Silicon Valley Bank – A Signature Failure

It remains to be seen how the Federal Reserve Bank will react when it meets next week to confront the ongoing battle of curbing inflation, stabilizing the economy, and keeping the banking system together

Breakfast With Bwana

By Anil Madan

The crash of Silicon Valley Bank (SVB) has rattled financial markets, and the entire banking system shows signs of strain. SVB found a special niche catering to the tech, biotech and crypto industry startups funded by venture capitalist (VC) industry. Its connections to VCs and high-net-worth people in the companies they financed, helped it to build relationships with depositors from those tech, biotech and crypto companies from Silicon Valley in California to Boston and beyond.

Startup-focused lender SVB Financial Group i.e., the Silicon Valley Bank Group became the largest bank to fail since the 2008 financial crisis. Pic – Daily Motion

Since the end of the financial crisis of 2008-09, there has been a boom in venture capital investments which gathered steam as innovations in technology, science, and the financial world took on new life with digital tools and new thinking on how to adapt technology and the Internet to manage the world’s business and solve its problems. 

But sometimes, even in the face of great technological advances, the simplest of problems get overlooked. This was SVB’s main problem as it grew exponentially and new deposits from VCs, seduced by the promise of riches to be generated by adventurous entrepreneurs, poured in. This surfeit of money had to be invested somewhere. The Covid pandemic and fears of a worldwide recession induced the US Federal Reserve and the world’s central bankers to keep interest rates very low, close to zero. As a result, the surplus cash was “invested” by SVB in low-yielding bonds. Then came the disruption of supply chains, and ultimately, the easing of pandemic restrictions — at least in the West, India, Japan, South Korea, and Australia where vaccinations seemed to quell the rage of the pandemic inferno—, a reopening of economies and resurgence of demand. As a consequence, inflation reared its head and bared its fangs.

The Fed and other central banks shrank in horror and responded by raising rates. As inflation roared and seemed ready to disrupt the lives of billions and upend commerce and trade as we know it, the bankers got more aggressive with their rate hikes. These rate hikes have not materially slowed economies although the threat of a slowdown looms. But they have made money tighter.

And what happens when interest rates are hiked? It’s not rocket science, but if you hold a bond paying 1% or 2% and interest rates on new bonds are raised to 3, 4, or 5%, the price of your bond will fall, else no one will buy it and accept a lower rate than is available from buying new bonds. When this happens, although the holder of the older bond, will eventually get its money back when the bond matures, if he tries to sell the bond, its market value is lower than the face value. What if a bank holding such bonds were called upon to honour all of its deposits? Clearly, there would be a shortfall because it could not recover all of the money representing its deposits that it had invested in the bonds. Therefore, accounting rules require banks to mark their holdings down to market value to recognize these kinds of potential shortfalls.

This is what happened at SVB. Sort of. But it was worse. As money got tighter and the prospects of recessions loomed, the VCs began to see their fund flows diminish, and they became more risk averse about funding new companies. The already funded companies also found it difficult to raise more money and began to draw down on available funds. All of this caused SVB’s deposits to shrink. New VC investments that had provided a steady flow of deposits vanished. The gap between SVB’s liabilities to depositors and the market value of its bond holdings grew larger.

Venture capitalist boom

The Financial Times recently provided some details. It reports that in 2021, at the peak of the VC boom, SVB saw its deposits surge from $102bn to $189bn, leaving it awash in “excess liquidity”. In search of higher returns in the Central Bankers’ ultra-low interest rate environment, SVB “ramped up” investment in a $120bn portfolio of highly rated government-backed securities, $91bn of these in fixed-rate mortgage bonds carrying an average interest rate of just 1.64 per cent.

Although SVB was now receiving a slightly higher return than what it could earn from investing in short-term government debt as it had been, its cash was now locked away for a decade and exposed to the “mark to market” accounting losses described above, if interest rates rose quickly. Interest rates did rise last year, and how. The value of SVB’s portfolio fell by $15 billion, an amount almost equal to SVB’s total capital. If it were forced to sell any of the bonds, it would risk becoming technically insolvent.

The story has a bit more intrigue to it. The crash in tech valuations in stock markets had caused SVB’s deposits to drop for almost a full year, but in February and March, they plunged faster than expected. SVB’s leadership decided to liquidate almost all of the bonds it held that were readily saleable and to reinvest the proceeds in shorter-term bonds for a higher rate of return. The rate hikes by the Fed had caused these short-term rates to rise. But remember that drop in price that the older bonds suffer when rates go up? That drop meant SVB would have to take a hit of almost $2 billion. To compensate for this loss, SVB’s executives decided to arrange a sale of additional shares of its stock. But an investor that had committed to buy $500 million worth of shares, backed off. The price of SVB’s stock was tanking. Goldman Sachs was scrambling to salvage the stock sale deal but was unable to keep it together.

Meanwhile, some VC heavyweights were advising companies to withdraw their money from SVB. Although SVB’s CEO tried to reassure investors and depositors, it became apparent that if deposits continued to flow out, SVB would be forced to sell those longer-term bonds and face the reality that a $15 billion loss spelled insolvency technically, and that “technicality” would soon become “reality”.

SVB’s attempt to sell about $20 billion worth of securities to offset the loss of deposits had exposed how soft its capital structure was. Investors dumped its stock, erasing about $10 billion worth of market value. The bank’s shares had already been plunging from a high valuation of $44 billion about 18 months earlier, and with another $10 billion loss, its market cap was down to $7 billion.

Last week, the CFOs and other executives of companies with deposits began to move their money out of SVB. The Financial Times reports that one CFO moved 97% of his company’s $200 million on deposit to HSBC. By Friday, depositors had moved $42 billion out of SVB.

$42 billion! SVB went bust.

The contagion has not been limited to SVB. Signature Bank, a New York City bank that has been a major lender in the New York City real estate market has also collapsed. Signature had built a portfolio of almost $36 billion in real-estate loans which represent about one-third of its $110 billion asset base as of the end of last year. But Signature also had significant exposure to crypto firms. Panicked real estate investors started to pull their deposits from Signature last week.

Generalized fear

Is there more to go? Who knows? Bank stocks have been plunging. To some extent, this is from generalized fear. But there may be more to it. The Wall Street Journal reports that SVB’s CEO, Greg Becker sold $30 million worth of stock over the last two years and altogether, SVB’s executives and directors sold $84 million worth of its stock over the same period.

In Europe, shares of Credit Suisse which has already undergone a $4+ billion capital raise and restructuring, plunged. In late 2022 Credit Suisse disclosed that it was experiencing “significantly higher withdrawals of cash deposits” and other assets by customers. And, in the fourth quarter of 2022, customers of Credit Suisse withdrew more than 110 billion Swiss francs which eclipses the $42 billion outflow from SVB last week.

Meanwhile, the Federal Deposit Insurance Corporation (FDIC) which insures deposits up to $250,000, announced that it was waiving that limit and would cover in full all of the deposits that remained in the bank. This has averted a cash crunch and perhaps even insolvency for many startups. The US can ill afford another hit to the economy, so putting aside issues of moral hazard, this was a good step to calming and hopefully stabilizing the markets.

It remains to be seen how the Federal Reserve Bank will react when it meets next week to confront the ongoing battle of curbing inflation, stabilizing the economy, and keeping the banking system together.

Cheerz…
Bwana


Mauritius Times ePaper Friday 17 March 2023

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