The end of Silicon Valley Bank
Silicon Valley Bank (SIVB), the 16th largest bank in the U.S., moved to frontpage news midweek for all the wrong reasons, and was out of business less than 48 hours later. A series of mistakes set the stage for a run on the bank that started on Thursday and ended mid-day on Friday when the bank was closed and taken over by the Federal Deposit Insurance Corporation (“FDIC”).
The failure of one of the nation’s largest banks stunned investors, ending one story but casting a long shadow of doubt around the survival of some of the company’s customers, consisting largely of emerging technology companies, as well as technology-focused venture capital firms and private equity firms. A JP Morgan Asset Management report (here) said that of SIVB’s $173 billion of customer deposits at the end of 2022, $152 billion (circa 88%) were uninsured, reflecting the bank’s strong reliance on targeted corporate deposits (rather than retail deposits). The collateral damage might also ensnare other middle market banks with similar customer or investment profiles. To be clear, this failure was different than many bank failures in the past in that it was not caused per se by overly aggressive credit underwriting decisions, but rather by a very bad mismatch of deposits and assets.
SIVB had around 8,500 employees and an equity market capitalisation of $15.9 billion as recently as March 8th. For its fiscal year ended December 31 2022, SIVB had de minimis credit losses and strong asset quality ratios, as well as a solid capital base (CET1 risk-weighted capital ratio of over 15%). Still, its failure came fast and furious over a period of less than two days once the run on the bank started, illustrating how a cocktail of poor decisions can ultimately lead to calamity if depositors lose confidence in a bank.
The two crucial factors to be aware of when considering the demise of SIVB are:
Client base: SVIB was the lending bank for emerging technology companies, a broad sector that can drift in an out of favour quickly, affecting the ability of these companies to raise capital.
Asset composition: SVIB was unable to meet the cash demands of its depositors because of the composition of its asset base, not because of dubious asset credit quality issues. The bank had a severe and costly asset-liability maturity mismatch which was crafted during 2021, and this was exposed when depositors en masse tried to withdraw their money from the bank.
The failure of SVIB reverberated through markets at the end of the week causing risk-on assets like stocks and cryptocurrencies to sink while safe haven assets like USTs and gold rallied. The weekend has provided an opportunity for investors to digest this news as we await the opening of financial markets on Monday, although certain policy actions by the Federal Reserve, the US Treasury and the FDIC announced Sunday afternoon (see “Subsequent Events” below) should largely quell these concerns. Some of the collateral effects during and just after SIVB’’s failure included the following:
Middle market bank stocks got hammered as the story played out last week, with the KRE ETF (profile here) down over 16% on the week. A number of banks were under intense scrutiny following SIVB’s demise.
One market that was open over the weekend was the cryptocurrency market, and one company on which there was a lot of focus was Circle Internet Financial, which sponsors stable coin USD Coin (USDC). Circle is important because it had $3.3 billion of deposits at SIVB that it cannot now access. As a result, USDC lost its 1:1 peg and plummeted to as low at 0.88 to USD 1.00 on Saturday before clawing back to its current level of around 0.96 following assurances by Circle that it would support the 1:1 peg for the stable coin.
Not surprisingly, an FT article over the weekend mentioned that lenders specialising in distressed assets have surfaced that are interested in buying trapped deposits from SIVB’s cash-strapped clients (i.e. emerging technology companies or VC firms ) at between 75 and 90 cents on the dollar. I suspect that once the dust settles, the most adversely affected segment by far will be some of the bank’s clients.
Subsequent Event (announced Sunday once this article largely penned)
The Federal Reserve announced a new Bank Term Funding Program (“BTFP”) on Sunday afternoon which would provide one-year loans to banks against US Treasuries, agency mortgage-backed securities and select other assets, with the securities valued at par. Size TBD but the Fed has said that it would be large enough to cover all uninsured deposits of the US banking system and would be backed by the Treasury, effectively shutting down concerns of systemic risk in the US banking system related to the failure of SIVB. You can find the Fed press release announcing the BTFP here.
Following this announcement, the Federal Reserve, US Treasury and FDIC released another statement (here) assuring depositors of SIVB and Signature Bank that they would be made whole on their uninsured deposits. How and when this will occur is unclear, but it clearly states that (the successor to) SIVB will reopen for business on Monday, suggesting that customers will get access to insured and uninsured deposits.
#CNBC provided their interpretation of these announcements in an article worth reading (here).
My assessment is that this is an isolated event, although it is impossible to be sure just yet. There will be undoubtedly be collateral damage, especially to SIVB’s clients, but I do not think the U.S. (or global) baking system is at risk. The reason I say this is that SVIB was mainly a tech-focused corporate bank, not a retail bank, that got its asset-liability maturity match wrong and was exposed because of the misfortunes of its client base, which went from cash rich to cash poor during the pandemic. Most other banks have better client diversity and less reliance on corporate (as opposed to stickier and smaller retail depositors). Nonetheless, this incident will heighten the scrutiny of asset-liability matching at many banks, specifically focusing on banks like SIVB that might have piled into low yielding bonds with intermediate maturities before yields began to rise. In addition, we now know that ithis unfortunate event has spurred regulatory action to quell systemic risk in the US banking system.
Sequence of events – the end of SIVB
This is a quick summary of SIVB and how its failure unfolded:
SIVB was a very successful emerging technology bank but its focus meant that its client base was not well diversified. One might argue that “all technology companies are not created equal”, a true statement. However, the willingness of investors to finance the overall emerging technology sector moves in correlated waves, with access to capital for these companies perhaps best characterised as “feast or famine”.
SVIB experienced a glut of cash during the early stages of the pandemic as its customers’ valuations soared and they tapped the capital markets, but this situation changed over the ensuing months and deposit growth began to stabilise and then shrink as capital-raising for the tech sector became increasingly difficult. In other words, in a space of two or so years, the bank went from incredible deposit growth to deposit shrinkage.
SIVB used its glut of cash from rapid deposit growth in the early phase of the pandemic to invest in what were – at the time – perceived to be higher yielding “safe” investments like US Treasuries and agency Mortgage-Backed Securities (“MBS”) with intermediate maturities, aiming to improve its net interest margin.
The Federal Reserve began raising interest rates in March 2021, causing bond yields to increase. The yield on the 10-year UST went from around 1.5% at the end of 2021 to as high as 4.25% in the autumn of 2022, inflicting severe losses on investors that had purchased USTs before the Fed began raising interest rates.
Banks generally invest on a “hold to maturity” basis that allows them to avoid recognising unrealised losses (or gains) on longer-term holdings as interest rates vacillate, which works so long as they do not need to sell these assets. However, as its customers were withdrawing cash to fund their businesses, SVIB suddenly found itself in a position of needing to liquidate some of its bond positions to make good on demand deposits, crystallising losses and creating a hole in the bank’s capital base that would need to be plugged.
The announcement on March 9th of the sale of $21 billion of underwater assets at a loss of $1.8 billion and a concurrent capital raise of $2.25 billion to plug the hole (press release here) spooked investors, leading to a run on the bank. SIVB could not muster up sufficient liquidity to meet the demands from depositors and the FDIC stepped in.
What mistakes did SIVB make?
The table below from the company’s annual reports from 2020, 2021 and 2022 show the growth in deposits, loans, the investment portfolios (both “assets for sale” and “hold to maturity” portfolios) and total assets of the company over the important period during which the damage was done and the stage for failure was set.
As the table illustrates, deposits nearly doubled between the end of 2020 and 1Q2021 (five quarters), increasing by over $96 billion. Total assets also nearly doubled. However, loan growth only increased $23.5 billion over the same period, meaning that the bank could not find loans as an outlet for its excess liquidity. As a result, this excess liquidity was used to purchase “hold to maturity” investment securities for the bank consisting principally of US Treasuries and agency Mortgage-Backed Securities. The “hold-to-maturity” bucket of assets, which is not marked to market as interest rates fluctuate, increased from $16.6 billion at the end of 2020 to $98.7 billion at the end of 1Q21 (around $82 billion). Keep in mind that these investments pre-dated the first increase by the Federal Reserve in the Federal Funds rate in March 2021.
The bank’s decision to invest in US Treasuries and MBS was made so it could achieve an increase in its net interest margin, achieved by borrowing short in the form of demand deposits at nearly nil cost and investing long at higher yields. This might be described as a classic carry trade. SIVB chose to invest in longer-dated and safe government-backed bonds, and it did not hedge these positions. After piling into USTs and MBS with average durations of three to six years, the bank encountered steadily increasing interest rates as the Federal Reserve began to tighten monetary policy in March 2021 to address rising inflation. Simultaneously, as the funding environment for emerging technology companies was getting more difficult, SIVB found itself “locked into” an investment portfolio of longer-dated bonds at yields substantially lower than market yields. Moreover, although deposits were starting to decrease, any new deposits would cost more as interest rates were rising. This deterioration in the company’s financial profile was not visible on the surface because “hold to maturity” securities are not required to be marked to market, but rather are carried at cost.
Based on my “back of the envelope” calculations, the mark-to-market value of the assets for sale (AFS) and those that were hold-to-maturity (HTM) as of Dec 31, 2022 would have resulted in a loss of around $15.5 billion.
The capital base of SIVB was $16.3 billion at the end of 2022, meaning that the bank would have been virtually insolvent had it been forced to liquidate its investment book (ignoring any calculations related to loans). This de facto erosion in the capital base caused by higher interest rates was readily available from the bank’s 10-K and other financial disclosures, but neither investors nor customers seemed to pay attention until it was too late.
The run-up to SVIB’s failure
The 48 or so hours before SVIB was taken over by the FDIC was well covered by the press. This coverage started as soon as it became known that the bank was in trouble, and this undoubtedly turbo-charged its failure. This is not atypical at all for any financial institution that suffers a crisis of confidence amongst its depositor base – the end comes fast and is ruthless. The question is “how did SIVB get in the position that caused its depositor base to suffer such a harsh crisis of confidence?”
Silicon Valley Bank started its operations in 1983 and is based in Santa Clara, CA. The company was listed on the NASDAQ in 1988. It has built its reputation on providing commercial and investment banking services to emerging technology companies including companies operating in the following businesses:
· Consumer internet
· Enterprise software
· Life science and healthcare
· Frontier tech
· Clean tech and sustainability
· Premium wine
According to the company’s website (still active as of March 11th and available here), the company states that “nearly half [of] U.S. venture-backed technology and life science companies bank with SIVB.” SIVB also was an underwriter in 2022 on “44% of U.S.-venture backed technology and healthcare IPOs.” Simply stated, the bank has a significant concentration in tech, life sciences and other emerging technology sectors. Major clients include Crowdstrike, Circle (sponsor of USDC stable coin), Shopify, Teladoc, ZipRecruiter, Roku and Roblox. However, SIVB surely provided financing and investment banking services to hundreds of other lesser-known companies, many of which are privately-held and backed by venture capital or private equity firms. There will most certainly be negative effects of varying degrees into the clients of SIVB that might quickly fail without access to their deposits or that lack an alternative for daily working capital needs, including payrolls. (I have had emails over the weekend from private companies in which I have invested to let their investor base know that they do not have deposits at SIVB.)
Emerging technology companies began to fall out of favour with public equity investors in February 2021. Recall that this is when the valuations of many emerging technology companies, which had become “high flyers” during the pandemic, began to fall to earth. Perhaps one of the best proxies is Cathie Woods’ ARK Innovations (ARKK) fund, which has had the following performance since January 1, 2020:
Recall also that the NASDAQ Composite – a proxy perhaps for listed technology and life sciences companies – was down 33% in 2022. Not only were publicly-listed emerging technology companies falling to earth, but poor performance across both equities and bonds more broadly during 2022 greatly reduced investor appetite for funding early stage companies in private rounds of financing. In summary, SIVB’s clients were under increasing pressure as many required on-going financing which was getting increasingly difficult to obtain and – in any event – more and more expensive.
Even though SIVB was recognised as a leading U.S. bank and was even nominated by Forbes recently as the 2022 “Bank of the Year”, it was likely starting to feel pressure well before it failed. SIVB’s stock increased over fivefold since its pandemic low, reaching $753/share on October 18, 2021. The company’s share price fell to an intraday low of $208/share on Dec 19, 2022 before stabilising and then rallying along with other NASDAQ shares this year, reaching a YtD high of $326/share on Feb 9th, 2023. Since then, the stock has weakened albeit the real sell-off did not occur until March 9th, as you can see below:
Given that the company went from a “normal” close on March 8th to a regulatory takeover the morning of March 10th – a span of less than two business days – it is fair to say that equity investors certainly did not see this coming. The short ratio (shorts % float) was around 6% on February 27th. During the YtD period up until March 8th 2023, SIVB’s shares outperformed the NASDAQ Composite, gaining 16.4% over the period while the NASDAQ gained 10.6%. The bank went from “fine” at the close on March 8th to effectively insolvent in a very short period of time, with virtually no warning.
The FDIC “takeover” – now what?
On March 10th, the assets of SIVB were transferred to a new company created by the FDIC – the Deposit Insurance National Bank of Santa Clara – which will open its doors on Monday to provide withdrawals of up to $250,000 (FDIC insured amount) to depositors. For amounts in excess of $250,000 that are not FDIC-insured, the new bank will gradually unwind assets to repay depositors over time. No clarity has been provided as far as amounts that might ultimately be repaid or the timing. In the March 10th press release (here) from the FDIC announcing the takeover, SIVB had $175.4 billion of deposits and $209 billion of total assets, although it is unclear whether the assets are valued at book value or market value. I strongly suspect it is the former.
I doubt that the FDIC wants to own the assets of SIVB very long and is actively looking for a buyer or buyers, although whether or not the “bank” can be sold piecemeal or in its entirety or will face a slow burn liquidation of assets over time, remains to be seen.
As previously mentioned, the Federal Reserve, the US Treasury and the FDIC released a press statement on Sunday evening suggesting that all depositors that had money at SIVB would be made whole, which I interpret to mean on both insured and uninsured deposits.
Lessons for us all
Banks: Risk management teams need to contemplate scenarios like the one that SIVB experienced. Credit risk has largely been and remains the major focus of risk management departments, but ultimately, asset-liability matching must also be carefully contemplated and effectively hedged. Also, the “stickiness” of deposits must be considered since most deposits are demand deposits. It is believed that retail deposits are substantially more sticky than lumpy corporate deposits, but what must be kept in mind is that demand deposits can be withdrawn on very short notice.
Depositors: For retail investors, this is fairly straightforward. Not many people have deposits over $250,000 (which is the government-insured amount in the US, varies in other countries), but if you do, spread it across multiple banks in maximum amounts of no more than $250,000 / bank. Depositors must be aware of FDIC limits which are on a per bank basis, and also should be knowledgeable about the asset composition of their banks. For companies which might have billions to invest, these limitations and the per bank analyses can be time consuming and problematic, so it is best to stay with the top few US banks.
Investors in banks: Make sure that you understand the asset composition of the banks in which you invest and understand their funding structures. Look for (or calculate on your own) mark-to-market valuations of assets – even those that are hold-to-maturity – that better illustrate the true solvency of banks.
Regulators: The SIVB failure raises the controversial topic of whether or not there should be some protection against “runs on banks”, meaning that depositors could be subject to staged withdrawals rather than allowing the winners to be those depositors that get out of the door first as a bank is failing. This unfortunate incident has also highlighted also for the first time how electronic banking – now widely adopted – can speed the demise of a bank in which depositors have lost confidence. It also raises questions about disclosure of mark-to-market calculations, even in footnotes perhaps, for all investments at banks. Lastly and perhaps most importantly, the failure of SIVB has spurred new regulatory actions in the form of a facility at the Federal Reserve to provide one-year loans against high tier collateral of banks to greatly diminish the risk of “runs on banks.”
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