The Three S's from L to R: Silvergate, Silicon Valley, and Signature
It’s been a bad couple of weeks for banks whose names start with “S”. But not only for them. The stunning incompetence exhibited by the management of these 3 banks not only brought about the collapse of their institutions but has threatened to spread contagion through the rest of the alphabet and damage the entire financial system. In addition to having a first initial in common, Silvergate, Silicon Valley, and Signature had other shared characteristics that defined their flaws and drove their ultimate and rapid demise. One common factor among these three banks was that each positioned themselves in the forefront of delivering financial solutions for the 21st century economy. It is the height of irony, of course, that all were brought down by an event that is as old as banking, itself – a run-of-the-mill, old-fashioned bank run brought about by Stupidity, Hubris and Greed.
Banking is Easy: Failing is Hard
Let’s face it, at its core banking is an easy business. In fact, the old joke used to be that all successful banks employ the 7, 3, 2 strategy – charge 7% on loans, pay depositors 3%, and be on the first tee by 2. CEOs who were really good at their job were able to tee off by 1:00. It was (and quite frankly still is) that simple. While there is no doubt that the business has become more complex over time, the management challenges more demanding, and weekday golf frowned upon, the fundamental business remains the same – make more on what you charge for money than on what you pay for funds, control expenses, and don’t do anything stupid.
Because the fundamentals of the business have not changed materially over time, neither have the rules that CEOs must follow to ensure the company’s survival. Luckily for most CEOs there are only two:
1. Understand that Banking is a Business of Managing Risk. That’s it. Full stop. Strip everything away -- all the bells and whistles, all the fancy strategies – and that’s what is left. In fact, one could argue that managing risk is not just a CEO’s most important job, it is their only job. But managing risk sounds boring. It’s not sexy. Being known as a great risk manager doesn’t get you on the cover of Fortune or get your ass kissed by Jim Cramer. Unfortunately, too many bank CEOs want to be rock stars, known for their innovation, cutting edge technologies, and unique business models. They want to be thought leaders, believing that higher visibility translates to more stock options and higher market multiples. They leave the boring business of managing risk to others and when something blows up (and it always does) they are shocked, shocked I say, at the incompetence of those who they relied upon. However, it always becomes clear that when a bank fails the real incompetence resides with very highly paid executives who spent way more time talking about how smart they were than actually doing their fundamental job. In fact, the only occupation that scores higher than a failed bank CEO on the Compensation to Competence ratio is to be a Kardashian. Remember, good banks are boring: great banks are really boring.
2. Manage the Business from the Balance Sheet, not the Income Statement. This is a rule that is violated more often than followed. And that’s the problem. All the risk is on the balance sheet – asset quality, duration, liquidity, capital – not on the income statement. In fact, the balance sheet drives all the components of the P&L – interest income and expense, types and number of staff, technology investments and a whole range of income and expense components that are driven by the bank’s business model which is reflected in the composition of its balance sheet. While it is clear that the balance sheet and income statement are inextricably linked, too many CEOs focus too much time and energy trying to optimize short term earnings rather than building a fortress balance sheet. The reasons are straightforward – that’s how they get paid and that’s what the market expects. It’s a lot easier for analysts to look at and understand metrics such as earnings per share and return on equity rather than dive deeply into the intricacies of asset/liability management. This is both short sighted and risky. Virtually every failed bank has one thing in common – to maximize earnings, they put way too much uncontrolled risk on the balance sheet.
So, what makes banking easy is that the fundamental business is straightforward and if you follow these two rules, it is almost impossible to kill the bank. What makes failing hard, is that there are really only three things that can bring a bank down, and you have to work really hard to screw up on one, let alone all three.
· Significant asset/liability mismatch. This is the classic, and time-honored, mistake of lending long and borrowing short or vice versa. All banks have some type and degree of mismatched maturities on their balance sheet, and most manage it effectively through various hedging and other risk management strategies. This only becomes fatal when unexpected rapid interest rate changes require management to take drastic actions that threaten the bank’s liquidity or destroys its capital. While inappropriate asset and liability matching strategies can reduce earnings, it should never cause the bank to collapse.
· Lack of diversification. High balance sheet concentrations in higher risk business lines or economic sectors can make the bank dependent on the health and stability of individual industries or customers. If the industry sector takes a dive they can pull out their deposits or stop paying their loans. This can cause both credit quality and liquidity problems which can, in extreme cases, prove fatal.
· Rapid growth in high-risk businesses or market sectors. This is the most common cause of bank failures – management pushing for growth in new businesses and/or markets that they don’t understand and have not built the infrastructure to identify and manage risk.
That’s it. Those are the three no-no’s of banking and our Three S's managed to hit every one. Stunning.
Stupidity, Hubris and Greed
As the noted philosopher, Gomer Pyle, once said “Stupid is as Stupid Does. Surprise, Surprise!”
While we know it’s not politically correct to refer to anyone as stupid, sometimes the description just fits. After all, we’re all stupid in one way or another and most of us at one time or another have done a lot of stupid shit. However, what elevates stupid above incompetence and into the realm of danger is when stupid people don’t know they’re stupid and have convinced themselves (and others) that they are the smartest person in the room. The rules don’t apply. The reason other folks got in trouble for violating these fundamental rules of banking is because they weren’t smart enough to figure out how to get around them. They’re smarter than all of these other folks and can push forward with impunity. While this is dangerous, catastrophe requires the active support of others who continually tell the leader how smart he or she is. But that’s what powerful stupid people do, they surround themselves with sycophants who are either unwilling or unable to say “no”.
Enter hubris, the big brother of stupid. As more people, both inside and outside of the organization, proclaim your brilliance, a feeling of invincibility sets in, obscuring potential hazards and creating complacency. Hey, Jim Cramer says I’m the best bank CEO in America so it must be true. (Note: Jim Cramer was touting Silicon Valley as undervalued when its stock was trading around $350/share as late as mid-February.) What most analysts don’t understand is that bad bank CEOs think they’re bullet proof, great bank CEOs are constantly paranoid.
Hey Ethel, I think we need a dash of greed
Once we have stupidity and hubris, the only thing we need to add to this witches’ brew is a dash of greed to really make this stew boil and bubble. Fortunately, this ingredient is plentiful and easy to find in the executive suites of many banks. And it seems that it grew wild in our Three S's as each one pushed the risk envelop to the limit in order to maximize short-term results without any thought of taking preventive measures to address impending risks and economic headwinds. After all, that would cost money and cause them to miss outrageous and unrealistic analyst EPS projections. If management had been willing to take a short-term hit to earnings (and their pride), the resulting dip in the share price would have been painful, but not fatal.
So was the law firm of Stupidity, Hubris and Greed running the Three S's? We don’t know for a fact, but if the shoe fits … well, you know the rest.
Round Up the Usual Suspects
Clearly, management of these three banks were solely responsible for their failure. However, that doesn’t mean that others weren’t complicit. Let’s take a brief look at some of the other villains:
· The Regulators. A number of Republican politicians and conservative media types have blamed the banks for being “Woke” as the primary cause of their failure. Let us let everyone in on a well-kept secret: There is no such thing as a “woke bank”. Banks do what they think is necessary to maximize their financial performance, and if that means verbally supporting various social issues, they do it. But they don’t spend much time on it and they certainly don’t let those issues drive major financial decisions. No, the problem is not that the banks were “woke”, the problem was that the regulators were not awake. As the industry has thrived over the past few years and credit quality remains pristine, the regulatory agencies have gotten lazy. They constantly make the same mistake of looking in the rearview mirror and fixing the last crisis rather than anticipating the next one. They neglected their fundamental job of focusing their examinations on the core issue of safety and soundness. While the speed of interest rate increases over the past 18 months is somewhat unprecedented, it was certainly not unexpected. Not analyzing these large banks to determine the impact of rising interest rates on their balance sheets and capital adequacy is a fundamental dereliction of duty.
· The Rating Agencies. Another repeat offender who looks backwards, not forward. These are the same folks that not only missed the last crisis but actually enabled it. Moody’s had a rating of “A” on SVB the day before it collapsed. Why are these people still relevant and in business?
· The Politicians. Under pressure from the banking industry, Congress in its infinite wisdom, along with the Trump Administration, rolled back many of the protections and risk management requirements enacted after the 2008 crash. Make no mistake, this was not a strictly partisan issue pushed through by a Republican majority for whom any regulation is anathema. No, this was one of those rare bipartisan pieces of legislation supported by Democrats in both the House and Senate.
· The Analysts: We include ourselves in this category. While we identified rising interest rates as a significant headwind to earnings and our indicators started signaling a downturn at the end of February, we didn’t see this coming, and neither did anyone else.
· Social Media. While we believe that social media is the cause of all the problems in the world, in this case social media did not cause the collapse of these banks, but it sure did help to accelerate it. Bank runs used to be somewhat slow. You could see it starting and get in front of it. Not any more, and certainly not when the impacted companies have strong connections with the tech industry and community. Now social media can be used to quickly spread both information and misinformation, providing a platform for those who might have a vested interest in the demise of a particular institution to spread fear and create panic. Did that happen in these instances? Absolutely.
The RjR Perspective
With the sudden and dramatic decline in bank stocks, we are being asked what to do from an investment perspective. We don’t give specific investment advise on the market and individual stocks so our answer is “it depends”. And, while everything we know about these types of crises and dramatic market moves screams once-in-a-lifetime buying opportunity, we understand that everyone has different risk tolerances. As Warren Buffett has always said, “When the market is greedy, be scared. And when the market is scared, be greedy.” We think that probably applies here, but another one of his famous sayings also applies, “When the tide goes out you can see who’s been swimming naked.” Not a pretty visual, is it? So, while we believe incredible buying opportunities exist, we think investors should focus on strong banks that have been unduly crushed and be prepared to experience additional and significant volatility over the next few weeks/months. This market is not for the faint of heart or weak of stomach. For identification of our top-rated banks, become a member by clicking the button above. It’s fast, it’s fun, but it ain’t free.
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