Bottle rockets and falling skies: how the SVB crashed and why it’s not the end of the world

On a sleepy afternoon on Friday, March 10, 2023, we witnessed the second largest banking collapse in US history. Around noon, the California Department of Financial Protection and Innovation (DFPI) announced that it had taken over Silicon Valley Bank (SVB), the tech sector’s institutional darling, and appointed the FDIC to manage the bank. Ironically, the firm’s parent company, SVB Financial Group, just received the Bank of the Year award at a posh London gala earlier this month. It is not surprising that timid investors immediately reacted to the news, as they did the day before. the four largest US banks lost about $52 billion in market value.. Read more about why this happened.

How did we get here and what does it mean? Well, first, let’s take a look at how SVB worked and what made it unique in the banking industry. While SVB was by no means the biggest dog among its banking brethren, it was still a success story as it has grown to $209 billion in assets since its founding almost 40 years ago. From the very beginning, SVB has served as a niche specialty bank, playing a critical role in providing capital for start-ups. As Deborah Piccione points out in her book Silicon Valley Secrets: What Everyone Else Can Learn in the Innovation Capital of the World, when SVB was founded, traditional banks suffered from a fundamental misunderstanding of the needs of start-up firms. Understanding that startups do not immediately generate income, founders Bill Biggerstaff, Robert Medearis and Roger Smith created a risk management model that initially connected clients to a vast network of lawyers, accountants and venture capitalists. Once that relationship was established, they began collecting deposits from start-up firms, which they connected with their venture capital partners.

A sort of double downturn followed as SVB began lending to both private equity firms and venture capital firms and start-ups. Initially, the startups were required to pledge about half of their shares to the bank as collateral for the loan, but as many of its loan clients repaid their loans early, the collateral requirement was reduced to seven percent. Borrowers were also required to enter into an exclusive relationship with SVB – the requirement that eventually laid the foundation for the liquidation of the bank. Although SVB created a risk management scheme that worked internally for a long time, it did not allow debtors to diversify their risk. This is an important factor in the recent tragedy, as most of the bank’s clients were exposed to some type of risk, namely interest rate risk. As a general rule, technology firms tend to finance their operations through the sale of shares because the cost of obtaining this type of capital is low compared to obtaining debt. This does not mean that they do not borrow; as noted earlier, much of SVB’s business consisted of lending to such firms. Rather, according to static trade-off theory, firms consider the weighted cost of capital and make decisions that maximize the return on those costs.

For venture capitalists and other investors, technology stocks are often attractive despite their risk due to the upside potential of the companies. However, they often pay low dividends and have a high price-to-earnings ratio. No one really cares if their investment is overvalued at low rates because expected potential future returns are higher at low rates. However, when rates rise, investors tend to focus on short-term gains. Namely, they start looking for safer havens for their investments. This causes a double difficulty for technology firms; demand for their shares is less and the cost of incurring debt is higher. This has a negative impact on cash flows and the ability to reinvest for growth.

The recent diet of the Federal Reserve’s hike in the federal funds rate has caused many SVB clients to start withdrawing funds to increase their liquidity and fund their operations. Remember that the shares of these firms were no longer in high demand, and the cost of borrowing had increased, so withdrawing your own deposits represented the lowest cost of capital. To fulfill these conclusions, SVB had to start selling assets – and this is where it gets interesting. Although interest rates were low, SVB used a standard banking practice known as net interest margin. generate a tidy income on the deposits of their clients. In effect, at zero-rate funds, they invested savers’ money in relatively stable, high-yielding securities, pocketing the difference between interest paid on deposit accounts and returns.

The securities purchased were a mixture of Treasury bonds and long-term mortgage-backed securities. Their exposure to mortgage-backed securities was high; capitalizing on a 1.5 percent return, they invested $80 billion of their $189 billion in these cars. There is nothing intrinsically risky about these mortgage bonds, but as with any bond, they are very sensitive to changes in interest rates. They are also not as stable as the other long-term bonds that SVB has used to secure short-term deposits: treasury bonds. Unable to sell those securities to deal with the cash shortage, the bank was forced to instead sell its $21 billion Treasury bond portfolio on Wednesday, March 8. the current 10-year Treasury yield is 3.9 percent, resulting in a $1.8 billion deficit. It still had obligations, so the next day SVB announced that it was selling $2.25 billion of both common and preferred convertible shares to cover the shortfall.

Investors were unimpressed but were concerned that the value of their shares would be further eroded. Share prices were down 60 percent by the end of the day. In addition, a number of influential venture capital funds, such as the Peter Thiel Founders Foundation started advising their clients to withdraw their deposits from SVBcausing a bank run. By Friday morning, SVB CEO Gregory Becker began to frantically look for a way to raise capital, even to the point of finding a buyer for the bank, but around noon the DFPI and FDIC turned it off. With the failures of crypto banks Silvergate and Silicon Valley Bank earlier in the week, the sale of SVB shares announced on Thursday triggered a general sell-off in banking stocks, which included four of the largest US banks – Morgan Stanley, JPMorgan Chase, Bank of America and Wells Fargo – lose a total of $55 billion in market share, because bank depositors were worried about the ability of banks to meet their obligations if depositors began to withdraw accounts en masse. It probably didn’t help that FDIC Chairman Martin Grutenberg noted in his speech to the Institute of International Bankers that same week that banks collectively suffered about $620 billion in unrealized losses. – ownership of an asset that has declined in value but has not yet been sold – in relation to their bond holdings.

At first glance, it may seem that all this paints a terrible picture of the state of the banking sector. But it should be the other way around, without an irrational bout of mass hysteria. To mitigate this possibility, FDIC, Treasury and Federal Reserve officials have decided that all depositors of both Silicon Valley Bank and Silvergate (Silvergate has voluntarily decided to liquidate and wind down) will be healthy. Generally, the FDIC Deposit Insurance Fund, funded by fees paid by its member institutions, guarantees only the deposits of those with $250,000 or less in any one bank account. Uninsured depositors or those with more than $250,000 in deposits must wait until the bank’s assets are liquidated and sold to recover any deposits that exceed the insurance limits. These limits have been lifted for depositors of both banks; all customers will be able to recover their deposits with any losses, which the FDIC covers by charging a special assessment from participating banks.

In addition, the Federal Reserve is in the process of reviewing a general bank loan to other financial institutions that could pose significant risks to SVPs; in essence, a type of lending scheme that provides loans to banks that may experience short-term liquidity problems to cushion possible runs. While some may incorrectly view this as a taxpayer bailout, the reality is that the Fed generates its own funds from the interest on its vast holdings of Treasuries and the higher rates it charges on loans to its member banks. While it is wise that the FDIC and the Federal Reserve are acting to appease fearful investors and bank customers, the most compelling factors in favor of stability have to do with the banking institutions themselves.

SVB, Silvergate, and Silicon served as niche specialty banks, and their business was heavily concentrated in one or two industrial sectors. This concentrates risk among parities that are largely exposed to the same types of risk. More traditional banking institutions do business in many different sectors and accept deposits from a wide variety of clients, spreading risk and hurting themselves in a particular shock. Speaking of risk, as a regional bank with less than $250 billion in total assets, SVB has been protected from liquidity coverage ratio (LCR) rules that require banks to hold an amount of liquid assets commensurate with 30 days of cash funding. outflows. This is very important because the business model of any bank, including niche specialized banks, involves the use of short-term deposits to provide long-term loans. Instead of providing its own liquidity, almost 40 percent of its assets at the time of the crash consisted of mortgage bonds, which were ultimately illiquid, and the sale of relatively liquid Treasury bonds could not fill this gap. More traditional banks hold a wider range of LCR-compliant assets, making it less likely that they will be unable to meet the required outflow.

As a result, it is unlikely that most traditional banks will be particularly sensitive to unrealized losses in their portfolios of securities held to maturity. Long-term bonds are not the main hub of their assets, which are diversified enough to hedge against things like rising interest rates. Finally, there are enough functioning, healthy banks to buy and absorb SVB assets without any major market disruption. Again, the Treasury and mortgage bonds held by SVB were structurally sound without any significant underlying risk. They simply held onto too many of them for too long, exposing themselves to rising interest rates. In fact, it’s fair to say that the biggest reason not to fear any major contagion effect shaking the banking sector is that SVB managers were simply irresponsible. The federal funds rate hike didn’t happen overnight, it was expected and announced, and took absolutely no one by surprise. Their failure to take steps to defend against imminent deflationary policies was grossly negligent and ultimately unlikely to be repeated by bank managers whose responsibilities extend beyond the specific boutique market.

Tarnell Brown

Tarnell Brown is an Atlanta-based economist and public policy analyst.

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