The Tide Goes Out On Silicon Valley Bank

I am sure by now you have seen the headlines of the failure of Silicon Valley Bank (SIVB). Our President wrote a letter on Monday (here) touching on the situation but also outlining what we are prepared for as we progress through this broader economic cycle. In this note I want to expand on that letter and give a more specific commentary on what took place at Silicon Valley Bank and how it reached the point of collapse. In this note I focus on SIVB but the same characteristics are shared by Signature Bank (SBNY) and First Republic (FRC) which have also gone under or are under significant stress.

Silicon Valley Bank is a chartered bank in Santa Clara California. In many ways SIVB operated like any normal bank. A classic bank has short-term deposits and long-term assets. Depositors loan their money to the bank for an interest rate payment. That bank then loans that money to fund useful projects that earn a higher interest rate payment (typically in bonds, stocks, loans, mortgage backed securities, etc). As long as the depositors do not withdraw their funds, the bank earns a profit. The deposits are liabilities to the bank and the loans are assets to the bank. All banks also use a fractional reserve system where they only hold a fraction of their deposits in liquid “cash”. The fractional reserve system is often characterized as a sinister system but it’s the main vessel of money creation in our modern economy. The drawback is if enough depositors rush to the bank to withdraw their money at the same time you get a “run on the bank” leading to a collapse of that bank. The FDIC tries to mitigate the risk of this by guaranteeing up to $250k of a depositor's money so as to provide confidence to depositors that their savings will not just vanish. Since Friday the federal government announced protections for depositors at SIVB above the $250K limit. But as can be inferred from this whole dynamic, a bank run can be a self-fulfilling prophecy where if key depositors withdraw their funds from the bank, that can scare other depositors into withdrawing their money ultimately resulting in a state regulator to call in the bank and dissolve it.

So SIVB pretty much followed this typical bank failure model but with some nuance which gives hints as to what is happening to the broader economy. SIVB saw a huge inflow of deposits in the last 3 years as their client base of speculative tech companies have been perhaps the main beneficiary of the fiscal and government stimulus policies. SIVB received this huge inflow of deposits from their technology/VC/crypto clients and they could not figure out how to invest all those funds into high yield assets since rates were so low. Thus, SVB ended up purchasing low-yield, long duration, but relatively safe mortgage backed securities and long term bonds that were intended to be held to maturity (HTM).

But the problem with these long duration assets is that even if they are safe, they have to be held until maturity, sometimes decades, in order to receive a positive return on them. Many of these investments were earning below a 2.5% yield and did not mature for decades. The products can still be bought/sold in the market before they mature but they are subject to market prices which swing up and down. What has taken place in the last 12 months is the Federal Reserve began raising the rate of interest that they would pay on risk-free government bonds. When the Fed does this it typically lowers the price of securities on the market because why would you buy SIVBs loan portfolio yielding sub 2% when you can now buy a risk-free treasury bond yielding 4%? Thus anytime the bank had to sell these assets in order to meet withdrawals from their depositors they had to lock in a large loss at the current market prices. This scenario of having the maturity of the liabilities, i.e. when payments are due, being much shorter than the maturity of the assets is called a “maturity mismatch”. So SIVB’s flood of deposits from fast-money VC firms at a time of historically low interest rates ended up being a curse rather than a blessing. 

 

Many banks protect themselves from this maturity mismatch by doing a number of prudent things such as shortening their asset portfolio maturity so they do not have to hold their investments for so long to earn a profit, or by hedging their portfolio against rising rates using derivatives. These actions typically act like insurance policies where it costs the banks some return to implement, but protects them against large losses if market conditions turn unfavorable. Silicon valley bank did not take these prudent steps and their deposit base was equally unprotected.

Silicon Valley Bank's deposit base was also more volatile than a normal bank. For years they were known as the one-stop-shop for venture capital (VC), technology, and crypto companies and entrepreneurs (hence the name Silicon Valley Bank). This high reliance on institutional/VC deposits certainly contributed to its demise as these depositors are cash intensive and need regular capital withdrawals to make payroll and capital expenditures as many of them are not profitable from operations. Compared to retail banking SIVBs depositors had far higher turnover and interest rate sensitivity.

I do not want to be dismissive of the collapses of Silicon Valley bank, Signature Bank, or First Republic as non-issues. Banks collapsing are never good and in fact I think their struggles illustrate the purging effect of tightening monetary policy which I will outline further on in this note. But I do want to give some reasons as to why it is different from the systematic collapse of 2008. First and foremost, these banks have a very niche clientele of the most speculative kind and are not indicative of the broader banking landscape – although contagion is always a risk in the financial environment. Unlike Lehman Brothers and Bear Stearns, these are not investment banks and key financial intermediaries to the global economy. As outlined previously SIVB has concentrated exposure to the US tech sector but its role in the global financial market is limited when compared to the banks that collapsed in the GFC. In fact, the blunder of these niche tech regional banks will likely be a boost for the large, systemically important banks as depositors pull their money from the smaller institutions and flock to the colossal systemically important banks (JP Morgan, Bank of America, Wells Fargo, Citi). Crypto is also playing a role in the liquidity crunch at the tech centric banks. Circle stablecoin, a type of crypto instrument, reportedly has $3.3 billion of its $40 billion in reserves tied up in SIVB deposits. This is part of a broader issue that plagues the crypto world: lack of fully audited disclosures on stablecoin reserves and the counterparty risk associated with them.

But the collapse of these tech centric banks does give some illustration to the problems that we think will strike the clients that they serve. As I keep mentioning, SIVB was a large part of the venture capital, technology, and crypto ecosystem. Just as low interest rates distorted the banks loan/bond portfolio, it also distorted parts of the equity markets -- namely by making money and debt essentially free to any company needing funding, even if their enterprise had no chance of ever becoming profitable. Many of the venture capital and crypto enterprises epitomize this. As interest rates rise investors will no longer allocate money to speculative investments where the payoff, if ever reached, will be far into the future and with a great deal of risk. Now they can simply buy a risk free US treasury bond or dividend paying equity with actual business fundamentals which will pay them cash flow now. And without the inflow of stimulus many of these tech companies which were growing at a rapid clip, will have their growth rates come back down to earth affecting their operations and business value.

Silicon Valley will take a large hit. Many startups will be dissolved and innovation will slow down in the short-term. This is what the central bank wants. They want investment to slow down and the economy to become more prudent with capital to curb inflation. This will create pain in the short term but this same cycle has played out many times and those companies that are prudent and provide real goods & services will survive and thrive. Those that are irresponsible or take undue risk will be eradicated. In our President's letter from Monday he emphasized the importance of owning the large companies which have a track record of operating through these kinds of environments. There is no doubt short term pain for everyone, but what happens is large companies end up taking share from the smaller companies focused on growth as opposed to long-term viability. I suspect this dynamic will be true for the economy as a whole as the tide continues to go out.

 

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