Silicon Valley Bank – Everything Everywhere All at Once
This year’s Oscars, the 95th, was dominated by the quirky independent film about a Chinese American in a high-stakes battle across several alternate dimensions. Unbeknownst to the Academy voters last Sunday, in yet another example of life imitating art, a similar struggle was taking place across the state in northern California between federal and state banking regulators and the now infamous Silicon Valley Bank (SVB), a subsidiary of SVB Financial Group (NASDAQ: SIVB).
Although it is still too early to understand the full extent of the failure of Silicon Valley Bank – along with two smaller financial institutions last weekend – like other financial crises, federal regulators have taken quick and decisive action to help minimize the impact on the rest of the U.S. financial system.
All of this may seem eerily familiar to those who remember the bailout of Bear Sterns, Lehman Brothers, and Washington Mutual in 2008. However, there are important differences we would highlight, mainly in the quality of each bank’s asset base. In 2008, the assets held by the failed banks and financial institutions were a toxic mix of high-risk mortgages and credit derivatives – many of which had zero value. In the case of SVB, however, the asset base was primarily long-duration AAA-rated U.S. Treasuries and government-backed mortgages, which have minimal default risk. In fact, if SVB had been able to hold these securities to maturity, they would have received the full value of their investments.
What was Silicon Valley Bank, and why did it fail?
Santa Clara, CA-based Silicon Valley Bank (SVB) was founded in 1983 and quickly became a top lender and financial advisor to hightech start-ups and venture capital firms. SVB was so successful that by the end of 2022, it had become the 16th largest bank in the U.S. and was providing financing for nearly half of U.S. venture-backed healthcare and technology companies.
So, what then caused SVB, a highly respected bank and integral part of the U.S. venture capital infrastructure, along with NY-based Signature Bank, to collapse, requiring an emergency government bailout? The short answer is – poor management and an almost textbook mismatch between assets and liabilities.
The seeds of SVB’s failure began during the global Covid crisis. In 2020 and 2021, Silicon Valley Bank received a large number of commercial deposits – either through PPP loans or by cash raised from venture capital-backed companies that had been taken public through initial public offerings (IPOs) or Special Purpose Acquisition Vehicles (SPACs). Since short-term interest rates were near zero at the time, SVB took those deposits and invested them in long-term bonds, such as government-sponsored mortgages and long-term U.S. Treasuries. SVB then took the cash flow from those higheryielding investments and distributed part – after all, they were still trying to make a profit – back to their corporate depositors in the form of higher yields. On the surface, this all seemed safe and perfectly logical. SVB was holding “ultra-safe” AAA-rated investments as collateral and was able to pay a higher yield on those deposits to their commercial banking clients. What could go wrong?
Unfortunately – and this is where SVB’s senior executives are to blame – they failed to protect their depositors (and shareholders) from the most significant risk to their business, rising interest rates. Once the U.S. Federal Reserve began to raise short-term rates – at about this time last year – duration, which is a measure of a bond’s price sensitivity to changes in interest rates, sealed the bank’s fate. Without getting too much into the mathematics of how duration is calculated, the longer a bond has until maturity (when it can be redeemed at its face value), the higher its duration and the more sensitive the bond’s price is to changes in interest rates. Unfortunately for SVB, this is an inverse relationship. Therefore, the more interest rates increased, the less SVB’s “ultra-safe” long-term bonds it held on its balance sheet were worth.
At first, SVB could hide its losses by reporting that its long-duration fixed-income investments were assets that would be “held to maturity.” Again, at maturity, these AAA-rated bonds could be redeemed at face value – 100 cents on the dollar. However, as the capital markets began to slow last year, many of SVB’s private equity and venture capital-backed deposit customers – the ones that previously relied on the stock market to raise additional capital – now needed to draw upon their deposits at SVB to operate their businesses. What occurred next can be summed up by Hemingway’s Law of Motion: things happen “Gradually, and then suddenly.”
As SVB’s business clients withdrew more and more of their deposits, the bank was forced to sell an ever-increasing amount of its now lower-valued long-term bond assets. Eventually, the bank’s savvy depositors, along with bank regulators, started to notice the growing losses of SVB’s long-term investments. On Wednesday, March 8th, SVB finally acknowledged that it needed to raise $2.25 billion in new investment capital in order to meet its rapidly increasing client withdrawals. Once that occurred, it was a classic “run on the bank” scenario that fans of Frank Capra’s “It’s a Wonderful Life” would recognize, turning the bank’s liquidity shortage into a solvency crisis.
What prevents SVB from becoming a systemic risk to the U.S. financial system?
The situation that led to SVB’s eventual failure had more to do with the inability of the bank’s management and, to some extent, bank regulators to foresee the duration risk embedded in the bank’s longterm bond portfolio. And, while it is too late for SVB, the U.S. Federal Reserve (The Fed) recently introduced a new program called the Bank Term Funding Program (BTFP) to provide small and mid- sized banks with a way to fund their short-term liquidity needs. A key element of this new program allows banks to raise capital quickly (in case of a bank run, for example). Now with BTFP, banks and other financial institutions can exchange – for a period of up to 1 year – any U.S. government bonds with the Fed for cash or new fixed-income securities, even if the bonds they are exchanging currently trade below their face (par) value. Therefore, this new short-term Fed lending program should allow banks and other regulated financial institutions to fund deposit outflows without needing to recognize the current losses on their long-duration bond investments, preventing another SVB-type failure from happening again.
What are we doing at DAC to ensure your investments are safe?
At DAC, our core investment philosophy remains focused on investing in businesses with strong and consistent dividend growth. An essential characteristic of companies that are capable of achieving this growth is a strong balance sheet and a business model that produces consistent and stable cash flows. Perhaps this is why, whether it was during the financial crisis of 2008 and 09, or the global COVID pandemic in 2020, our investment portfolios continued to deliver an ever-increasing stream of cash flow to our clients in the form of rising dividends.
So, even if it seems like Everything Everywhere All at Once is happening in the financial markets, we take comfort, as should you, that our disciplined investment philosophy can produce consistent long-term results, regardless of the market conditions.
Marc D. Saurborn, CFA® | Chief Investment Officer
T 843-645-9700 x239 | F 843-645-9701 | firstname.lastname@example.org
Dividend Assets Capital, LLC is a Registered Investment Adviser with the U.S. Securities and Exchange Commission. Registration does not imply any certain level of skill or training. You should carefully consider the investment objectives, potential risks, management fees, and charges and expenses before investing. The Firm’s Investment Adviser Brochure, Form ADV Part 2, contains this and other information about the Firm, and should be read carefully before investing. You may obtain a current copy of DAC’s Form ADV Part 2 by visiting our website at https://dacapitalsc.com/, emailing info@DACapitalSC.com, or by calling us at (866) 348-4769. Additional information about Dividend Assets Capital, LLC is also available on the United States Securities and Exchange Commission’s website at www.adviserinfo.sec.gov. You may search this site using a unique identifying number known as a CRD. DAC’s CRD is 129973. DAC-23-017
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