What really happened?
March 15, 2023
The facts behind the Silicon Valley Bank fallout.
In early March, 40 chief financial officers from various technology groups gathered in the Utah ski resort of Deer Valley for an annual “snow summit” hosted by Silicon Valley Bank, a crucial financial institution for start-ups.
Barely a week later, on Thursday morning, several of the finance chiefs were exchanging frantic messages about whether they should continue to hold their cash in the bank. A sale by SVB of $20bn of securities to mitigate a steep drop in deposits had focused investors’ attention on vulnerabilities in its balance sheet.
They dumped its stock, wiping $10bn off its shares and crashing the market value of the bank — worth $44bn just 18 months earlier — to below $7bn. “The prisoner’s dilemma was basically: I’m fine if they don’t draw their money, and they’re fine if I don’t draw mine,” said one of the CFOs, whose company had banked around $200mn with SVB.
But then some started to move. “I got a text from another friend — he was definitely moving his money. It was happening,” the finance chief said. “The social contract that we might have collectively had was too fragile. I called our CEO and we wired 97 per cent of our deposits elsewhere by midday on Thursday.”
By Friday morning, the bank was bust. Customers had initiated withdrawals of $42bn in a single day — a quarter of the bank’s total deposits — and it was unable to meet the requests.
The Federal Deposit Insurance Corporation — the US bank regulator that guarantees deposits of up to $250,000 — moved into the bank’s Santa Clara, California, headquarters, declared it insolvent and took control. The run was so swift its coffers were drained in full and carried a “negative cash balance” of nearly $1bn.
The rapid collapse of SVB has stunned the venture capital and start-up community, many of whom now face uncertainty about the fate of their bank accounts and business operations. SVB provided banking services to half of all venture-backed tech and life sciences companies in the US and played an outsized role in the life of entrepreneurs and their backers, managing personal finances, investing as a limited partner in venture funds and underwriting company listings.
“It turned out that one of the biggest risks to our business model was catering to a very tightly knit group of investors who exhibit herd-like mentalities,” said a senior executive at the bank. “I mean, doesn’t that sound like a bank run waiting to happen?”
SVB spectacularly unravelled in that bank run, but its fate had been sealed almost two years earlier. In 2021, at the height of an investment boom in private technology companies, SVB received a flood of money.
Companies receiving ever larger investments from venture funds ploughed the cash into the bank, which saw its deposits surge from $102bn to $189bn, leaving it awash in “excess liquidity”.
Searching for yield in an era of ultra-low interest rates, it ramped up investment in a $120bn portfolio of government-backed securities, $91bn of these in fixed-rate mortgage bonds carrying an average interest rate of just 1.64 per cent.
While slightly higher than the meagre returns it could earn from short-term government debt, the investments locked the cash away for more than a decade and exposed it to large losses if interest rates rose – which they did.
This is a sad misunderstanding of risk. Long term government backed bonds are an incredibly safe asset and it’s a very sensible place to keep funds – this was not their crime. BUT, to get the 1.64 per cent return over 10 years, they would need to keep the bond to it’s maturity, that’s how they work. Bond prices fluctuate in the market. If you’re depositing for 10 years with no need for the money, then this doesn’t matter so much. However, this is the very opposite of having liquidity. If large deposits become large withdrawals, they wouldn’t have the funds to comply. This becomes a bank run.
Here is what we would refer to as a ‘Fisher Price explanation of how bond pricing works’.
A bond comes with a fixed duration and a fixed coupon. The actual rate of return is then worked out by calculating the present value of a bond’s future interest payments, know as its cash flow, and the bond’s value upon maturity, known as its par value. This is the amount you get back when the bond expires.
Let’s say a bonds par value is £100. If the bond costs £100 and has a fixed coupon of 5%, then you would expect to get £5 per year until the bond expires.
However, interest rates alter the value of that bond. The duration and the coupon remain fixed, so the only thing that can change is what you are prepared to pay for that bond.
If interest rates are low, then that bond will be more valuable as 5% becomes more attractive. This means that the market for this 10 year bond might be trading at £120 as lots of investors would like a guaranteed yield, as SVB did.
So over 10 years, you will receive £5 per annum, meaning you have received a total of £50. However, you paid £120 for the bond, but will only get £100 back when it expires, so what you actually received over that 10 year period in profit is £30.
You get £100 back after the 10 year period, and made £30 over 10years, so the current yield when you bought it, would be 3%.
When rates rise, this coupon is less attractive to the market so the price of that bond falls. Yes, the yield goes up and it’s more attractive to new buyers, but you already own it so ultimately the cash value of your asset has decreased. As the owner, the only change you see, is the book value of your bond which may go from £120, to £105. If you keep it until maturity, it doesn’t matter quite so much as that was the deal you were getting into and you knew that upon purchase.
However, the banks depositors will want better rates. So although the bank might lock in 3 per cent, or in SVB’s case 1.64%, they now have to pay their depositors more, maybe even more than the yeid they are reciveling on the long term bonds. This is the exact opposite of how a bank works.
Had interest rates not moved, they would just be able to sell the bonds at the same price the paid for them. It’s a liquid market so again, not a bad investment. Just one that lacked foresight.
When rates did rise very sharply last year, the value of the bond portfolio fell by $15bn, 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 investments represented a huge shift in strategy for SVB, which until 2018 had kept the vast majority of its excess cash in mortgage bonds maturing within one year, according to securities filings. One person directly involved in the bank’s finances attributed the policy to a change of leadership within SVB’s key finance functions in 2017 as its assets marched towards $50bn, a threshold above which it would be labelled a “systemically important” lender subject to greater regulatory scrutiny.
The new financial leadership began to shift an ever-greater percentage of excess cash into long-term fixed-rate bonds, a manoeuvre that would appease public shareholders by bolstering its overall profits, albeit only slightly. But it appeared blind to the risk that cash pouring in was a symptom of low interest rates that could reverse if they rose.
Central banks often increase rates for many reasons. Currently, they are trying desperately to slow inflation and curb wages.
SVB’s bond portfolio was exposed to rising rates and so too were its deposits. “We had enough risk in the business model. You didn’t need risk in the asset/liability management profile,” said the former executive, referring to the bank’s ability to sell assets to meet its liquidity needs. “They missed that entirely.”
As a venture capital investment bubble began to inflate in early 2021, Nate Koppikar, a partner at hedge fund Orso Partners, began studying SVB as a way to bet against the industry at large. “The problem with the business model is that when capital dries up, the deposits flee,” said Koppikar. “It was one of the best ways to short the tech bubble. The fact this bank failed shows that the bubble has burst.”
While SVB bankers were entertaining finance chiefs on the Utah slopes in early March, the pressure was rapidly mounting on SVB’s executive team, led by chief Greg Becker. Although SVB’s deposits had been dropping for four straight quarters as tech valuations crashed from their pandemic-era highs, they plunged faster than expected in February and March.
Becker and his finance team decided to liquidate almost all of the bank’s “available for sale” securities portfolio and to reinvest the proceeds in shorter-term assets that would earn higher interest rates and improve the pressure on its profitability.
The sale of $21 billion worth of securities meant taking a $1.8bn hit, as values had fallen since SVB had purchased them due to surging interest rates.
To compensate for this, Becker arranged for a public offering of the bank’s shares, led by Goldman Sachs. It included a large investment from General Atlantic, which committed to buy $500mn of stock. The deal was announced on Wednesday night but by Thursday morning looked set to flop.
SVB’s decision to sell the securities had surprised some investors and signalled to them that it had exhausted other avenues to raise cash. By lunchtime, Silicon Valley financiers were receiving last-ditch calls from Goldman, which briefly attempted to put together a larger group of investors alongside General Atlantic to raise capital, as SVB’s share price was tanking.
At the same time, some large venture investors, including Peter Thiel’s Founders Fund, advised companies to pull their money from SVB – this sealed the banks fate.
Becker, in a series of calls with SVB’s customers and investors, told people not to panic. “If everyone is telling each other SVB is in trouble, that would be a challenge,” he said.
Suddenly, the risk that had been building on SVB’s balance sheet for more than a year became a reality. If deposits fell further, SVB would be forced to sell its hold-to-maturity bond portfolio and recognise a $15bn loss, moving closer to insolvency.
Rival bankers argued the plan was flawed from the outset — disclosing a $1.8bn loss at the same time as only securing $500mn of the $2.25bn capital raise from an anchor investor. “You can’t build a book while the market is open and you’re telling people there’s a $2bn hole,” said one senior banker at a competitor.
There was external pressure, too. Goldman bankers on the capital raise knew the deal was being done in a way that was hard to pull off with an unhelpful market backdrop. But the company was facing a time crunch due to the downgrade by Moody’s to Baa1 from A3 on Wednesday.
Ultimately, the bank committed a cardinal sin in finance. It absorbed enormous risks with only a modest potential pay-off in order to bolster short-term profits.
One hedge fund short seller who detailed the bank’s risks last year warned that SVB had almost unwittingly built the foundation for what could become “the first large US bank collapse in 15 years”. “They went for an extra 0.4 percentage points of yield and blew up the bank. It is really sad.”
However, governments have moved quickly. 2008 just wasn’t that long ago and there is no way any government was going to let the fall of one bank become systemic.
In the UK, HSBC stepped in to by the UK arm of SVB. Due to the speed of the purchase, we imagine it was a fantastic deal for UK’s largest bank, but it was also a necessary one. With a balance sheet of £8,8bn, HSBC paid £1. ‘This acquisition makes excellent strategic sense for our business in the UK’, HSBC said.
SVB UK is now safe and secure. ‘All services will continue to operate as normal and customers should not notice any changes’ a statement said.
In Germany, SVB’s Frankfurt branch only had assets of 789 million Euros at the end of last year. BaFin, the German regulator, pointed out that its ‘operations don’t pose a danger to financial stability.’ The Association of German Banks, a lobby group, confirmed that the country’s deposit insurance won’t be needed.
Europe is ok, and there shouldn’t (and we really hope there isn’t), any knock on effect.
In the US, regulators have said that SVB depositors would be fully repaid. The Federal Reserve announced a new lending facility on Sunday aimed at providing extra funding to eligible institutions to ensure that ‘banks have the ability to meet the needs of all their depositors’.
The US central bank said it was ‘prepared to address any liquidity pressures that may arise’. This is about as big a confidence boost as the American system could have hoped for. So far, the markets remain jittery, but this is to be expected.
In the words of the US President, ‘the banking system is safe’.
If he’s right, this could prove to be a fantastic stock buying opportunity.
This is where The Portfolio Platform stands out from everyone else. It’s the very reason that founders Lane Clark and Ed Davies built it.
Last week most of the active traders on the platform were holding short positions. This isn’t something you’ll get elsewhere. Most of our portfolios actually made money. Yes, what has happened is sad, BUT, as we always say, the real risk to your portfolio is not being able to do anything about it.
Long only can work as a long-term investment strategy, but it will never get you the returns our active strategies can.
What you can see here are the last 7 trades placed by one of our traders over the last week. 6 short positions and 1 long.
Build your own portfolio and you can see results like this. Nobody wants any banks to fail, but why not give yourself the chance to make money when they do.
If this sounds like something that might be of interest to you, then please do contact us here and one of our directors will get back to you.
The TPP Bias:
Many of our active strategies who were positioned for a sell off have now liquidated their profits and have evolved onto the BUY side of the markets.
If the markets do reverse from here, it will certainly be a month to remember for some of our strategies.
Sometimes the best opportunities are found in an uncertain climate.
We expect it will be a very interesting week in the markets.
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