Flaming Butterflies

The crisis at Silicon Valley Bank managed to outcompete US payrolls for space above the digital fold on Friday.

That speaks not just to humanity’s penchant for slowing down on the highway to stare at a car accident, but to the very real possibility that depending on how things develop, the fallout from the SVB fiasco could be more consequential for determining whether the Fed re-escalates its tightening campaign than any single macro data point, barring a multi-sigma upside surprise.

I implore readers: Don’t misconstrue my point. Absent evidence of contagion (real contagion, not just a few bad days for bank stocks), turbulence at a startup lender, no matter how important to the industry, isn’t going to deter the Fed from its terminal ambitions, particularly if the data continues to suggest “sufficiently restrictive” is at least 5.5% Fed funds.

What I mean is that if the odds of a re-escalation to 50bps hike increments were, let’s call it 33%, after Jerome Powell’s remarks to Congress this week, they’re infinitesimal if there’s a bank run going on at an institution that doesn’t count Barney Fife as a valued customer. Put differently: The bar to clear for the resumption of a half-point hike cadence will be materially higher in the event SVB turns into “an event,” if you will.

Indexes for European senior and subordinated bank debt widened Friday, and European bank shares tumbled, albeit not nearly as much as their US peers on Thursday.

The safe haven bid was evident in sharply lower German yields across the curve, and an extension of the Treasury rally (pre-NFP, anyway).

“We think the risk of contagion from small to large banks is remote, considering the low share of regional banks in the IG market,” Goldman’s Lotfi Karoui said. “Similarly, the risk that large US or Yankee banks experience a capital or liquidity event driven by assets/liabilities mismatches or concentrated positions on securities portfolios is remote, considering the post-global financial crisis regulatory environment,” he added.

Nick Anderson, an analyst at Liberum, described the implications of SVB’s problems in relatively benign terms. “NIMs will start to compress [but] this isn’t a canary in the coal mine,” Anderson wrote, “more a risk of a butterfly flapping its wings if customers move deposits forc[ing] banks to shrink bond portfolios and loan books.”

Read more: ‘Stay Calm,’ It’s Just A Bank Run

“Due to the volatility in yields after the prior protracted period of leverage-enabling policy, the most vulnerable (banks) currently are those vulnerable to both interest rate and credit risk,” Mohamed El-Erian said on social media. “Contagion risk and the systemic threat can be easily contained by careful balance sheet management and avoiding more policy mistakes.”

An analyst at Truist who downgraded SVB explained that the “increasing risk of accelerated deposit outflows” means “there’s too much uncertainty to recommend the stock.” I’d have to agree. And I’d also have to chuckle. While acknowledging the imperative of not screaming “Fire!” in a crowded theater, describing a bank run as an example “uncertainty” seems a bit euphemistic. If I were an analyst, and my supervisors were kind enough to afford me the latitude, I’d probably be inclined to suspend coverage temporarily given… well, given the bank run.

Anyway, this could be “it,” where “it” means the “event” that punctuates the Fed’s tightening cycle. Something always breaks somewhere. BofA’s Michael Hartnett described a “‘credit event’ appearance in tech and healthcare PE/VC lending,” without specifying.

“Government debt, shadow banking/private equity, crypto, speculative tech, real estate, CTAs, CLOs, MBS — [there are] so many potential catalysts for a systemic deleveraging event that sparks policy panic and the end of Fed tightening,” Hartnett remarked. “The truth is, the source of the event is irrelevant,” he went on. What matters is that “it will happen and will cause policymakers to panic.”


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5 thoughts on “Flaming Butterflies

  1. Gosh, the comments from Goldman, Anderson and El Erian sound like the same reassuring chatter we heard from the street in late 2008 & even into early 2009.

    SVB is not some obscure crypto player. Before we all chortle about VC players getting what they deserve, remember where many of the recent medical breakthroughs (such as Covid vaccines) came from.

    1. Almost all modern medical and technological advances can be traced back decades to federal government (i.e., public, not private) funding.

      1. Both government (funding for basic research) and private (commercial drug development) are required to bring new drugs to market. Research from NIH and academic labs identifies many possibilities for new pathways and therapies, but the vast majority will be dead-ends. VCs and industry are necessary to sift through the mountains of chaff to find the grains of wheat.

        The failure rate for compounds moving from pre-clinical to phase 1 is about 90%, the failure rate from phase 1 to phase 2 is similar, and so on. Well less than one-thousandth of possible drugs identified at the pre-clinical stage ever make it to market, and only a small fraction of those are commercially and clinically successful. For those that are, the typical payback period, i.e. when the ROI turns positive, is several years.

        Because the sifting process is so fantastically difficult and expensive, it requires rich economic incentives.

        (Basis: a decade managing a biotech and pharma sleeve, focused on clinical stage “binary” names.)

        1. JL – Thanks for the inside view. To some extent, the large pharma firms have outsourced much of their basic to VC-funded entities, which they look to buy once the probabilities of success look attractive, no?

          I’ve read about VC-funded start-ups around Route 128 dropping projects, even ones they’ve sunk a lot of time and money into.

          VC firms do not solely fund meal delivery and scooter rental start-ups.

          1. Yes, big pharma now relies less on internal early stage drug development and more on buying de-risked drug programs.

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