Until now, almost all of my commentaries about inflation have been focused on consumers and governments.
Consumers spend too much, while already leveraged governments refuse to support the efforts of central bankers to slow inflation by spending more money, not less, in their fiscal budgets.
To this, the market is belatedly staring a new bother squarely in the face, corporate financial leverage.
SVB Financial, a full service commercial bank serving the needs of tech companies and their employees, collapsed very suddenly, due, apparently, to a simple mismatch of treasury maturities against their deposit base.
Banks labored since the financial crisis of 2008 to reduce their owned mortgage books and have invested the overwhelming majority of the deposit base in treasuries. When held to maturity, treasuries are riskless on a principal repayment basis. However, they do fluctuate in value after issuance, based upon interest rate movements and the duration of the treasury owned. These fluctuations must be recognized via a “mark-to-market” valuation on at least a quarterly basis.
Just when did the “G” in ESG become silent?
The reputation of SVB as an “ESG” (Environmental, Social & Governance) champion, paying its employees well above industry standards, hiring and promoting using criteria that were less merit based, more virtuous box-ticking, will likely be poured over in the months and years to come as further details of the failure come to light. Banking, like many other low margin sectors of the economy, demands tight cost controls as well as rigorous compliance to generate a profit at the best of times. In the case of SVB, a well above average fixed cost of conducting business left the bank with a lower level of retained earnings capable of providing the needed capital buffer.
In order to offset the high costs of doing business under their ESG focus, it appears that SVB chose to deliberately mismatch the duration of too many of their treasury holdings so as to maximize the interest spreads against depositor funds. They were then caught off-guard by the absolute increases in interest rates. The upward move was too severe, the duration of the movement up in rates was too long. A recognition at the bank that rates were not going to come down quickly was almost certain to result in a massive mark-to-market loss on the bank held treasury portfolio, in the coming quarter/quarters, at SVB.
All of this would be temporary, were it not for objectives of depositors, which are to be able to access and secure their funds at any time. The minute depositors opted to remove funds from the bank, treasuries needed to be liquidated in order to maintain capital ratios. The more deposits that left, the more treasuries needed to be liquidated, which crystalize that paper loss and transform it to a hard loss. Efforts to raise external equity capital failed, likely due to the duration of the owned treasuries (banks will deliberately mismatch held deposits against owned t-bonds in efforts to earn additional interest, relying upon interest rate futures to hedge the mismatch). Regardless as to when a depositor withdrew bank funds during the ascent of the fed rate, the potential for a domino effect was always there with a duration mismatch. With an emphasis on the bank being a societal transformative eco-warrior, out there to change the world, whether it was profitable or not, essential governance was certainly missing.
Just as commodity hedges fail to eliminate inflation at the producer level, instead, merely smoothing impacts over a longer duration; so too do interest rate hedges fail to eliminate interest rate risk, they just defer some of the impact in one year and shift it to the future.
Investors owning leveraged companies need to be cognizant of mark-to-market risks and potential fallout as interest rates continue to rise. Central bankers can and will step in to prevent any systemic issues at banks through a variety of means tested tactics. This should prevent a repeat of a 2008 style financial crisis.
That said, what the failure of SVB has revealed is the core issue of any corporation relying upon leverage as a means to earn a profit; leverage kills profits in a rising interest rate environment.
Banks, insurance companies, BNPL companies, leveraged buyout investment firms, REITS, utilities, limited partnerships, master limited partnerships; a massive swathe of the publicly traded economy relies heavily, some almost entirely, upon interest rate arbitrage to enhance absolutely low levels of core business profitability. Just how do you take a business with a very low profit margin and increase earnings enough to justify public investment; you borrow a bunch of money at low interest rates, buy operating assets with a return above the cost of borrowing and juice up your earnings. This works, so long as the cost of borrowing is lower than the operating margin, but just like that, when rates rise and loans are reset, what was, at first, an accretive purchase, steadily becomes an albatross, a drag on earnings that cannot be repaired due to the fact that the purchase was never profitable enough to be justified without leverage.
Hedge risk sits front and center at some of the world’s largest conglomerates.
Berkshire Hathaway, for the past 6 years, has earned or lost more than 50% of its annual profits on interest rate, equity and commodity hedging, rather than from core business activities. In truth, when a business obtains more than half of its profits from financial contracts, it creates confusion as to the true, core, level of profitability on owned and operated assets.
In the annual letter to shareholders, Warren Buffett, on the heels of a reported $53.6 billion derivative/futures contract loss in 2022, recently railed at the mark-to-market system of accounting, expressing an opposition to GAAP standards which require unrealized losses to be noted on a quarterly basis. Yet, the rules are the rules, GAAP mark-to-market is standard, so the timing and degree of his selective outrage was puzzling indeed. Buffett certainly didn’t seem at all aggrieved in 2021, when derivative accounting juiced up Berkshire earnings by 69%, nor did he castigate GAAP mark to market regulations in 2020, a year in which derivative accounting improved Berkshire profits by a whopping 74%.
One is justified in opining on the totality of financial leverage supporting the income statements for entire sectors of the economy when a long-feted conglomerate is revealed as being utterly reliant upon derivatives, options and interest rate speculation to produce the lion’s share of its profit. If Berkshire Hathaway is getting its head handed to it on interest rate moves, to the point that the CEO has to complain “its not me, its the system“, then just who else is getting pasted?
The growing interest rate risk on leveraged corporate hedge books may go a LOOOONG way toward explaining why banks keep telling us, despite overwhelming evidence to the contrary, that inflation is just about licked.
I have been wondering, for a growing period of time, why most major financial institution, staffed with entire departments culling through reams of financial data on a minute by minute basis, sitting in on federal reserve briefings, lunching with Janet Yellen; why have they been so far off base with the peak interest rate forecasts required to reduce inflation? It really isn’t rocket science. Surely they cannot ALL be stupid, can they?
And the answer, just like that, in the form of SVB Bank going under, rings clear like a trumpet on an empty plain; at least some, and perhaps too many, financial institutions and leveraged corporations, have hedge book issues that are of growing concern, the further rates go up. When Buffett, of all people, gripes about mark to market producing a massive loss during 2022, and interest rates continue to rise even further, the outlook for 2023 becomes more murky.
It now is abundantly clear, to me at least, that the reason why major investment firms and banks continually underreport the risks of inflation lies in the fact that at least some, with treasury mismatches on their books, are themselves offside and they need to slowly “walk-up” interest rates rather than face the music. They, as the gatekeepers of capital markets, are doing precisely what we, as individual investors, are told “not” to do when confronted with a problem; they blame others and hope that it just goes away on its own. In publicly discounting the potential for rates to rise further, leading financial institutions are likely doing nothing more than seeking buyers willing to take the opposite side of their hedge transactions, without triggering a massive loss on their mark-to-market portfolio.
If inflation will be higher than previously expected, and for longer, there are important investment implications facing us all.
Leveraged businesses will need to be reappraised based upon the true core profitability of owned assets, not on their interest rate arbitrage actions. Any company that purchased a marginally profitable asset with borrowed money, during a time when borrowing costs were close to zero, might have a very rude awakening on the day the corporate loan extended to that purchase comes up for renewal. I estimate a full 70% of corporate purchases made within the past five years cannot be justified at the prices paid, based upon todays’ current rate environment.
We should also wake up to ESG risk.
ESG is not a profit maximizing set of policies, it is profit limiting, a trade-off where fixed costs are permanently raised and abnormal profits are either reduced or redistributed for the benefit of those other than equity holders. The clear emphasis on environmental issues and societal change are the overarching aims. This conflicts with capital markets, that operate ideally as a meritocracy. ESG seeks to reduce that meritocracy and throttle back superior profitability to a median level of financial success. Not well understood is that when the best corporate fiscal performers fall to the average, then the overall average is itself diminished, as a consequence.
Governance already encompasses adherence to environmental and labor laws and good governance is strict on the matter; it need not be part of any acronym, it stands entirely on its own two feet and it is not an afterthought. I won’t own badly governed corporations, nor, logically, would anyone else. To be forced to include G in a “woke” abbreviation salad, and place it last on the list, indicates the relative lack of importance for new capitalists. If governance (and the unsaid implication is that the “G” refers to good governance,) were truly paramount, then the abbreviation would be GES, not ESG, correct?
The corporate world doesn’t need ESG, they just need G.
An ESG focused bank just failed, and a large one at that. It failed due to a lack of sound governance. What does that suggest about the lack of real profit at companies that they have loaned money to, because a bank should be the last to fall in a line of dominos, not the first.