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Our Thoughts on Silicon Valley Bank and the Financial Sector

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Rising interest rates bring both opportunities and risks for the banking industry.  In a rising rate environment, banks typically can deploy their significant base of low-cost deposits into higher-yielding assets, which should result in higher normalized earnings.  Conversely, an inverted yield curve (where short-term rates are higher than longer-term rates) can be a huge headwind. A more deeply inverted yield curve, for longer, raises the risks of serious problems for the banks. Currently, the two-year yields’ premium over their 10-year equivalent is around 100 basis points. Such an inversion is a clear and ominous recession signal and it also is negative for banks. 

 

Not surprisingly, it’s been the worst week for bank stocks in years.  Specifically, it started when Silicon Valley Bank surprised the market with plans for a share sale and a $1.8 billion loss on securities sales.  Investors were left wondering if its problems were isolated or the harbinger of a broader funding crunch in credit markets. Sudden selloffs in financials do not sit well with investors at-large after the 2008 financial crisis.  That said, major banks are much better capitalized and far less leveraged than they were in the lead-up to the global financial crisis. And SVB’s client list is heavily concentrated in riskier venture-backed startups, unlike most other lenders.

 

SVB is deeply embedded in the US start-up scene and is the only publicly-traded bank focused on Silicon Valley and tech startups.  Their ordeal began after its parent company, SVB Financial Group, announced it had sold $21 billion of securities from its portfolio and said it was holding a $2.25 billion share sale to shore up its finances. The move was prompted by high deposit outflows at the bank due to a broader downturn in the startup industry, according to analysts. All of that unnerved a number of prominent venture capitalists, including Peter Thiel’s Founders Fund, Coatue Management and Union Square Ventures, which are said to have instructed portfolio businesses to limit exposure and pull their cash from the bank.

 

Regulators have now closed SVB, roiling the larger lending industry.  The FDIC said that insured depositors would have access to their funds by no later than Monday morning. Uninsured depositors will get a receivership certificate for the remaining amount of their uninsured funds, the regulator said, adding that it doesn’t yet know the amount.  Receivership typically means a bank’s deposits will be assumed by another, healthy bank or the FDIC will pay depositors up to the insured limit.  The FDIC created a new bank, the National Bank of Santa Clara, to hold the deposits and other assets.

 

SVB’s unique nature intensified an issue hitting all banks. All US lenders parked a chunk of their money in Treasuries and other bonds that dropped in value last year amid the Federal Reserve’s rapid rate hikes to contain inflation. But SVB took it to a different level: its investment portfolio swelled to 57% of its total assets. No other competitor among 74 major US banks had more than 42%. While higher rates have made all banks fret about depositors going elsewhere, most lenders have very broad customer bases (for both loans and deposits) spread among individuals and companies. However, SVB grew rapidly thanks to its focus on tech startups. For months, the company has warned that it has seen deposit outflows as those firms burned through cash. 

 

For one thing, SVB’s problems coincided with the abrupt shutdown of Silvergate Capital Corp. Those problems were in many ways unrelated: At Silvergate the problem was a run on deposits that began last year, when clients — cryptocurrency ventures — withdrew cash to weather the collapse of the FTX digital-asset exchange. But the withdrawals forced asset sales that locked in losses, as happened with SVB, leading Silvergate to announce plans to wind down operations and liquidate. And even before SVB’s woes became public, US bank stocks had come under pressure after KeyCorp warned about the mounting pressure to reward savers. On the other hand, analysts said that SVB’s depositor base and bond-heavy portfolio were both very different from those of most banks.

 

Concern had been mounting about the impact of rising rates on bank balance sheets. While rising rates buoy their revenue, in the short term they also force them to write down the value of assets they hold. In all, US bank had booked $620 billion in unrealized losses on their available-for-sale and held-to-maturity debts at the end of last year, according to filings with the Federal Deposit Insurance Corp. The agency noted in March that those paper losses “meaningfully reduced the reported equity capital of the banking industry.” As recently as January, SVB Chief Financial Officer Daniel Beck told investors there wasn’t “any desire” for a wholesale change in the bank’s available-for-sale portfolio. That all changed this month.

 

Is it time to panic? We don’t think so, although the stock market is getting anxious. We believe this has more to do with the easy-money growth stock phenomenon of the past two decades, now that rates are marching higher. Sure, it is more mainstream than the crypto routing  last year, but SVB has a relatively specialized client base in a niche area of finance. It feels more like the tech / telecom 2000 bubble where shocks were relatively mild, rather than the 2008 bubble where contagion infected every single nook and cranny of mainstream finance. Every mortgage felt like it was underwater and people wondered if money would come out of the ATM. Plus, banks appear better capitalized, and there is less leverage in the system.  What this means is that the struggles of Silvergate and Silicon Valley Bank need to be looked at in isolation. Sure, they’re under pressure, but they also serve very specific niches and have very specific risk exposures. As investors, we shouldn’t jump to conclusions and take their experience and extrapolate it to the rest of the financial system.

 

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