Scramble to contain SVB collapse

Warning: The situation surrounding the failure of Silicon Valley Bank is fluid and until banks open in California on Monday morning and we know what course of action the powers that be have agreed upon over the weekend will we be able to see their full implications.

While the UK was obsessing over Gary Lineker and the BBC, the United States has had some seriously large fish to fry in the form of Silicon Valley Bank and its holding company SVB Financial Group which on Friday collapsed in a pile of dust. There are two stories to consider, the first of which is how it could be that the 16th largest bank in the country could get it so dreadfully wrong as well as the possible systemic implications, and the second of which is what putatively catastrophic impact its failure might have had on the tech sector in general and especially on struggling start-ups in Silicon Valley. The salient facts appear to be as follows:

SVB was set up in 1983 and has emerged as the foremost institution in banking the Silicon Valley tech sector. It prided itself as serving 65% of all start-ups. The causes behind the regulators’ decision to shutter the shop are manifold but the headline story concerned its announcement that it had been obliged to sell US$ 21 billion of fixed rate securities in order to cover the losses incurred by its holding a fixed rate bond portfolio of US$ 21 billion out of total assets of US$ 200 billion. The fixed rate portfolio was yielding an average of 1.79% which might have looked fine and dandy when interest rates were at zero but the precipitous rise in the cost of money caught the bank off-side. Current 10 year US Treasuries yield 3.70% although just prior to the SVB news breaking which precipitated a massive flight to quality run, they had been knocking on the door of 4.00%. SVB’s portfolio, however, reported an average duration of 3.6 years. The inverted yield curve would have made the negative carry – cost of funding over income – even more painful. The bank decided to liquidate the saleable part of the asset portfolio, mainly government bonds, in the process of which it took a realised loss of US$ 1.8 bn. To cover this, it announced a capital raising. Depositors got the message that the bank was in trouble and piled in to get their money out. The rest is history. There were of course other issues stressing the bank, not least of all its exposure to the start-up techs which were struggling with the dearth of venture capital available which in turn forced them to go cap in hand to their bank and to ask to draw down contingency credit lines.

On Friday the FDIC, the Federal Deposit Insurance Corporation, stepped in and took control of SVB, announcing that guaranteed deposits would be honoured but that uninsured ones would for the moment be frozen. Hundreds of small businesses and start-up which do not have a variety of banking relationships and lines of credit to draw on found themselves looking down the barrel of a gun. It looked unlikely that any of the SIFIs – Systemically Important Financial Institutions, the “too big to fail” banks such as Citi, BofA or JP Morgan – would have much of an appetite to take onboard the ruins of SVB, so it will be incumbent of the FDIC to find a way of limiting across the vital sector of tech entrepreneurs the fall-out of the bank’s collapse. In its hands it had the means to protect deposits up to the limit which is currently set at US$ 250,000 – as opposed to £ 85,000 in the UK – but beyond that depositors would be on their own.

Beyond that, however, there are more pressing issues. During the GFC, the question was where Too Big to Fail begins and ends. The categorisation of SIFIs went a long way to covering that ground and the line was drawn at Washington Mutual which at the time became the largest deposit taker not to make it. Talk was now whether SVB’s collapse might trigger a repeat of 2008 and bring about another systemic banking crisis. The comparison with the GFC is wrong. If one were to seek similarities with anything, it would have to be with the crisis in the Savings and Loans sector of the late 1980s and into the early 1990s.

Without going into the details and the regulatory backdrop which enabled many S&Ls to get themselves into terminal trouble as well as some of the characters who led the lambs to slaughter by packing their balance sheets with leveraged securities, the true risk of which the lenders had neither the skills or experience to assess and to price, let us assume something similar but different to be prevalent in the US’s regional and community banking space. It is difficult to believe that there will not be many a smaller lender which has an equally under-water and so far unmarked bond portfolio. No doubt there will be some lesser horror stories waiting to emerge, albeit that the nature of Silicon Valley and its blithe acceptance of companies continuing to function even after many, many years of negative cash flow has, as mentioned above, placed added pressure on SVB’s balance sheet and solvency.

There is one significant difference between the period of the S&L crisis and also the GFC and now and that is that in both previous cases the Federal Reserve System was in a position to slash short end rates and to create a dramatically steeper yield curve. The benefit? Imagine the Fed telling the banks that they can borrow any amount of money from it at X% but that they can then also go out and buy 10 year Treasury notes and X plus 1.5%. That represents the provision of borrowing from Uncle Sam at X and then lending it straight back, risk free,  at X+1.5%. The steepness of the yield curve gifts the banks to all intents and purposes free money at the expense of taxpayers without those taxpayers ever being aware that they are bailing them out. Thus the banks get to rebuild their capital and reserves and other than themselves and the Fed, nobody is any the wiser. The artificially steeply positive yield curve is a huge hidden taxpayer funded subsidy which next to nobody ever appreciates or talks about.

But what when the yield curve is as negative as it currently is with the Fed Funds rate at 4.75% and slated to be raised to 5.25% at the next monetary policy meeting, until this weekend a near certainty which is, however, already being questioned by Goldman Sachs which believes the Fed cannot but hold off? Even if they don’t tighten further, it is still not  in the Fed’s gift to meaningfully ameliorate the painful situation of investment portfolios sporting significant negative carry. The rough guestimate is that there are at least US$ 200 billion of bonds sitting on banks’ balance sheets which are being held at cost rather than having being marked to market and which are burning holes in the respective banks’ P&Ls.

Mark to market is an interesting business which works nicely in calm markets and in liquid assets, the ultimate benchmark of which is set by US Treasuries. The further down the liquidity scale that given securities find themselves, the more illusory the mark to market price becomes in times of stress when looking for a price at which they will find an actual buyer. And when faced with a market trapped in panic mode, even the price of putatively liquid assets can become blurred to the limit of disappearance. The recent LDI fiasco which visited the gilts markets is a case in point. Sure, the banks’ balance sheets have been stress tested but anyone who believes that the tests have been calibrated to prove anything other than that the regulators are in control and have got their calls right must be on some kind of happy powder.

So, over the weekend President Biden has disguised himself as the 7th Cavalry and to the strains of Garryowen come galloping to the rescue and has, in what is effectively a breach of existing federal depots guarantee rules, assured all depositors access to their funds. To some extent this is not illogical as Silicon Valley Bank would appear to be have suffered a solvency issue and not of one of irresponsible lending and an imploding balance sheet. Bankrupt but not broke. At the same time, however, the FDIC’s rulebook has been torn up and rendered all but worthless. If more or less all deposits are now protected, moral hazard is once again off to the races and at an epic scale. This is not an act of bailing out a bank but one of bailing out its clients. What precedent will have been set? When First Hicksville Bancorp in East Dakota goes belly-up, will its depositors be wrong to claim the same rights as those which are currently being offered to the urban college kids with top knots who hate the NRA?

A cast of white knights is beginning to emerge – HSBC bought SVB U.K. subsidiary last night – and as I had suggested in my Friday musings, SVB will live to fight another day albeit not at all in the form in which I had expected. SVP’s troubles were not systemically risky to the banking sector but to that of innovative tech. If that becomes the sector which, irrespective of the causes, is about to be rescued at taxpayers’ expense, will it be asked to offer payback in the way the banks were in the aftermath of 2008?

The mood in market this morning is close to “Nothing more to see here” and SVB’s failure is being treated as an idiosyncratic storm in a tea cup. Index futures are up strongly. At the time of writing the Dow future is 1.2% better, the S&P up by 1.71% and the Nasdaq by 1.83%. No, the world is not about to come to an end but the strain of the inverted yield curve is not about to go away, irrespective of whether the Fed moves by 50 bps, 25 bps or not at all and there are surely more nasties out there still to be unearthed. Maybe not existence threatening ones but ones which have in all likelihood not yet been correctly priced.

Unwittingly, Silicon Valley Bank’s asset/liability mismatch disaster has once again shone a light on all businesses that are driven more by playing the leverage game than by making things and adding value. Look no further than hedge funds and private equity. The former at least trades on leverage whereas the latter invests on it. The rising cost of money has changed the landscape. Before private equity was private equity and was still referred to as corporate raiding the objective as to find a business in which the sum of the parts was putatively more valuable than the whole, borrow expensive money, buy it out, dismember the company, flog the bits off as fast as possible, pay back the silly expensive debt and hopefully find oneself left with a tidy profit. Leverage was expensive and the art was to have completed the process end to end before the cost of the borrowed money brought one to one’s knees. That fleet of footedness has gone in the same way as it has in the banks. Cheap money and a persistently positive yield curve injected complacency while the near impossibility of any deal struck against that backdrop from going sour helped credit spreads and risk premia to decline pretty much to nothingness.

Markets will rebound now that it is clear that there is no systemic risk to the financial system inherent in SVP’s demise. What should but might not yet take root is the understanding that the cheap money paradigm is not temporarily suspended but in all probability gone and businesses which are predicated on an ample supply of easy and cheap credit are, to coin a phrase, surely on borrowed time.

So, off we trot into a new week. Markets should take on board that they dodged the bullet due to luck and not skill and that SVB fired a warning shot across their boughs. Not that they will do. They will blame the bank, its risk management – I understand it operated without a Chief Risk Officer for nearly 9 months between April 2022 and January 2023 – and any other culprit they think they can identify. What they will fail to blame is good old complacency because they are probably knee deep in it themselves. Meanwhile, I will be out tomorrow but on Wednesday I will be launching my annual charity appeal. Details will be sent out on Wednesday morning. As in all of the past few years, it will be locally focused to a cause where every penny counts, makes a visible impact and where every donation
 is truly appreciated.

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