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Silicon Valley Bank: collapse and contagion in 1000 words

#SVB has collapsed after investing funds in long-term investments dependent on a low interest rate environment. Where next?

silicon valley bank Source: Bloomberg

On Friday 10 March, Silicon Valley Bank — the 16th largest in the US — failed. As a primer, the bank held $190 billion in deposits in 2021, and worked with more than 50% of venture capital-funded start-ups globally.

Silicon Valley Bank: collapse summarised

The bank was one of the key beneficiaries of pandemic-era ultra-loose monetary policy. With cash pouring in, it decided to buy more than $80 billion in mortgage-backed securities, which at the time may have appeared a sound policy to see a reasonable return on deposits held at the bank.

However, this strategy relied on interest rates staying low.

This is for two reasons; first, it’s uniquely positioned tech clients rely on cheap money to grow, and while it used to be preferable to seek new funding for this growth in the past, higher rates meant they were withdrawing cash from SVB at a more prodigious rate for day-to-day spending.

Second, increased rates saw the government increase the return investors could get from buying government bonds. This meant that where SVB could previously easily offload its mortgage-backed securities as they were competitive compared to newly issued government bonds, investors can now buy US government bonds with no risk and with more than 2.5 times the comparable return.

And for context, the federal funds rate is now at a range of between 4.5% and 4.75%.

Importantly, it’s worth noting that despite inflation and the falling near-term cash-in value of these securities, the money hasn’t been siphoned off. Client funds remained safe, but simply could not be accessed until these mortgage-backed securities came to maturity, in many cases a decade from now. And clients needed cash immediately.

CEO Greg Becker recognised the danger and decided to build a safety net; to start with by selling off $21 billion of funds at a $1.8 billion loss, while simultaneously raising $2.25 billion in equity and debt. SVB’s PR department even sent out a press release highlighting this strategy.

Management failures or unlucky timing?

SVB took its $1.8 billion loss on its available-for-sale (AFS) bond portfolio, which came as a surprise to investors who were under the impression the bank had sufficient liquidity to avoid this step. In the event of a ‘bank run,’ the first step is to sell off the AFS portfolio — worth $28 billion in this case — before being forced to sell some of the held-to-maturity (HTM) portfolio, which is where real problems start.

Bill Ackman noted that ‘Silicon Valley Bank senior management made a basic mistake. They invested short-term deposits in longer-term, fixed-rate assets.’

In addition, the bank had no official Chief Risk Officer for a full 8 months while the venture capital markets were spiralling. And there are also reports of senior management selling off shares while approving large staff bonuses in its last days of solvency.

However, management was also seriously unlucky. After the collapse of FTX, San Diego-based crypto bank Silvergate saw customers pull out $8 billion in January, leaving the bank closing its doors on 8 March, the same day that SVB announced its safety net plans.

Customers perceived the events to be related — and regardless of fairness, the bank lost $80 billion in value overnight.

But in the final analysis, management made a fatal error in assuming that rates would stay low over the next decade. In return for slightly higher at-the-time returns, they locked away far too much client funds, and did not hedge out their interest rate exposure.

Contagion questions

Containing the collapse became priority number one over the weekend. The bank holds $3.3 billion of Circle’s funds, $487 million of Roku’s cash, and $227 million of BlockFi’s capital amongst many others.

Secretary of the Treasury Janet Yellen ruled out a 2008-style bailout, though the urgency for a quick solution is obvious. Over 30% of US deposits are held in small banks in the states, and more than 50% of funds are above the $250,000 FDIC insurance limit — similar to the £85,000 FSCS limit in the UK.

There was, and to some extent, remains, a real risk of further bank runs at several of the thousands of smaller US banks where investors sense weakness.

Late on Sunday, US regulators announced that ‘depositors will have access to all of their money starting Monday, March 13. No losses associated with the resolution of Silicon Valley Bank will be borne by the taxpayer.’ They also guaranteed deposits at the smaller and similarly troubled Signature Bank.

While shareholders, most creditors, and the bank itself will be allowed to collapse unless a buyer can be found, there are now real questions over whether regulators have now opened the financial floodgates. Depositors at any failed bank will now demand similar treatment over deposit security, and while this step was clearly necessary to maintain financial stability, there is an argument to be made that this was a Pandora’s Box that should have stayed firmly shut.

Despite regulatory reassurance, Western Alliance Bank has seen shares fall by 75%, First Republic Bank by 67%, and PacWest Bancorp by 35%. Internationally, banks as large as HSBC and Barclays see smaller share price falls, while troubled Credit Suisse has fallen to its lowest ever market value as default swaps hit another record.

There is a risk that depositors at smaller banks will withdraw cash in favour of the security of those presumed to be too big to fail. This risk is compounded by the speed of social media — panic can now spread at lightning speed.

Finally, with CPI figures out this week, some question whether a Federal Reserve pivot is now inevitable. Goldman Sachs analyst Jan Hatzius argues that ‘in light of the stress in the banking system, we no longer expect the FOMC to deliver a rate hike at its next meeting on March 22.’ The bank expects the terminal rate will now be in the 5.25%-5.5% range.

And this leaves the Federal Reserve in an uncomfortable position. Governor Jerome Powell noted as recently as last Tuesday that ‘the ultimate level of interest rates is likely to be higher than previously anticipated’ in testimony before the Senate Banking Committee.

A pivot not only risks re-stoking inflation, but also sends a further message of uncertainty to the markets. But continuing with tightening could also see more chaos as the consequences of ultralow interest rates unwind.

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