Anyone with half an eye on financial markets will have seen the headlines about Silicon Valley Bank becoming insolvent over the last few days. The situation is rapidly escalating and with it the entire financial press and half of my financial contacts have become consumed by producing coverage. I am joining them. In this article, I’m going to provide a brief overview of what Silicon Valley Bank is, what is happening to it, and some thoughts about what might happen next.
Starting at the beginning, Silicon Valley Bank, or SVB for short, is a US banking institution that until recently had over $200bn in Assets Under Management. They were primarily focussed on providing banking services to start up and venture capital companies. Typically, these were smaller, technology-focussed businesses – big on ambition but less so on assets, track record and ability to access traditional banking services. Just like regular businesses, these companies needed somewhere to store their working capital, access debt and process payments.
Where most banking institutions are large, heavily regulated and diversified, SVB was more heavily focussed on businesses in this one area of the economy. Small, early-stage technology businesses. Over the last few years, the money held on deposit at bank has ballooned. Back in 2010, SVB had less than $1bn in revenue but since governments around the world started up the money printers, they experienced an enormous inflow of capital. By 2017 revenue had nearly doubled to $2bn, then doubled again to $4bn by 2020, and increased by another 50% to nearly $6bn by 2021.
All this capital needed deploying. Banks make profit by taking cash on deposit and lending it out in the form of loans. But as more and more capital begins chasing opportunities, lending standards decline. Capital is freely and cheaply available, first at 5%, then 4%, then 3%, and so on. At first, lenders will only consider companies with ten years of profitable trading, then five years, then three years, then one year. At first, lenders want to see tangible assets to secure their lending, at first 100% backing, then 75%, then 50%, then lower quality assets. As more and more capital floods into the system, lending standards continue to decline.
This part of the story, we all know. In 2007, the capital was pursuing opportunities to lend to mortgage borrowers. After all, no one ever defaults on their mortgage, right? Lending standards degraded until eventually the mortgage market became flooded with ‘sub-prime borrowers’ (a lovely euphemism for borrowers traditional banks wouldn’t usually touch with a bargepole).
After the inevitable collapse as borrowers became unable to pay rising interest rates from their insecure, highly leveraged income sources, regulatory attention turned to how to prevent lenders (especially banks) from becoming insolvent. A genius idea was born. Banks would have to increase their capital buffers of secure assets. What were considered the most secure assets, you ask? Bonds. Government bonds. Banks and financial institutions were forced into buying increasing quantities of government bonds. After all, government’s don’t default, so in the event of losses generated by lending portfolios, the increased capital buffers would enable banks to have a high quality reserve of assets to raise liquidity.
Fast forward a decade, and the flood of capital flowing into SVB needed a home. Rather than dropping their lending standards (arguably already risky enough), the bank decided to deploy some of its capital into secure assets. That way, it could earn a small profit by investing in bonds paying 1%, paying customers 0.5% on their deposits, and pocketing the difference. But as more and more capital entered the bank, interest rates were declining – fifteen years ago, government bonds paid 3-4%, but since 2017, most have paid less than 1%. As interest rates decline, bond values rise – the capital invested in the bonds appreciated in capital value, adding to the profits of the bank.
Then, disaster struck. COVID-19 hit and with it one of the greatest financial shocks the world had ever seen. Economies around the world were locked down, supply chains froze up and demand evaporated. Governments were forced into huge bailouts to keep things moving. As economies were gradually reopened, inflation returned with a vengeance – first a few percent, but then skyrocketing into double digits. Russia invaded the Ukraine, disrupting global energy markets and pressure on prices increased even further. Central Banks were forced to begin raising rates, first by tenths of a percent, but eventually to many multiples of where they were.
As interest rates rise, investors are able to access bonds paying bigger coupons which are more attractive. After all, if you could lend the UK Government £1,000,000 at 1%, wouldn’t you prefer that to 0.25%? And what if they offered 2% the month after? How about 3%? 4%? You see the problem. As interest rates rise, demand for existing bonds paying lower rates fall – their value declines rather than rises.
Coming back to our friends at SVB rumours have started to swirl that the ‘cash’ on deposit at the bank isn’t as liquid as depositors think. Pressure on the economy is causing customer to increase withdrawal requests as costs rise rapidly. For the first time in years, customer deposits are actually falling – but ‘cash’ to fulfil repayments has been invested. The money deposited by Company A has been lent to Company B, and the money deposited by Company C has been invested in bonds. We need to use the cash deposited by Company D to repay A & B, but the problem is that they want their money back too. You start to see the problem?
Even better, SVB hadn’t just bought government bonds but mortgage backed securities protected by government agencies (after all, no one stops paying their mortgage). As interest rates rise, these MBS products face a dual problem – not only do fixed coupons become less valuable to investors but the mechanism by with interest payments are made, the mortgage holders, become less secure. As interest rates rise, mortgage rates rise with them. Mortgage borrowers face increasing costs (in the UK mortgage costs have double from around 3% to 6% over the last year). Some are unable to pay those increasing costs and decide to sell their properties. New borrowers decide to postpone getting a mortgage. If too many sellers enter the market at the same time as too many new borrowers decide to postpone taking out mortgages, the market begins to collapse (a la 2007).
SVB needs to sell their portfolio of MBS products to raise capital and pay depositors but suddenly, those bonds aren’t worth as much as they were. $100m of MBS products are purchased but are now only worth $80m. If the bank holds these assets on their books to maturity, then no loss is incurred, but if they’re forced to sell, then they lose $20m of capital. Depositors don’t really care – that’s the bank’s problem – and they just want their cash back. You see where this is going?
Eventually, SVB decided to raise fresh capital, rather than crystalise losses on their bond portfolio. Only problem is that no one wants to lend to a bank with unknown liabilities and a broken balance sheet. The capital raising failed. The bank escalated the issue and decided to put itself up for sale. After all, if someone with a big enough cash pile buys them, they could pay out all the depositors. But buying over $200bn in depositor liabilities is a large pill to swallow and no buyer had the appetite.
Now, the Federal Deposit Insurance Corporation (FDIC) has stepped forward and regulators have placed the bank into insolvency.
This leaves me with a few questions. Firstly, how many other financial institutions are facing the same dynamics as SVB? I am well aware that if I go to my own bank and attempt to withdraw my capital in physical cash, the bank would be unable to accommodate me immediately. Likewise, if every customer of my bank simultaneously attempted to withdraw notional value deposited, the bank would be unable to return deposits. In theory, the UK Government steps forward at this point and guarantees deposits of up to £85,000 – but could they really do this for all banking customers in the UK? If the desire to withdraw capital spreads across institutions and borders, who will actually make customers whole?
Cue lots of wise, grey-haired men sitting around telling us that ‘the average man on the street is fine’. Nothing to see here. But my question is this. If an SVB client has $20m on deposit at the bank, they are only insured up to a total of $250,000. Out of that $20m, they will pay rent, pay suppliers to the company, pay staff salaries, invest in new machinery and fund research and development. Now, they only have $250,000 – but how much do they need in the next four weeks? Four months? Four years? What happens if the money is really gone?
Now, multiply that scenario by the thousands of companies that banked with SVB ($200bn in assets remember). Add in the risk of other subsidiaries in the group and intercompany risk. Throw in the on-going debacles at Credit Suisse, Deutsche Bank, Softbank, Evergrande…we’re talking hundreds of billions of dollars of losses – and it’s escalating.
In this scenario, I can already hear investors telling me to stay calm, don’t panic, buy the dip. And sure enough, odds are that this too will blow over. But like 2007, the damage along the way may well be more immense than we’re prepared for. Monday morning will likely see the beginning of more significant volatility in financial markets are the potential for more news of financial institutions facing distress. I await next week with bated breath.