Leave it to some financial news for me to come out of hibernation on my blog. The former banker and current bank investor in me perked up this past Wednesday when I saw a headline about Silicon Valley Bank: It was raising capital. Immediately I knew this was not going to be good. By Friday morning, the company’s stock was halted and it was announced the bank was shut down.
I haven’t watched something like this unfold for 14.5 years, specifically since I was sitting at a hotel breakfast as a young banker watching the news about Wachovia Bank. Fortunately or unfortunately, I’m a bit of a nerd when it comes to banks and many people are asking me questions, so here it goes.
What are the fundamentals of a Bank?
Assets = Loans + Securities Portfolio, usually low risk / short term government debt
Liabilities = Depositors and other Debt
Equity = Assets minus Liabilities
Silicon Valley Bank had a few things that were unique to it’s business as a bank, but specifically SVB’s deposits were concentrated in the cash heavy technology industry. They housed large account balances. This note from their last financial statement showed 96% of their deposit balances were above the $250,000 limit.
SVB’s cash has increased rapidly, peaking at $192bil in June of 2022. Total deposits were $50bil in June of 2018. The bank had to put this money somewhere and it’s depositors were mostly technology companies that didn’t borrow money. Where did it go? High quality bonds. Unfortunately they made a choice that was different then their peers: Almost 50% of their securities were greater than five years.
What happened to bonds after February of 2022? These bonds started going down in value. Interest rates up, bond prices down. Further complicating matters, SVB had turnover in both their Chief Risk Officer and Chief Investment Officer positions and these individuals came into the position at a time when most of the decisions were already made.
By November, SVB’s bond portfolio went down in price and it went down in price enough to wipe out all the equity. Accounting is math: Assets = liabilities + equity. Bank assets = loans + bonds. Liabilities = deposits and other borrowings. Equity cushions the difference. The equity was negative, but nothing happened.
So why wasn’t this caught?
After the failures in the Great Financial Crisis, mark to market accounting was closely looked at. If a bank was going to hold a security to maturity, should it have to write down it’s value? If held to maturity, all the original principal is returned plus interest. The response was banks were allowed two accounting buckets for it’s securities portfolio, an available for sale bucket and a held to maturity bucket. The available for sale bucket has to be adjusted for market prices each quarter, but the held to maturities bucket was excluded.
The rationale for this change made sense. Wachovia failed due to it’s mortgage portfolio being marked to market, at a time when there were virtually no buyers for the mortgages. 1st lien residential mortgages were being marked to 40% of their original value, which was only it’s value if sold in a panic, but not it’s value if held and either paid by the borrower or foreclosed on and resold. Unfortunately avoiding temporary fire sale prices when not needed is a different scenario than rapid repricing of a bond portfolio based on interest rates.
For Silicon Valley Bank, when the held to maturities bucket was included, the bank was mathematically insolvent.
Why was the bank not closed then? Fundamentally this is how a bank operates. It owns debt that is paid for over a number of years but funds that debt with deposits that it agrees to pay back at any time. This works well, until all the depositors demand their money at once:
So how did the bank run start?
Silicon Valley Bank announced a secondary offering on March 8th and their depositors realized the bank wasn’t solvent. Specifically sophisticated venture capital funds telling companies they invested with to move their funds. The Bank run ensues. Except this time it isn’t people standing at a teller line, but company CFOs hitting the transfer button. They were doing this because it was rational: There’s zero upside to keeping the deposits there but a major downside to leaving them. Not just the risk of loss, but the risk of accessing the money for a while even if they don’t take a loss. Since SVB’s depositors were mostly businesses with deposits in excess of $250,000, the outflows happened quickly.
According to the repossession order on March 9th, depositors withdrew $42 billion from the bank, dwarfing any other bank run in history. The FDIC in coordination with the state regulators had no choice but to shut down the bank and pause withdrawals because liabilities were greater than assets.
So what do I think about all this? Will there be contagion in the financial sector? Will there be investment opportunities? What will the consequences be?
I think Silicon Valley Bank will be a case study talked about for generations in banking. They are the new poster child for asset liability management, known as “ALCO” for the board committee that oversees this part of a bank.
There were many unique circumstances to this failure, including but not limited to:
- Interest rates went from 0.25% to 5% on two year treasuries in twelve months.
- Industry concentration: This led to deposit growth and lack of traditional lending
- Unique funding structure. Most banks have a higher percentage of insured deposits and insured deposits don’t flee the bank
- Unfortunate investment decisions, compounded by turnover in the two critical positions that oversee this risk.
- Questionable regulatory oversight. Why was a top 20 deposit bank allowed to essentially be a bond fund? Why wasn’t additional capital pushed for earlier? Were there questions about the duration risk eighteen months ago? Is the AFS vs. HTM account change acceptable?
What are the consequences?
I don’t think you’ll see other failures anywhere near the size of SVB soon. The bank had a unique funding scenario, made poor investment choices, and parked those investment choices away for a few months before the depositors realized the issue.
Most banks don’t have SVB’s funding concentration. There are plenty of others who’ve made poor decisions in their bond books, but these are usually lazy community banks with old deposit franchises that are bad at lending. For example, First Financial Bank in Texas wiped out 1/3rd of their bank’s equity in the last year, yet still trades at a premium to book value as of March 10th. Fortunately the remaining banks with these issues are small enough where the losses are disclosed in the available for sale bucket and most of their deposits are FDIC insured.
I’m also interested in the regulatory reaction. During the GFC, the FDIC temporarily provided insurance on transaction deposits to calm the market and guarantee all checking account balances. Thus far, we have not seen a similar action on SVB. If that doesn’t happen, I expect to see short term treasury products make a resurgence. If deposits are declining across the sector, that does create other challenges. At this point, the market expects all depositors will be made whole.
Update: On March 12th at 6pm, the Federal Reserve and FDIC announced depositors would be made whole. From my early research, it like if there are any losses related to SIVB, the FDIC will make a special assessment (tax) against surviving banks.
Is this an opportunity to invest in banks?
This probably sums up my thoughts better than I can write it.
If you are looking at bank stocks, please learn about Tangible Book Value (TBV) and TBV per share. Do not buy bank stocks much above tangible book value, it’s a business that’ll generate a nice 10-15% return on equity but comes with the downside risk of being wiped out or diluted for a decade or more if things go wrong. I personally own some bank stocks, but it’s a combination of Bank of America purchased at a small premium over book value, and a couple smaller banks currently trading at or below book value. Otherwise it’s a challenging industry to be an investor in.