareholder support, etc.).  Unlike the US banking crisis this was entirely a self-generated crisis of confidence which started at the very top and which was entirely avoidable.  This saga will ultimately play out over a number of years, involving official inquiries and enough litigation to keep all the lawyers who’ve only recently finished dealing with the 2008 financial crisis busy for the foreseeable future.  The cackhanded treatment of AT1 investors by the Swiss regulators will also have long term ramifications.

Needless to say, both the speed with which the US crisis enveloped the market and the CS AT1 write down adversely affected the market.  At the lows immediately after the CS resolution AT1s were indicated down 15-20 points before recovering slightly as Euro area regulators quickly moved to disavow the “Made-in-Switzerland” solution.  Nonetheless risk assets suffered, with the bank equity index falling 13.8% to add to credit woes while government bonds unsurprisingly rallied.  For the month, the fund’s A shares were down -5.7%, leaving it +1.4% for the year.  Credit was overwhelmingly the biggest negative contributor at -532bps while the equity contribution was -35bps. Credit Suisse’s contribution was negligible, as we finished neutralizing our AT1 exposure on the name on March 1st.

Looking forward, a considerable opportunity has emerged.  The banking crises of March and a moderation of economic data will surely hasten the end of rate rises.  Currently the market is still pricing a considerable risk premium on financials, particularly credit.  If we are headed to a downturn than there will undoubtedly be instances of loss provisions, but it is difficult to foresee an extreme loss scenario baring exogenous shock.  On top of this, ex-Swiss AT1s have not fully recovered from the effects of the CS resolution, despite repeated assurances that EU rules are different.  Faithful readers will know that we came into the year with a firm conviction that opportunities would prevent themselves, and that we used the strength of early Q1 to create further capacity.  We started adding risk – primarily AT1s and select equities during the volatility of late March and will make further commitments in the coming weeks as the uncertainty recedes.