Silicon Valley Bank - a deep dive into the crash
Its collapse would mark the 2nd largest bank failure in US history
Panic spread across the US banks after a warning from Silicon Valley Bank, a major lender with significant market share in the start-up world, prompted Peter Thiel’s Founders Fund and other prominent venture capitalists to advise portfolio businesses to withdraw their money.
The bank serves about half of all venture-backed US tech and life sciences companies and has total assets worth US$ 212bn, making it the 16th-largest bank in the US. Founded 40 years ago, it has grown into a fixture in global tech, having banked groups such as Cisco, Ring, Beyond Meat and Shopify in their earliest stages.
It all started when some analysts, shareholders and short sellers pointed to the bank move to put US$ 91bn of its assets into a poorly performing bond portfolio that has since amassed an unrealized US$ 15bn loss.
Then the turmoil came by surprise with the California-based SVB announcement that it was holding a US$ 2.25bn shares sale after a significant loss on its portfolio, which included US Treasuries and mortgage-backed securities. The bank said that it has seen elevated cash burn from its clients, and this triggered worries about the state of deposit bases and capital positions for smaller banks that drove concerted selling interest in the space.
As a consequence, its stocks plunged 60%, and another 40% in pre-market today and its bonds posted record declines. SVB’s market cap fell from a peak of more than US$ 44bn less than two years ago to just US$ 6bn.
This event saw the S&P 500 slice through its 200-day moving average (3,941) and close near its low for the session in a steady selloff that involved most stocks. The bank stocks sold off sharply yesterday amid concerns about rising rates, higher deposit costs, and weaker loan demand that collided with the news that Silvergate Capital (SI, -42%) is voluntarily liquidating Silvergate Bank, and that SVB Financial (SIVB, -60%), is seeking to raise capital. Global stocks slid alongside Treasury yields, implying that the move in Treasuries was more of a flight-to-safety than anything else. On a related note, the CBOE Volatility Index jumped 18.2% to 22.59.
The balance sheet: SVB has US$ 200bn in assets, of which US$ 116bn are securities. About US$ 80bn of that are high quality liquid assets that could be sold or repo'd for cash. Seems good, but US$ 55bn of it has already been pledged as of year end 2022. Perhaps even less is available today. And US$ 150bn of their deposits seems to be uninsured (people could lose everything if it goes under). And the bank may have trouble borrowing emergency liquidity from the Federal Home Loan Banks, because they are already borrowing US$ 15bn, equal to their capital.
Bill Ackman, the hedge fund manager and CEO of Pershing Square Capital Management said:
“The failure of SVB Financial could destroy an important long-term driver of the economy as VC-backed companies rely on SVB for loans and holding their operating cash. If private capital can’t provide a solution, a highly dilutive gov’t preferred bailout should be considered”.
The bad news surrounding SVB drove banking stocks to tumble with S&P down 2%, and the KBW Bank Index — a benchmark of banking stocks — sank 7.7%, the most in nearly three years. Major US banks including Bank of America Corp., Wells Fargo & Co. and JPMorgan Chase & Co. all slid at least 5%, while shares of Asian banks later followed their Wall Street peers lower.
KRE, the S&P US Regional Banking index, shattered its all time volume record with US$ 2.7bn traded, on ripple effects from SVB (2.3% weighting in KRE).
The SVC’s origins and business
The bank derives its income from a variety of business lines: fund and asset management; investing in companies alongside VC firms, underwriting tech IPOs and even providing billions of dollars of financing for vineyards and wineries. But SVB’s core business is centered on banking deposits of cash raised by tech start-ups, and lending to the venture capital and private equity firms that back them. At the peak of the tech investing boom in 2021, customer deposits surged from US$ 102bn to US$ 189bn, leaving the bank awash in “excess liquidity”.
SVB caters to California’s tech industries, and has grown fast alongside those industries for years. But then, with the explosion of speculative financing in the coronavirus pandemic boom, deposits rose super-duper fast. SVB’s core customers, tech start-ups, needed somewhere to put the money venture capitalists were shovelling at them.
At the time, the bank piled much of its customer deposits into long-dated mortgage-backed securities issued by US government agencies, effectively locking away half of its assets for the next decade in safe investments that earn, by today’s standards, little income. Becker said the “conservative” investments were part of a plan to shore up the bank’s balance sheet in case venture funding of start-ups went into freefall.
“In 2021 we sat back and said valuations and the amount of money being raised is clearly at epic levels […] so we looked at that and were more cautious.” That decision also created a “stone anchor” on SVB’s profitability, said Oppenheimer research analyst Christopher Kotowski, and it had left the bank vulnerable to changing interest rates.
The yield on SVB’s assets is anchored by the level of long-term government bonds bought when rates were low; meanwhile, its cost of funding is rising fast. In the Q4 2022, its cost of deposits rose 2.33%, from 0.14% in the final quarter of 2021. That’s bad but not lethal: the company’s interest-bearing assets yielded 3.36% in the fourth quarter, up from 1.99%, rendering a tightening but still positive spread. But deposit costs will keep rising as more deposits roll over, even in the absence of further rate increases.
That’s why SVB sold US$ 21bn of bonds. It needed to reinvest those funds in shorter-duration securities, to increase yield and to make its balance sheet more flexible in the face of any further rate increases. And then it needed to raise capital to replace the losses made in those sales.
SVB can borrow against the value of its bond portfolio to raise liquidity if required: Becker said it had borrowed US$ 13.5bn this way in the first nine months of 2022.
“We can comfortably say we have so much liquidity available to us in case something happens. We think deposits will stabilise, but if not, we can protect ourselves if we need to.” (Becker)
But SVB’s relative exposure far exceeds its peers. It had US$ 120bn of investment securities — which include its US$ 91bn mortgage-backed securities portfolio — at the end of 2022, far exceeding its US$ 74bn total loans.
The bank is committed to holding its US$ 91bn portfolio of bonds to maturity, an important accounting designation that shielded its profits from turmoil in financial markets last year, as long-term bond yields rose sharply above the 1.64% yield of the portfolio.
But that also meant that at the end of last year the “held-to-maturity” assets were valued at their purchase price of US$ 91bn on SVB’s balance sheet, against a US$ 76bn market value.
The unrealized US$ 15bn loss disclosed by SVB is almost as much as the group’s US$ 17bn market capitalization, and greater than the total profits reported by the bank over three decades. Since 1993, SVB has never had a lossmaking year, declaring a cumulative US$ 11.1bn in net income since then.
But the investments decision has attracted the attention of short sellers who are betting that its shares, which have lost 50% of their value since last February.
Shareholder returns have also suffered. SVB reported a 12% return on common equity in 2022, down from 17% the prior year and its lowest return since 2016.
What could happen next and what's the worst-case scenario?
Startups withdrawing funds are on the lookout for other lenders where they can park their cash, while investors in financial firms are closely watching other banks that may also be affected by malaise.
As we mentioned in our reports in the past, this is what could happen when the Fed is in an aggressive tightening cycle: something could "break" in the market, with the potential to create a credit market event. We think this is an aperitive.
SVB’s problems arise from balance sheet peculiarities that most other banks do not share. To the degree that other banks have similar problems, they should be much milder. There is one important addendum, though: in banking, failures of confidence can take on a life of their own. If enough people think SVB-style problems are widespread, bad stuff could happen.
Why probably won’t most other banks face a similar crisis? First, few other banks have as high a proportion of business deposits as SVB, so their funding costs won’t rise as quickly. At Fifth Third, a typical regional bank, deposit costs only hit 1.05% in the fourth quarter. At gigantic Bank of America, the figure was 0.96%.
Second, few other banks have as much of their assets locked up in fixed-rate securities as SVB, rather than in floating-rate loans. Securities are 56% of SVB’s assets. At Fifth Third, the figure is 25%; at Bank of America, it is 28%. That is still a lot of bonds, held on bank balance sheets at below their market value. The bonds’ low yields will be a drag on profits. This is no surprise and no secret, though, and banks with more balanced businesses than SVB should be able to work through it.
Most banks’ net interest margins (asset yield minus funding cost) will soon start to compress. This is part of a normal cycle: when rates rise, asset yields rise quickly and the deposit costs catch up. Gerard Cassidy, banking analyst at RBC, expects NIMs to peak in the first or second quarter and decline from there. But everyone knew this was coming before SVB hit the rocks. RBC held its annual banking conference this week, at which all the major regional banks spoke. Only one (Key Corp) lowered its guidance for net interest income.
For most banks higher rates, in and of themselves, are good news. They help the asset side of the balance sheet more than they hurt the liability side. Of course, if rates are higher because the Fed is tightening policy, and that policy tightening pushes the economy into recession, that is bad for banks. Banks hate recessions as they are purely cyclical business. But that risk, too, was well known ahead of SVB’s very bad day.
SVB is the opposite: higher rates hurt it on the liability side more than they help it on the asset side. As Oppenheimer bank analyst Chris Kotowski sums up, SVB is “a liability-sensitive outlier in a generally asset-sensitive world”.
SVB is not a canary in the banking coal mine. Its troubles could cause a general loss of confidence that hurts the sector, but that would require a different metaphor: shouting fire in a crowded theatre, perhaps. Investors should keep calm and keep their eyes on fundamentals.
Yesterday, the institution experienced the typical “bank-run”. This is worst-case scenario for any bank that it ends up with too little cash to operate or suffers enough losses to erode its capital, prompting regulators to sell the bank to a stronger rival or wind it down. But SVB's stock sale should help to prevent that. Time will tell.
great coverage, thank you!