HyperNormalTimes

Written by our Director of Equity Advisory, Jeremy McKeown, the HyperNormalTimes provides in-depth and considered long-term commentary on major macroeconomic and market-shaping themes.

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March 12, 2023

Pleasant Valley – Not So Serene

Broken,Fence.,Damaged,Weathered,White,Picket,Fence,With,Broken,Rails

And Mr Green, he’s so serene

He’s got a TV in every room

Another pleasant valley Sunday

Here in status symbol land

Mothers complain about how hard life is

And the kids just don’t understand.

Pleasant Valley Sunday, Carole King and Gerry Goffin, 1967.

 

In The Valley

The Monkees’ popularised the Carole King and Gerry Goffin song, Pleasant Valley Sunday. It highlighted American middle-class suburbanites’ shallow, uniform, and uninformed lives during the Vietnam War. The words were subtle but, to some, subversive. Their sentiments echo Silicon Valley Bank’s (SVB) demise caused by people not adapting to a post-QE period of interest rate normalisation. While clinging to the outdated notion that tomorrow’s blue sky remains cheap, they obscured the true impact of collapsing bond values from their investors and depositors.

 

Office Hubris

Speculative large-scale commercial office development epitomised by the emergence of Olympia & York as the world’s largest property developer was a hallmark of the go-go 1980s. Having built Canada’s tallest office tower, they turned their attention to the mammoth job of building London’s Canary Wharf. However, the downturn of the early 1990s and the delay to the Jubilee Line extension saw Olympia & York file for bankruptcy, among other office building titans like the Trump Organisation and Rosehaugh, London’s Broadgate developer. Today much of London’s financial life courses through the veins of monuments to hubris, excess and unexpected interest rate rises.

 

Subprime Hubris

By the early 2000s, the banks and the commercial office developers had adapted their operating models. However, residential property developers with subprime mortgages took over, providing the new high-octane fuel for our lenders’ animal spirits. The consequences of the GFC mean that the banks have understandably had their ability to assume mortgage risk neutered. Indeed, banks today have become so heavily regulated as to resemble branches of government.

 

Pump It Up

The West’s principal policy response to the GFC was adopting a little-known Japanese experiment called QE. Suppressing interest rates and loosening monetary conditions resulted in asset price inflation, none more so than for early-stage, long-duration technology companies. Silicon Valley’s deal machine was pumped up more than most.

 

The New Religion

Today’s PE and VC titans primarily have QE to thank for the billions they have accumulated. A business model predicated on borrowing money (almost freely) to buy assets to hold them for future sale became the new golden egg-laying machine for its enablers. The banks that stapled on the debt finance learnt a new religion.

 

Bonfire of the Vanities

Over the last fifteen years, the big PE houses and the Sandy Road venture capital titans have become the new Masters of the Universe. And just like the real estate tycoons of the 1990s and the bond dealers of the early 2000s, they have started to believe their own PR and hype. This is a familiar behaviour pattern, the preconditions for hubris and excess harming the ability to judge value and risk. Same disease, just different carriers.

 

Small Enough to Fail

However, unlike the banks in 1992 and 2009, SVB was not a pusher of debt or novel derivative instruments. It was more of a by-product of the VC industry’s huge QE fuelled growth spurt. SVB was more of an innocent bystander, albeit ill-conceived and poorly managed. SVB slipped under the bar for the closest regulatory scrutiny as a regional bank. By definition, regulators considered it to be small enough to fail. However, there remains some $5500bn of deposits still parked in “small domestic US banks” (threshold <$250bn in assets). This is a worry.

 

HTM or AFS?

As the banking industry lurks from one crisis to the next, we learn new elements of its absurd complexity. Who knew that today, after so many attempts to regulate the banks, they can still classify their bond assets differently depending on whether they are available for sale (AFS) or held to maturity (HTM)? When bond yields go from 0.5% to 4.5%, this has dramatic consequences, particularly when your deposit base is concentrated in a region and focused on one industry, an industry whose success had blinded it to the reality that the future is no longer worth the same as today. This hubris is compounded by bank accounting, which allows holders of government bonds to conceal their true value. As Marc Rubinstein points out in his excellent Net Interest account:

[O]n a marked-to-market basis, Silicon Valley Bank was technically insolvent at the end of September. Its $15.9 billion of HTM mark-to-market losses completely subsumed the $11.8 billion of tangible common equity that supported the bank’s balance sheet. 

What neither the CEO nor the CFO anticipated, however, was that deposits might run off faster, which is odd because they’d seen deposits run off before. In the aftermath of the dotcom crash 20 years ago, deposits at the bank fell from $4.5 billion to $3.4 billion by the end of 2001 as customers drew down on their cash reserves. 

The Chief Risk Officer may have spotted some clouds, but she didn’t hang around to find out. She left her role in April 2022 (after selling some stock in December) and wasn’t replaced until January 2023. 

 

Probably Containable

The failure of SVB is unlikely to produce the same level of systemic crisis that followed the demise of Lehman Brothers. More likely, SVB is the canary in the coal mine, the US economy’s LDI moment informing policymakers of the costs of rapid interest rate normalisation. It is the credit event that Fed watchers have been expecting and that regulators need to deal with. Investors and depositors will be spooked that other versions of this movie are yet to show. Monetary conditions will need to be relaxed. However, SVB will probably be a harsh lesson for a containable minority, like property developers, in the 1992 downturn.

 

History Judges

As the era of free money disappears into history along with the Vietnam War, we will adapt and move on, leaving collateral damage in our wake. Last year, the Monkees’ drummer, Micky Dolenz, 77, the band’s sole surviving member, sued the FBI to reveal the truth behind the files it holds on the Monkees and its members for their subtle but popular anti-war protests. The status symbol land of VC-empowered Silicon Valley will endure but not quite so serenely. Its era-defining part in our economic journey has started to fade.

Jeremy

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