Bank Failure

Silicon Valley Bank failed on Friday, March 10, 2023. It was the second biggest bank failure in the United States, after Washington Mutual in 2008. Silicon Valley Bank was America’s 16th largest lender. 

While economists at JPMorgan Chase & Co. retained their forecast for a quarter-point rate hike by the Fed next week, their counterparts at Goldman Sachs Group Inc. said they no longer expect the Fed to raise rates.

The Collapse of Silicon Valley Bank
San Francisco-based Silicon Valley Bank (SVB) largely served start-ups and venture capitalists. They had 209 billion in assets with 165.4 billion in deposits at the time of failure. It's financial position slowly deteriorated over several years, but just two days elapsed between the bank’s announcement on March 8 that it was seeking to raise $2.25B of new capital to plug a hole in its balance sheet and the declaration by the Federal Deposit Insurance Corporation (FDIC) that SVB had failed.

SVB’s share price plunged over 40% from $268 to $163 after the capital raise was revealed late on March 8. In a public note to investors, the company wrote “support us as we have supported you.” Investors were not impressed and Bill Ackman, a well-known hedge fund manager, tweeted that the federal government should bail out SVB.

During the next day March 9, SVB's shares slid by another 35% to $106, before the trading halt was ordered. On March 10, the bank scrambled to sell itself to a larger institution, without success. Customers were trying to withdraw as much funds as possible. Finally, on the same day, the FDIC regulators announced they would step in and take over SVB. See chart “Silicon Valley Bank Stock Price” for details about the share price development.

These events raise two important questions. The first is how did SVB get into this position. The second is whether this is an isolated incident in the financial market or a tell-tale sign of troubles to come.

Why Silicon Valley Bank Went Under
SVB was a bank for start-ups, a risky line of business that can lead to above-average returns or the loss of invested capital. It opened accounts for them and lend them money, often before larger lenders would do so. Other banks were often reluctant because few start-ups have collateral assets they can put up as security. As the tech industry in Silicon Valley and at large boomed over the past five years, so did SVB. Its clients were flush with cash, and they needed to store more money than they needed to borrow.

Consequently, SVB’s deposits more than quadrupled from $44B in 2017 to $189B in 2021. Meanwhile, its loan book only grew from $23B to $66B. Since banks make money on the spread between the interest rate they pay on deposits and the rate they are paid by borrowers, having a far larger deposit book than a loan book is a problem. SVB solved this problem by acquiring interest-bearing securities, mainly in the form of mortgage bonds and treasuries. By the end of 2021, the bank had invested $128B in these securities.

Recall from our newsletter “2022 Review and Outlook 2023” that bonds had their worst year on record in 2022. As interest rates soared, the value of SVB’s interest-bearing securities declined in the market. Meanwhile, venture-capital fundraising began to dry up and SVB’s formerly cash-rich depositors began to withdraw their funds, causing SVB’s deposits to fall to $173B at the end of 2022.

In its public note to investors, SVB wrote “we expect […] elevated cash burn levels from our clients as they invest in their businesses.” Clearly, SVB understood its business model was no longer working in the current market environment and that the outlook was bleak.

In order to regain liquidity to pay out its “cash-burning” depositors, SVB was forced to sell off its liquid bond portfolio at a loss of about $1.8B. This led SVB to ask for the additional $2.25B capital in the equity market, causing investors to lose confidence and more depositors to withdraw their money. In two days, SVB collapsed and the FDIC took over.

Isolated Incident or Tell-Tale Sign of Troubles to Come?
Was this an isolated incident? The shortcomings of SVB shouldn’t be surprising. They were a product of easy monetary policy. SVB catered to start-ups that relied on excessive valuations to raise funding. Investors piled into start-ups chasing yields that conventional means cannot produce in an artificially low interest-rate environment. Now that easy-money faucets are turned off, start-ups are going through drawdowns and have increased demands for cash.

This is a reset in the venture capitalist space. Financial institutions which specialized in this arena are especially at risk, but well-diversified banks will be able to draw on other sources of income to meet their liquidity demands. Banks, like other businesses, fail when their business model no longer works. This is how markets correct themselves.

Impacts on Banking
The second-largest bank failure in U.S. history will not entirely be without consequences. Other banks have immediately fallen under scrutiny, following the bad news surrounding SVB’s troubles. The S&P Banks Select Industry Index fell by 13% between March 8 and March 10. Some of America’s largest banks, such as Wells Fargo, Bank of America, Morgan Stanley, and JPMorgan Chase have collectively lost $50B in market value in two days.

The main driver of concern is a balance sheet characteristic that nearly all banks share with SVB – they are all holders of securities with unrealized losses. The chart “Unrealized Gains/Losses on Investment Securities” shows how significant the issue is across the banking industry. The underlying investment securities are treasury or mortgage bonds.

At the end of the 2008 financial crisis, the unrealized losses on such securities were $75B. Following the covid pandemic, at the end of 2020, banks were sitting on an unrealized gain of $125B. Now, at the end of 2022, following a series of sharp interest rate hikes, banks across America hold an unrealized loss of $620B.

This ballooned level of unrealized losses on investment securities due to high market interest rates is a reason for concern in the banking industry. The combination of a high level of longer–term asset maturities and a moderate decline in total deposits underscores the risk that these unrealized losses could become actual losses should banks need to sell securities to meet liquidity needs.

Bail Out
On Monday, October 13, the Treasury, the Fed and FDIC announced they would make all the depositors whole. According to numerous reports, well over 90% of SVB’s deposits exceeded the FDIC-insured threshold of $250,000.

The Fed also announced a new “Bank Term Funding Program” that offers one-year loans to banks under easier terms than it typically provides. $25B is available. The central bank also relaxed terms for lending through the discount window, its main direct lending facility.

Contagion fears within the regional banking sector have been reduced, but longer term issues now present themselves.

“If the Fed is now backstopping anyone facing asset/rates pain, then they are de facto allowing a massive easing of financial conditions as well as soaring moral hazard,” said Michael Every and Ben Picton, strategists at Rabobank.

Other Impacts
In addition, it will become even more difficult to raise venture capital financing. Rising interest rates have provided investors with alternative investment options. Now, with the failure of SBV, start-ups have lost one of their strongest financing partners, leaving fewer players in this financing space to support new start-ups.

The housing market in the San Francisco area will likely decline further. In our last newsletter titled “Not out of the Woods Yet”, we described that San Francisco, CA had the biggest price drop in the country, year over year, in Q4 of 2022, following a steep drop of 21% from its peak in Q2 2022. This downward trend in the San Francisco housing market will likely continue in the coming months, especially as people in the tech and start-up sectors will lose their jobs, and it may impact California at large, as many tech workers have discovered remote work.

The cryptocurrency scene may also be highly impacted by the collapse of SVB. The Boston-based stablecoin firm Circle tweeted it has $3.3B of its $40B of USD Coin reserves at the collapsed SVB. While other cryptocurrency firms like Binance reported that they had no exposure to SVB, the entire cryptocurrency scene could be destabilized and discredited yet again, should Circle get into financial trouble as a result of SVB’s collapse.

Also noteworthy is the “Fear and Greed” index published by CNN Business. It jumped from neutral, one week ago, to fear on March 9, to extreme fear on March 10. The coming weeks will likely be a bumpy ride for financial markets.

What Does it Mean for Investors?
Investors should consider converting their assets into cash. This is particularly true for the housing investments in San Francisco and California in general, as these markets will see increased downward pressure from the slowdown in the tech industry, which has now been accelerated by the collapse of SVB.

In addition, it would be prudent to convert stocks into cash, until it is clear how the situation surrounding SVB’s collapse will play out. It took nearly 17 years for the tech industry to recover from the .com bubble crash in 2000.

Investors should consider safe investment opportunities with predictable returns, such as secure first trust deeds with stable returns and low risk.

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