(March 15th, 2023)
By (Matteo Renda, Equity Analyst)
Edited by (Ascanio Cicogna, Head of Research)
What’s Going on With Silicon Valley Bank?
Silicon Valley Bank ($SIVB) suffered a collapse last Friday, triggered by a run on deposits that resulted in the second-largest bank failure in US history. With assets totalling around $212 billion as of December 31st, the bank was the 16th largest in the US. Its implosion represents the biggest test to date of the post-financial crisis regulatory architecture designed to force banks to curtail risk and manage it more closely.
How Did the 16th Largest Bank Fail in Just 36 Hours?
Silicon Valley Bank's failure can be attributed to poor risk management. The bank grew too fast, using borrowed short-term funds from depositors who could request repayment at any time to invest in long-term assets that it was unable or unwilling to sell. When interest rates began to rise, the bank took heavy losses on their bond portfolio, prompting them to try to raise fresh capital. However, this move spooked depositors, who withdrew their funds from the bank and ultimately led to its collapse.
Image 1: SIVB’s Stock Price - Halted at $39.40
In hindsight, the risks were clear and hiding in plain sight. The bank mainly served start-ups, tech companies, and venture-capital firms. As the tech industry boomed, total assets at its parent company, SVB Financial Group, grew from $116 billion in 2020 to $211 billion in 2021. The bank poured tens of billions of dollars into long-term US Treasuries and government-backed mortgage securities. Although these assets are considered safe and virtually free of default risk, they pay a fixed interest rate for many years. When market interest rates started to rise, the value of these lower interest rate bonds held by the bank began to decline. With every rate hike, the $80 billion SVB had locked up looked worse and worse. No one wants a portfolio of bonds yielding 1.5% when the current market is selling bonds with a yield of 5%. This would not necessarily have been a problem unless the bank suddenly needed to sell the bonds and be forced to take a loss.
By the end of 2022, SVB’s unrealised losses had reached around $17 billion. At the same time, the bank experienced deposit outflows, as the slowing economy caused its clients to burn more cash, and they stopped receiving new funds from fundraising and public offerings. With the Federal Reserve hiking interest rates, savers began to demand higher interest rates on their deposits, making it more expensive for the bank to acquire and keep customers.
The situation all came to a head when the bank decided to sell a portion of their bond holdings, take a $1.8 billion loss, and reset their interest earnings by buying today’s higher yields. Additionally, the bank decided to try and raise new capital by selling new shares to meet potential outflows, have more balance-sheet flexibility, and still be able to fund new lending.
Following the announcement of the share sale, Silicon Valley Bank’s stock began to plummet. Selling new shares dilutes the value of existing shareholders, leading investors to worry about the value of their investment decreasing. As the stock cratered in price, the bank had to scrap their plan to sell new shares. At the same time, venture-capital firms began advising many start-ups and tech companies to withdraw their funds from the bank. As withdrawals began to accelerate, the bank ran out of money to pay back depositors.
In short, what SVB did with their investment portfolio was an embarrassing signal of enormous incompetence. SVB concentrated their portfolio in long term assets, reaching for yield, at the worst possible time, right as the Federal Reserve began to hike interest rates, while completely failing to hedge for the rise in interest rates.
Image 2: Portfolio duration is the same after being hedge adjusted, indicating lack of basic risk management practices.
How Did the Government Resolve the Problem?
The Federal Reserve and US Treasury unveiled an aggressive plan on Sunday night to prevent a fallout from the collapse of SVB. Regulators announced that all depositors would have full access to their money starting Monday, along with the depositors of another failed bank, Signature Bank, which was forced to close on Sunday.
The Fed also announced a new program, called the Bank Term Funding Program. This will allow banks to bring safe assets such as government bonds to the Federal Reserve and swap them for cash for up to a year. This will enable other banks to quickly take out loans to meet any liquidity problems they may run into, without having to take large losses by selling assets.
What Does SVB’s Failure Mean?
Silicon Valley Bank’s collapse has had profound impacts on the financial system. The failure has led to a sharp selloff in regional bank stocks, along with banks such as Charles Schwab ($SCHW) and Bank of America ($BAC). The KBW Nasdaq Bank Index is down around 21% in the last three trading days.
Additionally, the Federal Reserve may revise the pace of their interest rate hikes. Until SVB’s failure, the economy had shown few side effects from the Fed’s aggressive rate hiking campaign, apart from a slow down in the housing market, but the crisis has led many market participants to bet that the Fed will slow down in light of recent events. Investors in the interest-rate futures markets had previously been weighing the possibility of a 50 bps hike in March, and now priced in a greater than one-in-three chance that the Fed would hold rates steady. Going forward, the Fed now faces dual threats of inflation and financial instability.
The turmoil in the banking sector also resulted in a wild rally in government bonds, with yields on shorter term US Treasuries declining 50 bps in a matter of hours. For context, the 2 year Treasury posted its biggest 3 day decline since the 1987 stock crash. This drop reflects how investors have pivoted from worrying about inflation to evaluating the risks posed by the banking crisis to the economy.
Image 3: The two year treasury yield futures eye-popping decline.
Value Hunting in Turbulent Times
Amid the SVB crisis, shares of other regional banks have been pummelled as investors sell shares hand over fist in fear of more insolvencies. As an investor, it is critical to remain calm and objective amidst the swings of fear and greed in the financial markets. The banking sector currently offers discounts on high-quality banks that have been around for decades, with some trading at record low PE and PB ratios.
On Monday, shares of First Republic Bank ($FRC) closed at $31.21, a price it hasn’t been at in over a decade. At this price, it has a Price/Earnings ratio of 3.79, with a 5-year average of 21.43, meaning it is trading at an extreme bargain. Additionally, shares of Charles Schwab ($SCHW) closed at $51.91, down around 46% from it's all-time high of $96.24. At this price, the stock has a Price/Earnings ratio of 14.83, with its 5-year average of 22.81. At these valuations, there are many regional bank stocks and larger banks that are trading at incredible discounts.
A smart investor could open a few small positions at these lower prices, then start adding if the position is proven correct, the banking crisis is resolved along with the risk of insolvency, and a clear, predetermined trading plan is created. This involves the stop loss, duration of the trade, and take profit prices.
Citations
Guardian News and Media. (2023, March 11). USD coin value falls after revealing $3.3bn held at Silicon Valley Bank. The Guardian. Retrieved March 12, 2023, from https://www.theguardian.com/technology/2023/mar/11/usd-coin-depeg-silicon-valley-bank-collapse
News, L. J. B. (2022, November 11). Rising interest rates hit banks' Bond Holdings. The Wall Street Journal. Retrieved March 12, 2023, from https://www.wsj.com/articles/rising-interest-rates-hit-banks-bond-holdings-11668123473?mod=article_inline
Annual reports & proxies. SVB Financial Group - Financials - Annual Reports & Proxies. (n.d.). Retrieved March 12, 2023, from https://ir.svb.com/financials/annual-reports-and-proxies/default.aspx
Andrew. Ackerman. (2023, March 12). Where were the Regulators as SVB crashed? The Wall Street Journal. Retrieved March 12, 2023, from https://www.wsj.com/articles/where-were-the-regulators-as-svb-crashed-35827e1a?mod=trending_now_news_1
Press, P. M. A. (2023, March 13). Were SVB and signature bank just bailed out by the U.S. Government? The Wall Street Journal. Retrieved March 14, 2023, from https://www.wsj.com/articles/were-banks-just-bailed-out-by-the-government-6b0a582f?mod=markets_major_pos2
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