The failure of SVB Financial Group (SIVB) is epic in terms of the size of deposits lost to so many fledging companies, the payrolls it won’t be able to meet, the mismanagement of the balance sheet, the job losses it will likely trigger and the damage to investor sentiment that was evident when the 15th-largest bank in the United States collapsed.
To be clear, one chart that was widely circulated at the Federal Reserve and the Treasury Department was that of the bank sector. After eight months of building a base in the face of the most aggressive rate hike cycle in history, seeing shares of the purest bank exchange-traded fund (ETF), the Invesco KBW Bank ETF (KBWB), slice through the low like a hot knife through butter surely sounded alarm bells. How could the bank where the smart money does its banking get it so wrong? This was a full breach of investor confidence.
Forget the bullish jobs report that showed a silver lining in wage inflation. When SVB never reopened for trading for lack of being able to raise capital amid too many unanswered questions, the path of least resistance was lower. The age-old investor reflex of “sell first, ask questions later” took complete hold of price action. This banking bombshell taking place on a Friday only made things worse, heading into a weekend of unknown consequences and wild speculation on perceived outcomes.
For those wondering what the heck happened, there are some glaring outliers in the SVB situation. Roughly 87% of SVB’s deposits were above $250,000, and thereby uninsured, whereas the typical regional bank has roughly 40% of deposits above the $250,000 level of the FDIC insurance limit. Why didn’t regulators raise this red flag when it came to net capital requirements? But this just helps to explain the panic regarding the run on the bank. Last Friday, SVB failed following a bank run that saw investors and depositors trying to withdraw $42 billion on Thursday alone. The core of the story was so clearly put forth by Marc Rubenstein over the weekend:
“Driven by the boom in venture capital funding, many of Silicon Valley’s customers became flush with cash over 2020 and 2021. Between the end of 2019 and the first quarter of 2022, the bank’s deposit balances more than tripled to $198 billion.”
“The bank invested the bulk of these deposits in securities. It adopted a two-pronged strategy: to shelter some of its liquidity in shorter duration available-for-sale securities, while reaching for yield with a longer duration held-to-maturity book. On a cost basis, the shorter duration AFS book grew from $13.9 billion at the end of 2019 to $27.3 billion at its peak in the first quarter of 2022; the longer duration HTM book grew by much more: from $13.8 billion to $98.7 billion. Part of the increase reflects a transfer of $8.8 billion of securities from AFS to HTM, but most reflected market purchases.”
“Based on the current environment, we’d probably be putting money to work in the 1.65%, 1.75% range,” said the bank’s chief financial officer (CFO) at the beginning of 2022, referring to the yields he wanted to achieve. “The vast majority of that… being agency mortgage backed, mortgage collateral, things along those lines.”
“The trouble is that when rates started to go up, mortgage assets got hit hard. The duration of Silicon Valley’s HTM portfolio extended to 6.2 years by the end of 2022, and unrealized losses snowballed from nothing in June 2021 to $16 billion by September 2022. That’s a 17% mark-to-market hit. The smaller AFS book was also impacted, but not as badly. Mark-to-market losses there amounted to 9% by the end of September.”
“So big was this drawdown that on a marked-to-market basis, Silicon Valley Bank was technically insolvent at the end of September. Its $15.9 billion of HTM mark-to-market losses completely subsumed the $11.8 billion of tangible common equity that supported the bank’s balance sheet.”
This “technical insolvency” is right out of the movie Margin Call, where the market pushes that firm’s leverage in commercial mortgage-backed securities (CMBS) beyond the equity of the firm. Considering this took place back in September should have sounded alarm bells. While SVB held bonds with an average duration of 6.2 years that would ultimately be redeemed at par, the bank ran out of time. Its management did not anticipate the venture capital (VC) market drying up completely in 2021 and the rate of deposits to fall by some $33 billion over the past year. The bank struggled to contain bond losses at a time of accelerating deposit outflows.
And then there is the issue of SVB operating without a chief risk officer for nine months leading up to the current collapse. SVB’s former head of risk, Laura Izurieta, who formerly performed a similar role for Capital One, left the bank in April 2022. She wasn’t replaced until January 2023, when the bank hired Kim Olson, formerly of Japanese bank Sumitomo Mitsui. This is bad. Who was overseeing risk in between?
With the SVB crisis at the forefront of all that matters to the market, one could argue the Fed will take whatever inflation data in stride and put any further rate hikes on hold. And here is why: SVB’s problems of holding government securities that are trading way below par are not idiosyncratic, as has become the go-to phrase for this event pushed by the financial media.
The fact is that the banking community has also suffered hundreds of billions in mark-to-market losses on its securities portfolio. According to a recent speech by FDIC Chairman Martin Gruenberg, banks under his purview have accumulated $620 billion in unrealized losses on investment securities as of the fourth quarter due to elevated market interest rates. The elevated level of unrealized losses is at risk of becoming realized if the banks need to sell securities to meet liquidity needs.
Figure 8: FDIC-regulated banks have $620 billion in unrealized losses on investment securities (FDIC)
The accompanying chart is probably the other most circulated one going around at the Fed this past weekend. Here, too, SVB might be the canary in the coal mine if further stress is added to what is already taking on the appearance of a potential liquidity event. If the charts don’t lie, I would venture to say we have seen the last of rate hikes for the cycle.
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