Analysis by Jeff Liguori
Silicon Valley Bank (SVB), a California-based lender, was taken over by the FDIC due to fears of insolvency. The process was one of the swiftest in history.
Silicon Valley Bank was a niche banking franchise founded in 1983 to fill a growing need in the financial-services marketplace. The primary customers of the bank were private equity firms and their principals. Typically, private equity firms (or venture capital, which is a subset of private equity) invest in startup companies, help those companies grow, and eventually, if successful, have those companies go public or get sold in a liquidity event. Liquidity events — or lack thereof — are a critical piece in the demise of Silicon Valley Bank.
As a banking partner to these firms, SVB routinely made loans to its portfolio companies. The bank filled a very specific need: extending credit to companies that were often in growth mode, and not profitable — a distinct customer base that generally could not get credit from traditional commercial banks. As a result, when those private companies either went public or were sold, loans were paid off, and deposits at the bank (proceeds from liquidity events) rose, which created a loyal customer base. And not only was SVB extending credit to these firms, but the bank also held the operating accounts for those growing businesses as well as accounts for its private equity firms’ investors. Balances on such accounts regularly exceeded the FDIC insured level of $250,000. SVB generally held a larger number of uninsured deposits than most banks.
From its founding in 1983 to the end of 2022, with a very narrow customer base, Silicon Valley Bank’s assets grew nearly 25,000%, and its stock price appreciated 7,000%.
Deposits are considered a cheap source of funds for banks. A customer deposits money into his or her account and earns a nominal amount of interest while the bank makes loans against that deposit at a higher interest rate to a borrower. The spread between the two, called the net interest margin, is a major source of revenue for a bank. Deposits are generally invested in a portfolio of bonds by the bank treasurer. Depending on the interest rate environment and the loan liabilities of its customers, a bank generally creates a bond portfolio that allows for an appropriate level of liquidity to fund loans, with minimal volatility. It is crucial to understand that bond prices are inversely correlated to bond yields: as yields rise, bond prices go lower, and vice versa.
In the case of Silicon Valley Bank, the overall level of the bank’s deposits has been highly correlated to IPO activity. From 2015 to 2019, on average, almost 210 companies per year went public, slightly higher than the previous five-year average. In 2020, even with the pandemic, the number of IPOs rose to 480, and in 2021, 1,035 companies went public, the highest number ever recorded in the U.S. Consequently, SVB’s deposit base grew rapidly, from $60 billion at the beginning of 2020 to a peak of almost $190 billion by the first quarter of 2022, an increase of more than 200%. For context, Bank of America’s deposits grew by about 44% in that same time frame.
Not coincidentally, deposits at Silicon Valley Bank peaked in March 2022. As the bank was flooded with deposits, those had to be invested into bonds. But here’s where it got tricky: the rapid rise in short-term interest rates by the Federal Reserve was particularly damaging to SVB’s balance sheet. When banks invest deposits, there are two tranches: securities deemed ‘available for sale’ (AFS) and those ‘held to maturity’ (HTM). AFS are the most liquid and least volatile, with HTM having a longer maturity because the bank doesn’t project those securities will be needed to fund loans.
In 2022, because of weak financial markets, initial public offerings decreased sharply. There were 181 IPOs, the fewest since 2016 and an 80% decrease from 2021. Private companies shelved their exit strategies. That meant many private companies needed to take on additional debt. SVB management greatly underestimated this dynamic. To fund loans, the bank was forced to not only use AFS securities, but HTM as well, which, because of a sharp rise in rates, generated a loss and a hit to their required capital levels. It was a negative cycle, whereby bank management was caught between making decisions based on the adverse effect to its profit margin (selling securities at a loss) to actual solvency as a financial institution as the deposit base shrank — an exponential negative impact to the bank’s capital that quickly spiraled out of control.
After the stock market closed on Wednesday, March 8, Silicon Valley Bank announced an offering to sell additional shares of its own stock to raise capital. The amount targeted to be raised — $1.2 billion — was unusually large considering the market value of the entire company was about $16 billion at that time. After market hours, the price of the stock was lower, but only by about 10%. Investors did not seem terribly worried at that point. When the market opened on Thursday, the stock was already down about 30%, eventually losing 60% of its value that day, which ended up being the last day the stock would ever trade. Unbeknownst to many, the bank run by SVB’s customers had started earlier in the week.
Panic ensued for many customers who had large, uninsured balances at SVB. As one chief financial officer of a private equity firm told me, it was common for him to move substantial sums in and out of the bank. Meanwhile, his firm’s portfolio companies spent last weekend worried about whether they would make payroll in the coming weeks, among other concerns.
At some point, we will know exactly what transpired. Expect as many shareholder lawsuits and congressional hearings as there were for the fall of Lehman Brothers or Enron. But the Silicon Valley story, based on available information, does not seem to be one of corporate malfeasance. Rather, it was a timing issue. Bank management clearly did not anticipate the speed at which rates would rise or the sharp decline in deposits. That dynamic was exacerbated last week as customers heard insolvency rumors and withdrawals accelerated en masse. Interestingly, withdrawals were almost completely done online, an unforeseen consequence of a digital world. Having to wait for a bank teller to make a withdrawal is almost nonexistent, which probably would’ve helped the bank slow the run in this case.
On Sunday night, there was a joint announcement by the FDIC and Treasury that all balances would be insured. Also in that announcement was the news that another financial institution, Signature Bank, was put into receivership by the FDIC. The regulators are probably working overtime to avoid another failure.
Silicon Valley Bank — seen as critical to entrepreneurs and innovators in the economy — was unique. The irony is that past bank failures were due to poor credit decisions. SVB had a duration mismatch of assets and liabilities with a narrow customer base, all of which was adversely affected by higher interest rates and weak financial markets. Bank management should be held responsible, but the difference from a 2008 Lehman or Washington Mutual type of failure was that both those institutions held incredibly risky, or toxic, assets on their balance sheets.
While the issues seem clear today, almost no one anticipated the collapse of Silicon Valley Bank. Reputable analysts had maintained ‘buy’ ratings on the stock. Goldman Sachs, as recently as three weeks ago, upgraded the company with a $312 price target (it was trading around $275 at the time). The insolvency of this institution was a surprise to nearly the entire investment community.
Silicon Valley Bank was about one-fifth the size of PNC Bank, one of the largest super-regional banks, and about 1/20th the size of Bank of America. It was approximately the same size as Citizens Bank or First Republic Bank in terms of total assets prior to last week. The failure of this institution seems idiosyncratic in nature and not a huge threat to the banking system. The additional insurance measures by the federal government seem appropriate. And now, for very good reason, bank balance sheets are coming under extreme scrutiny in the wake of this historic event.
In an interesting twist, the bond market has rallied and interest rates have gone lower since last Wednesday. The collapse of a meaningful financial institution has actually helped improve the health of many bank balance sheets across the country.
Jeff Liguori is the co-founder and chief Investment officer of Napatree Capital, an investment boutique with offices in Longmeadow as well as Providence and Westerly, R.I.; (401) 437-4730.