For those who follow the market, you would have noticed banks’ share prices taking a hammering on Friday. The reason behind these stocks selling is because of one bank located in Santa Clara, California, called Silicon Valley Bank (SVB). This article is a case study on SVB’s failure. It is in no way a comprehensive study but instead written to help us laypeople understand what happened.
Who is SVB?
SVB is a 40-year-old bank focused on lending to the technology industry. The bank lends to start-ups, venture capital firms, private equity, emerging companies, and established corporations. All focused on the tech sector.
According to the 2022 10-K (A company’s annual financial statements), of the $74 billion loans SVB held on its balance sheet, 55.6% went to “Global fund banking”, which the bank defines as “global private equity and venture capital clients”. These private equity and venture capital firms focus primarily on tech start-ups. The remaining loans went to tech companies, with only a tiny portion of the “Other” loan book outside the industry.
Source: SVB’s 2022 10-K
To lend, a bank first needs deposits. So where do SVB’s deposits come from?
I assume the profile of deposits is similar to that of the loan book as the bank states in its 2022 10-K: “Our deposits are largely obtained from commercial clients within our technology, life science/healthcare and private equity/venture capital industry sectors. We also obtain deposits from our SVB Private clients, including premium wine industry commercial clients.”
Not only is SVB’s lending book concentrated in one industry, but so is its source of funds. Being over-concentrated is never good for a bank or a business.
Are the deposits the problem?
When a bank collapses, it is generally because of a rush by depositors to withdraw their money; therefore, it is crucial to understand the banks’ deposits profile. We have already established that SVB’s deposit base is too concentrated.
Next, we looked at how the deposits have grown over the last several years:
Source: Data obtained from various SVB 10-Ks
As we can see, SVB’s deposits tripled from 2019 to 2021. What caused this?
The reason money flowed into the industry is a case study in itself. Still, I’ll attempt to summarise in one sentence: Money flowed into private equity, venture capitalism, and the tech industry due to unprecedented money printing from the government during the pandemic. To be more precise, money flowed into the entire economy. Still, the tech industry was a considerable benefactor as it was the darling industry at the time.
So what did SBV do with these deposits?
A bank’s primary purpose is to safeguard deposits. It then uses those deposits to lend to clients. Given the record rate of deposit influx during the pandemic, it is no surprise the bank struggled to lend out all the funds flowing in, especially if it wanted to do so responsibly. Instead, SVB placed the money into securities:
Source: Data obtained from various SVB 10-Ks
What are Securities?
Securities come in all shapes and sizes. In SVB’s case, these securities were split as follows:
Source: SVB’s 2022 10K
So what does this mean for SVB?
Well, let’s better understand what these securities are:
- US Treasury Securities are bonds issued by the US government. They are considered the lowest-risk investment as it will require the US government defaulting for an investor to lose their money.
- Mortgage Backed Securities (MBS) are a large number of individual mortgages (think home loans) bundled together and sold as one product. These typically are not high risk as it is unlikely that a collection of thousands of mortgages will default (let’s not discuss 2008 here).
Another thing worth commenting on is the duration (or lifespan) of the securities SVB invested in. As can be seen below, SVB took the influx of deposits and invested the majority into MBSs with a lifespan of over 10 years;
Source: SVB’s 2022 10K
So to summarise where we are thus far;
- SVB lends to the tech industries and all the players within the ecosystem.
- SVB’s deposits come from the same source as it lends to.
- At the start of the pandemic, there was a mass inflow of deposits into the bank.
- SVB invested most of these deposits into long-term, low-risk, mortgage-backed securities.
Great! Simple enough, and so far, nothing overly alarming. However, the pandemic ended, and so did “Free Money”.
A necessary detour in our story
As we all know, the solution to the pandemic was for the world to lock down. Reserve banks worldwide panicked that lockdown would be the equivalent of economic armageddon and did what they had been doing since the 2008 financial crisis; they printed money and handed it out. As always, if you give people money, they spend it. So the globe saw unprecedented demand for almost any product you could think of. If it could be used in lockdown, we wanted it. But of course, as demand for products increase, so does the price, especially when distribution channels are disrupted too. The finance industry likes to refer to these price increases as, you guessed it, “Inflation”.
Inflation makes life harder for the average person like you and me as products become more expensive. Inflation makes life harder for companies as their supplies become more expensive. We like to spend; therefore, the world doesn’t like inflation, and central banks worldwide are tasked with inflation management.
The US inflation post-pandemic reached a 40-year high of 9.1% in June 2022. The Federal Reserve (US Central Bank), tasked with controlling inflation, had to act to bring inflation under control. One tool Central Banks have to control inflation is raising interest rates. Raising interest rates increases the cost of borrowing and, in theory, results in individuals and corporate borrowing less and, as a result having less to spend. If we have less to spend, demand declines and when demand declines so do prices—the exact opposite of what we experienced during the pandemic and precisely what the Federal Reserve wants.
So the Federal Reserve started to increase interest rates. This had an unintended consequence as any newly issued MBS would earn higher interest as the underlying mortgages’ interest rates have also increased. That is all fine, except MBS in the US are typically fixed-rate instruments, meaning that the rate they earn does not adjust as interest rates rise. Therefore as new MBS are created and sold at higher rates, these new instruments are far more attractive than the old instruments. Thus, demand for the old instruments declines. And when demand drops, the price of the product declines!
Back to SVB…
SVB is holding a large quantity of these “older”, less attractive MBS, and the prices of these instruments dropped. SVB has to show this price decline on its financial statements, and it shows them as “unrealised losses”. SVB’s unrealised losses were $1.3 billion as of December 2021:
Source: SVB’s 2022 10K
Not great, but probably manageable as interest rates were still low and the tech industry continued to thrive. Also, SVB enjoys a shareholder equity value of $16.6 billion, so the bank could absorb the loss with minimal impact on shareholders. But look what happened in 2022 after interest rates increased:
Source: SVB’s 2022 10K
SVB’s unrealised losses in MBS jumped to over $15.2 billion. In fact, going through the entire securities holding, unrealised losses were over $16 billion as of December 2022. This is scary since interest rates have increased since December 2022, and shareholder equity value is only $16.2 billion. But it is essential to point out that these unrealised losses are okay as long as SVB can hold these securities to maturity (expiration date) because then it will never have to sell the instruments at a loss. But SVB was forced to sell!
As the tide turned and interest rates increased, money could no longer be borrowed for close to nothing. The tech industry was hardest hit as a few of its unicorns were suddenly seen as what they really were; unprofitable, overleveraged, unproven business models that had been ridiculously valued based on what they might be should the stars align! Private equity and venture capital firms investing in these companies were, of course, not spared.
Suddenly, SVB’s high concentration of deposits from the tech industry became a massive concern as the industry wanted/needed its money sitting in the bank. As clients started withdrawing their money, unrealised losses became realised. And as the market caught on to what was happening, panic set in, causing a rush to take money out of the bank (a run on the bank). Suddenly, a once stable SVB that has done everything by the book is forced to start selling securities it doesn’t want to and realising hefty losses.
Summary of what happened at SVB
- SVB is a 40-year bank which has been a lender and holder of deposits to the tech industry ecosystem.
- The pandemic resulted in an influx of cash into the ecosystem, and as a result, deposits skyrocketed.
- SVB, unable to increase loans at a similar rate to deposit, bought US treasuries and MBS.
- As inflation hit the US, the Federal Reserve increased interest rates.
- SVB’s MBS, mostly at fixed rates, declined in value as interest rates increased, resulting in massive unrealised losses for the bank
- A downturn in the tech industry and the end of borrowing for “free“resulted in clients withdrawing their deposits. This caused panic as unrealised losses were now becoming realised as the bank is forced to sell down these securities to cover the deposit withdrawals.
- This results in a run on the bank (rush to withdraw money) and the end of SVB!
Is this 2008 all over again?
Banks globally lost value on Friday due to concern that the fate of SVB is not unique to SVB, and there might be contagion and hence more banking collapses. We briefly looked at Bank of America (BAC), one of the largest banks in the US, to see if they could experience a similar problem:
Well, you probably don’t want to read this bit, but BAC is sitting on substantial unrealised losses too:
Source: BAC’s 2022 10-K
This is not great but should only be a problem if there is a sudden decline in deposits. At the start of the pandemic, BAC did experience an influx of deposits, but nowhere close to the rate of SVB.
Does this mean BAC is in trouble?
We know that BAC’s deposits are not concentrated to one industry and are made up more of retail deposits, which means the Federal Deposit Insurance Corporation insures a higher proportion of the BAC’s deposits than SVB’s. And although it experienced a spike in deposits during the pandemic, the levels were more manageable than SVB. So it is unlikely, but not impossible, that BAC would experience a sudden withdrawal of deposits and, therefore, a run on the bank. Finally, given that the bank’s shareholder equity is more than $273 billion, significantly more than the $113 billion in unrealised MBS losses, BAC is in a much better position than SVB.
In 2008, due to sheer recklessness by the banking industry, the MBS assets held by banks were the problem and defaulted. In SVB’s case, the MBS are healthy and performing, but a downturn in the tech industry has caused a mass withdrawal of funds from a bank concentrated only on that sector.
Due to rising interest rates, banks are likely sitting on significant unrealised losses for their fixed-rate securities. These banks must hold these instruments until maturity or at least until interest rates decline unless they want to realise those losses. But that certainly doesn’t mean there is a systemic problem within the banking industry.
So as long as we don’t panic and all rush to take our money out of the bank at once, we should all be okay! (I think)