Hello All-

As you may have heard, as of Friday, a major US financial institution, Silicon Valley Bank (the 16^th largest US bank) was insolvent, and taken into “receivership” by the FDIC (Federal Deposit Insurance Corp.) This means there will be an orderly winding down of the bank. First off, let me make clear, your portfolio has no ownership Silicon Valley Bank shares, and no ownership of any of the regional bank cohort of companies that seems to be affected by the news (Signature Bank, though for news related to crypto exposure, as well as First Republic, which seems to share some clientele with Silicon Valley Bank, also had shares that were hit hard on Friday.) We have always believed that regional banks are a dangerous place to be late in the business cycle, which is where we are today. SIVB, in particular, screened as a very low quality asset in our quant model, scoring in the 40^th percentile. By contrast, the majority of our stocks are in the 80^th percentile or above. The basic screens we run for quality include the Piotroski F-score (also known as a continuous improvement factor), the Altman Z score, and the Beneish M Score, which explicitly test for earnings manipulation as well as the probability of going bankrupt. Due to the low scores in each category of late, SIVB was a low quality asset; and Wall Street started to punish the stock last year (thus it also violated our momentum criteria, as it kept continuously going down).

Okay, that makes sense, but the obvious question you are asking yourself is, how did this happen? Are there broader implications? I will share with you what we have heard, read about, and seen, and what the implications could be. First, how did this happen: This was a classic bank run. A bank run appears from a crisis of confidence. Depositors panic that they will not be able to get their money out of a failed bank, thus everybody pulls at once. In this case, news came out that SIVB had taken a substantial, multi-billion dollar loss on its bond portfolio by selling safe treasuries that it had bought before rates increased. Such assets were held under US GAAP accounting rules as AFS (available for sale). In other words, the assets would have to be marked to market, and eventually show up in other comprehensive income as a loss. SIVB was forced to sell the bonds, because rumors generated from Venture Capitalists such as Peter Thiel, that SIVB was a risky place to be, and that folks should pull their money. Due to the multitude of VC’s all saying this at once, it generated a run on the bank. Could this happen to other banks? Not likely. SIVB is a very unique business model in that 89% of the funds were not FDIC insured. This is because a majority of their deposits were from small businesses/ start-ups in the tech space. Such business accounts by and large were above the $250k threshold. Since there is no other bank in the world with this exact business model, it gives us much greater confidence that this will not turn systemic in the way the Great Financial Crisis (GFC) did in 2008. It nonetheless remains to be seen what will happen to the bank. For instance, SIVB recently acquired Boston Private Bank, a local Boston based wealth manager and bank. What will happen to these wealth managers? We don’t know yet. The Fed is facilitating an auction for the sale of SIVB. My hunch would be that if nobody buys it as a whole, selling it off into parcels may be one other alternative. Boston Private Bank would be a gem of an asset for any serious wealth management franchise to add.

History doesn’t repeat, but it does rhyme. The stark increase in interest rates rhymes with ’08, but that’s about it. The rise in rates was the catalyst in the bond market sell-off, leaving SIVB vulnerable to the spark which caused the bank run. That is largely where the similarities end. Strict banking regulations such as the Basel accords and Dodd Frank came out after ’09 to help ensure banks held more, and higher quality capital. We also don’t see many other banks as being particularly in the same situation as SIVB. First Republic bears watching, as 68% of its deposits are uninsured. However, the majority of their accounts fall under the $250k threshold. This likely implies there are some billionaire or large business clients (likely to be small in number) that account for a large portion of the assets.

Already, the Treasury, Federal Reserve, and FDIC have announced steps to ensure deposits will be paid in full. On Sunday night the Federal Deposit Insurance Corporation (FDIC) announced they will make additional funding available to ensure all Silicon Valley Bank deposits, both insured and uninsured, will be paid in full, and that depositors would have access to all of their money as of this morning. The Treasury is currently taking measures to ensure liquidity, including a newly announced $25 billion backstop in case the FDIC ever came under pressure. (It is a multi hundred billion dollar organization, still, it helps that the Treasury is taking precautions.) Simultaneously, Janet Yellen has come out and said there will be no “bail out” of SIVB. This may be purely lip service to try to convince tax payers that this is not a repeat of ’09. In reality, it is in the Fed, Treasury, and Congress’ best interest to stem contagion abruptly and forcefully. The measures being taken with SIVB look a lot like a bail out, even if not in name.

The FDIC insures up to $250,000 per depositor, per insured bank. So if you have deposits over these limits, you should immediately address this and move funds accordingly. For cash deposits, these days we typically recommend StoneCastle which is a high-yield federally insured cash account, currently yielding 4.05% APY. With StoneCastle, you get up to $25 MM in FDIC insurance per tax ID, because they spread deposits across 100+ banks and automatically distribute funds to other banks once you reach $250k. This is a special high-yield savings program offered ‘exclusively’ through financial advisors. We do not receive any form of compensation from StoneCastle. This is simply a value-add for our client relationships.

One silver lining here is that we believe the Federal Reserve will be forced to choose between aggressive rate hikes, which were increasingly getting priced into markets, and pivoting back to a more neutral stance. Due to the panic Friday, we strongly believe the Fed will not raise rates by more than 25 basis points at its next meeting, and it may not raise interest rates at all. After all, it was the interest rate increases that ultimately led to all this. It is often said that during a market meltdown and end of an economic cycle, the exuberance of the bull market are corrected. In this case, one of the “exuberances” was venture capital funding that was very abundant due to 15 years of near ZIRP (zero interest rate policy). Such conditions cannot last forever, and indeed, sowed the ultimate undoing of many of these now struggling or defunct tech start ups. Right now, a petition is going around silicon valley because in a worst case scenario, over 100,000 people could lose their jobs due to SIVB going under. This alone would cause the Federal Reserve to pause any further increases, due to what they have said about wage inflation and a strong labor market being their impetus for raising rates. It will raise eyebrows if Jay Powell sticks to his hawkish guns as we approach the final year of a Presidential cycle. More broadly, it does not appear that many “major” US tech companies banked with SIVB; if any did, they probably did not put all their eggs in one basket. Below is a list of some banks that CNBC has found bank with SIVB: Circle holds $3.3 billion, Roku $487 million, BlockFi $227 million, Roblox $150 million, Ginkgo Bio $74 million, iRhythm $55 million, Rocket Lab $38 million, Sangamo Therapeutics $34 million, Lending Club $21 million and Payoneer and $20 million. None of these firms would ever meet Marathon’s strict criteria for investment, and indeed many of them are not even profitable.

It remains to be seen if much damage will come to the tech industry, or the banking industry. It is notable that JPM actually increased in price Friday. B of A, Morgan Stanley, and Goldman were all off by a couple percent, but nothing major. Fidelity, which is where your assets are held, is probably going to be a very large beneficiary of this outcome. Fidelity is not a bank, and thus a bank run could not occur here. Fidelity is also a privately held company, and not subject to the vagaries of the stock market, which SIVB was. We believe tech, and especially profitable Large, Mid, and Small cap tech will hold up well. Banks should be fine, eventually, but much will depend on the regulatory response. Will the Fed blindly keep raising interest rates even though things are starting to break? We feel one or fewer hikes remain, and only to save face and not walk back on what they had previously penciled in. The treasury is already signaling a strong response. Even though PNC bank has decided not to go through with an asset purchase of SIVB, many good options remain. In a perfect world, all depositors, not just the insured ones, will be made whole, and the stocks that sold off on Friday will regain their value. In any case, we do not feel there is a need to panic. If anything, this will lead to a very good buying opportunity for the profitable companies we already own. We believe the ultimate silver lining of the end of the rate hiking cycle is nearing, faster than the market anticipated. This is actually starting to coincide with a very dovish jobs report last week, which showed the unemployment rate ticking up from 3.4% to 3.6%, while still adding jobs and with many folks coming back into the labor force! This is excellent news, and truth be told, even had the SIVB crisis not occurred, there would be a strong case for the Fed to be curtailing rate hikes. In the span of two days, the probability of a the next rate hike went from 20% favoring a 50 bp rate hike to an 80% chance of that happening. Then after SIVB, that market action unwound and we are now back to strongly favoring a 25 bps hike next month. While we feel zero rate hikes would be more appropriate, 25 bps will likely have a negligible market affect at this point. The broader point is that we feel, with the knowledge we have now, the SIVB crisis is not likely to cause a banking crisis, and should be contained to a couple more aggressively capitalized companies. We strongly favor a strong response from the Fed and Treasury. We feel it will be in their best interest to not cause another banking crisis, but the regulations in place already have done most of the heavy lifting to prevent that. Please do not hesitate to reach out, as we are here to 24 hours a day to help you navigate these issues. If you hold cash in any regional banks, feel free to consult with us about whether you realistically need to be worried (most likely not, but wouldn’t hurt to check.) We will be re-assessing the situation in a few days, as it remains fluid, and will reach out with a subsequent email when we have more clarity. Do not be surprised with further market volatility in both directions this week and likely lasting until there is more guidance from key regulators.

Thank you,

Charlie & John