We write to you today on the heels of the Silicon Valley Bank (SVB) and Signature Bank failures. A combination of a significant increase in short-term interest rates, regulatory oversight, and deposit outflows quickly undermined two very large banks, very quickly.
March 13, 2023
We write to you today on the heels of the Silicon Valley Bank (SVB) and Signature Bank failures.
A combination of a significant increase in short-term interest rates, regulatory oversight, and deposit outflows quickly undermined two very large banks, very quickly. Episodic/black swan risk is by definition, a surprise and is often obvious in hindsight.
Increasing yield preference spurred depositors to pull dollars and appropriate these towards higher-yielding options in the face of banks’ slow movement to raise deposit rates in-line with market interest rates. Add a significant deterioration of bond values in the face of rising interest rates and forced liquidation, and you have the making of a liquidity crisis. There will also be an additional unintended consequence of further strengthening the largest of US banks, and the stability of the regional banking system will be deeply questioned and evaluated.
The government announced a $25 billion “Bank Term Funding Program” designed to stem greater than $300 billion of losses on securities by providing banks access to credit valued at par and offering loans larger than usual to reduce pressure to generate cash liquidity by selling securities that are underwater. This program will protect depositors, whether the size of the funding program needs to be expanded or not – however, the bondholders and shareholders will not be protected. As we write, most of the affected regional banks are down between 50-70%, with trading halted, and in the case of SVB and Signature Bank – are now seized by regulators and are in receivership.
If you had $100,000 in any of these stocks, it would be worth somewhere between effectively zero (barring price discovery on any merger/rescue), and $50,000 in the best case. Even the most sophisticated investors have been caught off-guard and are facing significant markdowns in their equity, with no short-term outlet to recoup your dollars. The options are waiting for the stock to recover while likely receiving little to no income or waiting for a prolonged legal period (in the case of a forced sale of SVB or Signature) to recoup a fraction of your investment. Even unaffected regional bank stocks will be faced with compressed net-interest margins going forward as they increase deposit rates to avoid a similar depositor outflow issue as the SVBs and Signatures of the world. Profitability and earnings per share (EPS) will be affected moving forward. Share prices will be slow to recover.
The case for “Real Assets”
The clarion call for diversification into real assets cannot be any clearer than it is at this moment. Nothing we own on behalf of our investors is worth 50-70% less today than it was on Friday afternoon. We invest in tangible, real assets with a cash flow stream that predicates the asset’s value. Quite literally, a fundamental investment with an easily discernable market value based on the quality and consistency of its earnings stream.
Do interest rates and inflation affect real estate, and are there inherent risks in what we do as well? Yes, of course – but we are insulated from short-term market dynamics, and we represent a tangible, hard asset alternative that has a use case and is the wealth engine that has made more millionaires in the US than any single asset class or individual investment. In inflationary periods, real estate outperforms. In deflationary real estate environments, the cost of financing generally decreases, propping up asset value and making assets more valuable. In either scenario, specifically in cash-flowing assets, the former exists and provides a reliable, albeit potentially fluctuating, income stream. Specifically, in our business, people still need a place to live. In other real estate asset classes, take industrial, for example, products still need to be manufactured and delivered. This doesn’t change day over day. The world understands risk – this is why the Treasuries and hard assets like gold are rallying. People want safety and uncorrelated surety. Fortunately, a third option is available – cash-flowing real estate. Tangible, tax-advantaged, and in-demand – our asset class has it all. Yield can be stronger than fixed-income equivalents – both pre- and post-tax, and you’re investing in an asset that will not be subject to the daily public market fluctuations that equities and fixed-income are exposed to.
Real estate, specifically multifamily and industrial, is generally recession resistant and performs well under economic pressure. The case for the Fed engineering a soft landing has been eroding, and in our opinion, as of this exact moment in time, is no longer a reality. The Fed has been hiking, a lot of which has been a subject of debate – how much, how long, what will break? Well, we now see the first of many unintended consequences of this tightening campaign. We went from a 60% probability of a 50bp rate hike at the next meeting one week ago to a today higher likelihood of a 25bp hike and now calls for a 0bps hike. Should the Fed lose the inflation hike, whether, in actuality or perception, we will face a tough road ahead. Continued tightening will break more pieces of the financial system. We will face a hard landing and a reckoning in either scenario as things stand at this time.
All investments carry risk, including those at our firm. Diversify your investments and step away from public market volatility. If you are an accredited investor and want to learn more, email my partner, David Hansel at David.email@example.com. Experience the difference and run to real assets today.
Chief Investment Officer & Managing Partner
Lucern Capital Partners