You have likely heard by now that Silicon Valley Bank and its parent company SVB Financial Group (Nasdaq:SIVB) failed as a bank on Friday last week. There were a number of influences that together spelled the downfall of the bank.
In 2020 through 2021 Silicon Valley Bank took in incredibly high deposits through PPP loans and through their clients that were taking their companies public through a SPAC (Special Purpose Acquisition Vehicle). The bank took those deposits and decided to invest in long-term bonds such as mortgages and treasuries while interest rates were low.
2022 was a very different year and not only did Silicon Valley Bank’s unique customer base of private companies start to need cash and so pulled their deposits but also interest rates increased which impacted the mark-to-market value of their longer-term bonds. The bank, in an effort to appropriately deal with the impact of mark-to-market losses, used a valid accounting change to consider those bonds “held to maturity”. Any bonds that are held to maturity do not need to be updated with the market value but can be held on the books at cost.
Unfortunately, Silicon Valley Bank was unable to hedge their interest rate risk for any bonds that are in the “held to maturity” category as the accounting rules say that any bond that is hedged is not considered "held to maturity" and thus be marked at current value.
The combination of reducing deposits and too few assets that were marked at the market forced the bank to sell their held to maturity bonds to meet withdrawals by their customers. When the bank sold the mark-to-market securities they were forced to realize the losses and those losses effectively overwhelmed the bank equity causing the bank to fail.
This all happened over the course of a week and really over 2 days. The stock was worth $267.90 close of business Wednesday and worthless by the close of business Friday.
Did Silicon Valley Bank do anything wrong? The bank did not break any rules as they are written but they also did not effectively hedge their interest rate risk. Their poor risk management ultimately spelled their doom. It would have been easy enough to reduce purchases of so many long-term bonds back in 2021 but the appeal for the bank to make a little bit more money on their deposits was likely too strong. Also how many market participants expected the Federal Reserve to raise interest rates so much so quickly? They were caught offside.
Some have said it was a “bank run.” Is that right? Yes, when depositors realized that the banks tangible equity was falling, those who have more than the FDIC insured limit of $250,000 decided to take their additional savings out to be safe. Some depositors also wanted higher interest rates they could achieve with a money market fund (4.5% vs. 1% at many banks), and finally many of their depositors needed money because their startup businesses were not as successful due to the market environment.
Is this a risk for the big banks (over $250B in assets)? No. Big banks are stress tested regularly and are required to hedge their interest rate risk. As a result those banks are not at risk of the same problems from Silicon Valley Bank.
What about smaller banks? Yes, some smaller banks with more aggressive treasury operations (what they choose to do with the deposits and how they hedge or not) are at risk. Signature Bank of New York has also been seized by regulators and there are other midsize (less than $250B in assets) banks that seem to have low tangible equity. Banks can be notoriously hard to analyze so I expect many who invest for dividends to find greener pastures.
Impact to the market? We’re not sure yet how this will impact that market other than introducing more volatility. Some think the Fed must stop raising interest rates immediately to stem the losses of these poorly performing long-term bonds on bank balance sheets, while others think the Fed needs to continue to raise rates to combat inflation. One thing is certain – bond market volatility as measured by the MOVE index is likely to be heading higher. Last year when the MOVE index went higher, financial conditions tightened and the stock market declined and the economy slowed. It is likely that will be the case again in 2023.
We invest for long-term returns and recognize events like this do happen. Depositors will end up being OK. Equity holders of the banks will not. If you have any questions about this or your portfolio, please give me a call.
