Silicon Valley Bailout

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Transcript

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Today’s video is sponsored by Power Corridor, a new publication covering the tectonic forces shaping Wall Street and DC, exploring the ways powerful people, companies, and interest groups shape the trajectory of our economy. Ok, we have got a lot of banking news to discuss today.

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My last video was on Silvergate bank which went bust on Wednesday, I barely got to mention Silicon Valley Bank in that video as it blew up on Friday as the video was going out. My plan was to cover Silicon Valley Bank today and of course news hit last night that Signature

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bank had gone under. – so I’ve had a busy weekend and there’s a lot to cover.

Silicon Valley Banks 10K which was submitted to the SEC just two weeks ago, had one sentence that really stood out. “We have experienced significant growth during 2021 and into 2022, including deposit

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growth. If we again experience deposit growth at a similar or greater rate than has occurred in the past, we may need to raise additional equity to support our capital ratios”.

It turned out that rapid deposit growth would not be their problem.

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And this sentence possibly highlights the blind spot in the vision of the management team at SVB which led to it’s downfall. A number of things went wrong at Silicon Valley Bank over the last days, weeks and years, there were huge failures of risk management.

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The risk manager would have some tough questions to answer, except that it appears that they didn’t have a risk manager on staff for almost nine months of the last year. There were issues tied to the different regulations applied to community banks when compared to

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national banks in the United States. There were investment decisions that were made that I struggle to understand, and the final stroke was a capital raise attempt that had next no chance of succeeding.

You can’t raise capital from investors on the same day that you announce a close to

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two-billion-dollar hole in your balance sheet and the equity is tanking in value. Anyhow, let’s go over the issues at Silicon Valley Bank, try and understand how banks work, look at the news from last night, and try to imagine how things might work out going

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forward. So, the sudden collapse of Silicon Valley Bank shocked the start-up and venture capital community worldwide, many of whom were concerned about the cash balances they kept at SVB and their ability to continue business operations if that money was unavailable.

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While most people outside of California won’t have heard of the bank, it mattered a lot within the startup community as it provided banking services to half of all VC backed tech and life sciences companies in the United States and played an important role in the

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life of founders and VC’s, being both where their businesses banked and they banked. Silicon Valley Bank invested as a limited partner in venture capital funds and underwrote company listings.

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It would appear that a lot of VC firms specifically encouraged the startups they funded to bank at SVB. Last Thursday, in the wake of the collapse of Silvergate, a number of Tech CFO’s began

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messaging each other about Silicon Valley Bank and whether they should continue to keep their cash there. The firm had just announced a large loss, was trying to raise capital, and its stock price was falling rapidly.

Some of the large VC funds, allegedly advised their portfolio companies to pull their cash

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balances from the bank and we got to see the first bank run ever organized by Slack take place. By Friday morning, the bank had been totally wiped out.

Customers had demanded $42bn of their money back in a single day — a quarter of the

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bank’s total deposits — and the bank simply couldn’t meet the requests. The FDIC — the US bank regulator that guarantees deposits of up to $250,000 — took over the bank’s headquarters, declared it insolvent and took control.

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The run was so sudden that the coffers were completely drained, and the bank was left with a “negative cash balance” of almost one billion dollars. Up until last night, most people expected another bank to step in and buy Silicon Valley Bank, protecting both insured and unsecured depositors.

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But it appears a deal could not be struck, so yesterday evening the Treasury, Federal Reserve and FDIC announced that they were dealing with the problems themselves, not only for Silicon Valley Bank but also for Signature Bank, a New York based lender with

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exposure to the crypto industry which had suffered deposit outflows too. The announcement was that both banks would be resolved and all their depositors, insured and uninsured, would be made whole.

The besties at the “All In” podcast could not have been more delighted.

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The regulators announcement added that shareholders and certain unsecured debtholders would not be protected. Senior management would be removed, and any losses to the FDIC to support uninsured depositors would be recovered by a special assessment on banks.

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This is an improvement over the bailouts during the credit crunch. In the UK it was announced that the government and the Bank of England had facilitated a private sale of Silicon Valley Bank UK to HSBC for one pound (that’s a dollar and

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twenty-one cents – for those keeping count) and that deposits would be protected, with no taxpayer support. OK, so let’s look at what went wrong to begin with and then discuss the subsequent bailout that occurred.

So, Silicon Valley Banks’s problems began with the investment boom that followed the start of the pandemic in early 2020.

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As the first stop bank for California venture capital firms and start-ups, SVB was flooded with billions of deposits from young companies flush with investors’ cash. As they describe it in their 10K “Much of the recent deposit growth was driven by our

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clients across all segments obtaining liquidity through liquidity events, such as IPOs, secondary offerings, SPAC fundraising, venture capital investments, acquisitions and other fundraising

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activities—which during 2021 and early 2022 were at notably high levels”. So much money came in — almost $130bn in new deposits in 2020 and 2021 — that the

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bank just couldn’t lend it all out. The tech startups they dealt with didn’t need loans, in part because equity investors gave them loads of cash and also because tech startups don’t usually qualify for loans, they don’t have significant fixed assets and they are often burning cash rather than

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being cash flow positive. There was some mortgage lending the bank could do, and they could lend some money to VC funds so that they could juice their published returns by borrowing money before drawing from their limited partners.

But SVB was still in a situation where money kept coming in as deposits, but not going

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out, as loans. So instead of making loans, they invested the money in long-term bonds.

The bonds paid some interest and were safe, and because Silicon Valley Bank’s deposits paid almost no interest, this could have seemed like a win, despite the very low interest

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rates they got on those bonds. For a quite some time I have been confused as to why anyone would tie their money up in long dated bonds at such low interest rates.

It’s basically risk without return. But one way or another this is what Silicon Valley Bank chose to do to get that juicy

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1.56% interest rate that they were earning. They of course didn’t have to buy such long dated bonds which are very sensitive to interest rate changes, but they did… To understand why banks, buy so many bonds we need to look at the regulation changes

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So, in the wake of the credit crunch new regulations were put in place in pretty much every developed

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market in the world to make sure that Banks held enough liquid assets to meet stressed deposit outflows basically so that they’d be prepared for a bank run, should one occur. Banks were supposed to own a lot of liquid assets to be able to service their deposits.

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The liquidity coverage ratio had to be kept at 100%, meaning that banks had to have enough of the type of assets that could be quickly sold - on hand to meet a stressed outflow of deposits. So, what was classified as liquid assets then?

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Well, cash (of course) which for banks means reserves at the Central Bank and then certain bonds. The new regulations treat government bonds, high quality liquid corporate bonds and certain mortgage-backed securities exactly the same as Reserves at the central bank, as these

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are assets that can be quickly sold if needed. Assets like these face no haircut and were considered to be as liquid as cash under the new regulations.

So, Banks were faced with the decision to either keep reserves at the central bank or

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buy a portfolio of bonds, and from a regulatory perspective they would be treated exactly the same. Now, obviously the bonds will pay a higher interest rate than reserves at the central bank so, Banks started buying bonds.

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There is a problem though, bonds have interest rate risk and some have credit spread risk, and as interest rates and credit spreads change, these liquid investments will change in value giving the bank more profit and loss volatility than they would typically want to have.

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To sweeten the Pill of pushing banks to own all of these bonds the regulators made it easier from an accounting perspective to dampen the profit and loss swings that they would have to report. Banks could classify bonds as either available for sale or held to maturity.

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The bonds you classify as available for sale can be bought and sold as much as you want, but the volatility would hit your capital position rather than your profit and loss. So, your profit and loss won’t change as interest rates or credit spreads change, but

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your capital will. Now that is OK, but, if you want these fluctuations to have no impact on your accounts, banks could classify the bonds they hold as “held to maturity” and then they are held at amortized cost which means market volatility won’t show up in either your profit and loss or

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your capital. And this is what Silicon Valley Bank decided to do with a large portion of their portfolio.

Now just because gains and losses are not showing up in a bank’s accounting statements on held to maturity assets doesn’t mean that banks don’t manage that risk.

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There has been a lot of misinformation going around over the last few days on this topic. Silicon Valley Bank was an outlier with regard to the risks they took, and was regulated differently to other large banks, which I’ll discuss shortly.

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So classifying your bond holdings as held to maturity will be fine in calm markets, or at a bank with stable deposits, but if there are losses on your bonds (like when rates go up) and a lot of your deposits go out the door, you’ll have to realize these

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losses that you were keeping a lid on, and that’s exactly what happened at the banks we’ve seen go bust in the last few days. So, Silicon Valley Bank had a very large amount of bonds in their portfolio classified as

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Hold to maturity. Now any bank who is exposed to this risk will of course hedge their interest rate risk and their credit risk.

It appears that Silicon Valley Bank got rid of all of their interest rate hedges in 2022 at a time when interest rates were at historic lows – and really only had one direction

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they could go in. It would appear that the firms chief risk officer stepped down from her role in April 2022, and a successor was only appointed this January.

So, the bank was not hedging risk at the time when rates were rising and when there was

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a huge tech sell-off which would have impacted their clients. If we look at their accounts you can see that their “portfolio duration” and their “hedge adjusted portfolio duration” were the exact same number(5.6years) meaning that they basically

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had no hedges in place at all. To be really clear, this is not just extremely unusual, it is unheard of.

All large banks hedge their interest rate risk. They do it because, if you don’t, you can be wiped out.

(as we have just seen) The next problem is the depositor base at

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SVB. 89% of their funding came from deposits, which is very high for a bank, and on top of that, most of their depositors were venture capital backed startups, which are mostly high growth loss making businesses.

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These businesses all have the same investors, and they are very interest rate sensitive. In a zero-interest rate environment, profits that come in ‘ten or twenty years’ time are worth the same as profits that arrive today, but as interest rates go up, those

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distant cashflows are worth a lot less. Thus investors become a lot less interested in giving money to a money burning growth company that is hoping to be profitable in the distant future.

This stuff is finance 101 and no one should be surprised by this.

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Another very unusual feature of Silicon Valley Bank is that 90% of their deposits were uninsured. This compares to an industry average of 52%.

A friend of mine runs corporate banking relationships at a large bank, and I was speaking to him

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this weekend. He said none of his clients leave their entire cash balance at the bank at all.

This seems peculiar to Silicon Valley. Maybe there is a reason for this in Silicon Valley, but I simply can’t understand it.

A Sequoia partner Michael Moritz wrote a piece for the FT yesterday claiming that startups

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just couldn’t deal with big banks, as big banks don’t understand founders. He explained that as soon as he makes a seed investment, he would recommend that the startup open an account at SVB.

Are we supposed to believe that Sequoia are actually funding businesses that don’t have

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bank accounts? Gardner’s, food truck operators and window cleaners have bank accounts – but the businesses they invest in I guess don’t.

No wonder Sequoia were so impressed with FTX and Sam Bankman Fried’s everything app on

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which you would one day be able to buy a banana. They seem to think that banking is unavailable to the general public and to businesses all over America.

Who knows – maybe other banks were refusing to open accounts for businesses turning up with huge wads of venture capital money.

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In his article he says that big banks only provide accounts to airline companies and nationwide retailers. To me, the fact that so many Silicon Valley companies were holding all of their cash uninsured

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at one bank indicates a shocking level of financial incompetence. And it is even worse that their VC investors advised them to do this.

Any semi competent CFO or treasurer of even a small firm is aware of the FDIC’s 250

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thousand dollar insurance limit and manages their cash such that it is not sitting uninsured at a community bank earning zero interest. ROKU’s CFO announced over the weekend that $487 million of its cash was sitting at Silicon

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Valley Bank. You have to wonder what the corporate treasurer did all day long at ROKU looking after that single bank account where they kept all their cash?

Anyhow, I guess things are done differently by the disruptors in the valley, and maybe

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there is an explanation for what looks like utter foolishness to an outsider. I’ve seen some press over the weekend knocking the silicon valley VC’s and entrepreneurs as being herd animals driven entirely by FOMO, and I think its probably unfair to say that

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about them, but one way or another they all did wake up on Friday morning – as individuals, and while drinking their blue bottle coffee they checked their twitter feeds and saw what was happening, they quickly pulled on their Allbird shoes and Patagonia vests, hopped

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in their Teslas and raced down to the only bank willing to deal with them to withdraw their money. God knows what they did with it – they don’t have other banks, but importantly, they did

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this all as individuals. So, are other banks as risky as Silicon Valley Bank?

Well, few other banks have nearly as much of their assets locked up in fixed-rate securities as Silicon Valley Bank did, rather than in floating-rate loans.

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Fixed rate securities were 56 per cent of SVB’s assets, at Fifth Third, the figure is 25 per cent; at Bank of America, it is 28 per cent. Additionally other banks will not have put nearly as much into long-dated bonds when

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interest rates were at all-time lows. For most banks higher rates, are good news despite what you might be reading in the press.

They help the asset side of the balance sheet more than they hurt the liability side. As Chris Kotowski an analyst at Oppenheimer describes it, Silicon Valley Bank is “a

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liability-sensitive outlier in a generally asset-sensitive world”. Silicon Valley Bank owned over $80bn of mortgage-backed securities in their hold-to-maturity portfolio.

97% of those were 10 plus year duration, with a weighted average yield of 1.56%.

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When the Fed started raising interest rates last year, the value of these bonds plummeted. This is because investors can today buy long-duration "risk-free" bonds from the Fed at a two and a half times higher yield.

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Was Silicon Valley Bank a victim of the Fed's interest rate shock then? No!

The rate rises weren't that big, and they weren't such a shock as the Fed telegraphed every move that it made. Silicon Valley Bank's problem is that it made a big bet and let its losses ride.

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If you run a bank that mostly gets cash deposits from frothy businesses that do well in a zero interest rate environment and you put all of that cash into bonds that are locked up for ten years at 1.56%. Your bet is that interest rates will stay low forever.

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As otherwise, when rates go up, these businesses will stop getting new capital and start spending their savings. The fact that Silicon Valley Bank locked the money up for ten years at 1.56% meant that if rates went up and their customers started draining their accounts, they would have to

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start selling bonds that had fallen significantly in value and show losses. So, their bet was - that the tech party would go on forever.

There are more scandals in this story than there is even time to discuss.

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The senior management of Silicon Valley Bank sold millions of dollars’ worth of shares in the weeks leading up to the bank collapse, and employees received bonuses on Friday morning, hours before regulators seized the failed bank.

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We will have to see what happens with that. A topic that I should focus on is regulation, as since the credit crunch, Basel III rules relating to the “net Stable Funding Ratio” have applied to all banks in almost every

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developed market other than in the United States, and this is because the US has a powerful community bank lobby. Due to this lobbying, the Fed adopted a rule under which only the very largest international banks were subject to the full Basel requirements.

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It adopted a second tier, under which the net stable funding ratio only had to be 85%, and a third tier where it was set to 70%. And even then, the majority of US banks are not required to follow the Net stable funding

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ratio or Liquidity Coverage Ratio standards at all. Despite being the 16th largest bank in the United States by balance-sheet size, Silicon Valley Bank was able to skirt these risk management standards.

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European and UK banks grumbled a lot about having to meet these standards in the 2010’s, and the standards did reduce their profitability but banks of all sizes did manage to comply. We are likely to see more regulatory scrutiny of community banks in the US after this scandal.

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So, US regulators announced yesterday that Silicon Valley Bank depositors would be fully repaid and that a new lending facility aimed at providing extra funding to eligible institutions to ensure that “banks have the ability to meet the needs of all their depositors”

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would be made available. The US central bank said it was “prepared to address any liquidity pressures that may arise”.

The new “Bank Term Funding Program” will offer loans of up to one year to lenders that

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pledge collateral including US Treasuries and other “qualifying assets”, which will be valued at par. This is more of a big deal than the unsecured depositors being bailed out just to be clear – as this is a huge subsidy that will benefit bank shareholders.

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The new program is supposed to eliminate an institution’s “need to quickly sell securities in times of stress” and would be enough to cover all uninsured US deposits, according to the Fed. The facility is backstopped by the Treasury, which put up $25bn.

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The discount window, where banks can access funding at a slight penalty, remained “open and available”, the central bank added. The regulators said all depositors of SVB would have access to their money on Monday

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(so today), as would those of Signature Bank, which was closed by the New York Department of Financial Services before being placed under FDIC control and marketed for sale. Officials on Sunday said that no losses stemming from the resolution of either SVB or Signature’s

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deposits would be borne by the taxpayer. Any shortfall would be funded by a levy on the rest of the banking system.

They added that shareholders and certain unsecured debtholders would not be protected. That means that taxpayers won’t bear the cost of the bailout, bank customers will bear

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it instead. Of course bank customers and taxpayers are roughly the same group of people… Allowing the banks to pledge collateral that will be valued at par according to Danella Garbor a professor at UWE Bristol goes against every risk management commandment of the past

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30 years and turbocharges the monetary power of collateral. We will have to see how things resolve going forward.

Anyhow, that’s all for now. If you enjoyed this video, you should watch my video on Silicon Valley Blitzscaling next.

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Don’t forget to check out our sponsor Power Corridor, by clicking on the link in the video description, it’s a great publication that I can firmly recommend. Talk to you again soon, bye.