The Fallout From Silicon Valley BankSubmitted by Silverlight Asset Management, LLC on March 14th, 2023
Silicon Valley Bank's (ticker: SIVB) collapse last week was an old fashioned bank run that happened extra fast thanks to modern social media. It took less than 48 hours for the 16th largest bank in the US to become insolvent, marking the second biggest bank failure since Washington Mutual's demise in 2008.
SIVB specialized in lending to early stage technology companies. Per the bank's website, nearly half of US tech and health care firms that went public last year after raising venture capital funds were Silicon Valley Bank customers.
Here is a look at SIVB's deposit and off balance sheet funding sources:
Source: JPMorgan Asset Management
"I always tell people I'm confident I've got the best bank CEO job in the world," SIVB CEO Greg Becker said on Bloomberg TV in May 2021.
Around the time of that comment, the bank's deposits had exploded higher over the previous 12 months, rising to $124 billion from $62 billion. The 100% surge vastly outpaced deposit growth at other big banks such as JPMorgan (+24%) and First Republic Bank (+37%).
Deposits surged as government stimulus funds and VC money poured into Silicon Valley's early-stage companies at a breathtaking speed. The money was rolling in so fast that some of SIVB's customers apparently overlooked a very important rule: the FDIC only insures deposits up to $250,000! Many of SIVB's clients had much more than that. According to regulatory filings, over 93% of the bank's domestic deposits were uninsured as of December 31, 2022.
The bank run started when several big money clients became spooked and rapidly withdrew funds. Word got around that SIVB was facing material unrealized losses in its portfolio of long-duration bonds. Many of the bonds were purchased during the pandemic when the Fed pushed interest rates to an all-time low. But when the Fed's easy money policy led to a surge in inflation, monetary officials quickly backpedaled and began to raise interest rates, causing widespread losses in bonds -- particularly the type of long duration bonds SVB was concentrated in.
In hindsight, many banks made the mistake of buying too many bonds at a generational low in yields. According to Michael Cembalest of JPMorgan, between the fourth quarter of 2019 and the first quarter of 2022, deposits at US banks rose by $5.4 trillion. Due to weak loan demand, only about 15 percent of deposits were lent out. The rest was invested in securities or kept in cash. Banks can designate securities they invest in as "available for sale" or "hold to maturity." In SVB's case, a lot of bonds were marked as "hold to maturity," which required marking to market when some of the securities had to be sold.
The longer the duration of a bond portfolio, the more sensitive it is to interest rate risk. So, even though many banks are now underwater on their bonds, it is important to note that SIVB was in a league of its own in terms of duration risk exposure.
Sources: JPMorgan Asset Management, FDIC
Historically, most bank failures are tied to credit risk issues. This is the first failure in modern times relating to a duration mismatch between a bank's assets and deposit liabilities. As Cembalest writes, "Being flooded with deposits from fast-money VC firms and other corporate accounts at a time of historically low interest rates might have been more of a curse than a blessing."
While SIVB had by far the highest degree of unrealized losses, other regional banks also plummeted in value on Friday and Monday as investors sought to avoid contagion risk by shedding their bank holdings. This will contribute to a tightening in financial conditions and increases the risk of a hard landing in the economy.
Over the weekend, regulators brought out the proverbial "bazooka" and pledged to bail out deposit amounts over $250,000 that are parked at SIVB. This action was taken in order to shore up confidence and stem the tide of deposit losses at other banks. The Fed also created a special emergency facility that will provide banks with large unrealized bond losses access to liquidity.
Thus far, the policy actions were aggressive enough to spur a relief rally in risk assets. Whether risk sentiment continues to improve or erodes from here mainly depends on the Federal Reserve's monetary policy.
Today, the consumer price inflation (CPI) report showed that prices in aggregate rose 6.0 percent year-over-year. That level of inflation is much too high and triple the Fed's stated target of 2.0 percent.
If you're Fed chairman Jerome Powell, what do you do here?
The Fed appears backed into a corner with its impossible dual mandate to control inflation while maintaining low unemployment. If the Fed continues to raise interest rates, it risks promulgating further losses on bank balance sheets, which will exacerbate financial contagion risks. On the other hand, if the Fed stops raising or cuts interest rates to help the banks out, it risks undermining its credibility as an inflation fighter, which could lead to lingering high-inflation like in the 1970s.
Neither outcome is desirable, obviously. But my guess is the Fed will ultimately choose to tolerate above-average inflation and try to do whatever it takes to avoid sparking a banking panic. Even if that means printing even more money.
Yesterday saw an eight standard deviation move in interest rates, which is extremely unusual. Traders are now betting the Fed is almost finished raising interest rates and that rate cuts are not far off.
A march to lower interest rates normally buoys equity valuations and bond prices, so a Fed pivot here could be construed as theoretically bullish.
However, the severity of the underlying problem the Fed has created on bank balance sheets is hard to underwrite presently. When we're unsure about something as serious as financial contagion, we automatically push the de-risk button.
Silverlight client portfolios were fully invested at the beginning of the year, but we started trimming risk exposure in February and we have continued to do so in light of recent developments. We now have above-average cash levels and favor a defensive tilt in sector allocations.
It's important to remember that SIVB was a financial institution that specialized in the technology sector. Thus, it seems ironic that tech stocks are leading the present rally. We don't expect that trend to last for long.
Prior to SIVB failing, Silverlight managed portfolios were already extremely underweight both the financials and technology sectors. We plan to maintain that sector stance until clear evidence emerges that says recession risk is receding.
This material is not intended to be relied upon as a forecast, research or investment advice. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by Silverlight Asset Management LLC to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by Silverlight Asset Management LLC, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any of these views will come to pass. Reliance upon information in this post is at the sole discretion of the reader.