Silicon Valley Bank Collapse: A Lehman Brothers Deja Vu?

As seasoned investment experts, it's not every day that we come across a story that leaves us scratching our heads. The recent collapse of the Silicon Valley Bank (SVB) has certainly been one of them. How could a bank that was once known as the go-to lender for tech start-ups find itself in such a predicament?

Let's start with some background information. SVB Financial Group, the parent company of Silicon Valley Bank, was founded in 1983 and was originally focused on providing banking services to the technology industry. Over the years, it expanded its services to include life science, venture capital, and private equity industries. It had grown to become a major player in the banking sector, with total assets of $212 billion as of the end of 2022.

Factors contributing to SVB's downfall

So, what went wrong? Well, it turns out that SVB was heavily exposed to the tech and start-up industry, which - as well all know - had been on quite a rollercoaster ride since 2022. The market had been buoyed by massive investments from venture capitalists and private equity firms, but concerns over inflation and rising interest rates led to a sell-off, leaving many start-ups struggling to survive.?

The root cause of SVB's woes was its investment strategy that relied heavily on long-dated US government bonds and mortgage-backed securities. During the tech boom, SVB's customers deposited large sums of money, which the bank invested in these securities to earn interest income. However, when the central banks around the world raised interest rates sharply to fight inflation, the bond prices fell, leading to unrealized losses on SVB's portfolio. It’s worth mentioning that the management of SVB actively decided not to hedge this very material duration risk - a very unusual and risky strategy for a bank. Under normal - or more stable - circumstances this wouldn’t be a huge problem as accounting rules allowed SVB to put these into the hold-to-maturity-bucket of the balance sheet without any effect on the equity. However, bigger and bigger outflows forced the bank to sell the bonds to raise cash, which realized the losses and weakened dramatically its balance sheet. SVB's investment securities were a ticking time bomb that exploded when the interest rates turned against the bank and the customer asked for withdrawals. According to the filings in November, SVB had unrealized losses of $16 billion on its investment securities. As rumors about its difficulties spread the bank faced a kind of bank run and the resulting outflows accelerated SVB’s downfall. SVB's customers were able to easily move large sums of money using their phones, and as news of the bank's financial troubles spread, they began withdrawing their deposits at an alarming rate. Within just a few hours, customers withdrew deposits in the amount of $42 billion, according to FDIC filings - an absolute record! The combination of online banking and panicked customers contributed to the rapid depletion of SVB's liquidity, making it difficult for the bank to weather the storm. The problem at Silicon Valley Bank was compounded by its relatively concentrated customer base. In its niche, its customers all knew each other. And Silicon Valley Bank didn’t have that many of them. As at the end of 2022, it had 37,466 deposit customers, each holding in excess of $250,000 per account. Great for referrals when business was booming, such concentration could magnify a feedback loop when conditions reversed.

Market Reaction

In the USA, the collapse of SVB triggered a massive flight to safety as investors drastically pared back expectations of a big Federal Reserve rate hike next week and sought refuge in government debt. The yield on the US two-year Treasury note fell below 4% for the first time since last October, with its yield recording the biggest three-day drop since the Black Monday stock market crash in 1987. The US two-year/10-year yield curve also steepened sharply, narrowing its inversion as investors reduced rate hike expectations. The crisis led Goldman Sachs to predict the Fed would not raise rates at its meeting next week at all, helping drive a massive rally in short-dated government debt on Monday. With the uncertainty of the market, it's not surprising that investors are seeking the safety of government bonds as the Fed looks unlikely to raise rates as previously anticipated.

So, what does this mean for the US banking sector??

The collapse of SVB has sent shockwaves through the US banking sector. Many are concerned about the potential for contagion, with other banks that have a high exposure to the tech industry now at risk. The fear is that if one bank goes down, it could trigger a domino effect that could bring down the entire sector.

First and foremost, it's important to note that SVB, with a market capitalization of approximately $6.3 billion, is a relatively small bank. However, it is important to recognize that SVB is the 16th largest bank in the United States in terms of assets, holding a substantial $212 billion. Although any disturbance in the banking sector can cause a domino effect, the size of SVB puts a limit on the possibility of contagion.

Furthermore, the investigation into SVB's financial statements seems to prove that it is an isolated incident. So it seems unlikely that this will lead to widespread panic or a loss of faith in the banking system. According to recent data from industry sources, the global banking sector has seen a steady improvement in credit quality metrics in recent years, with a decline in delinquency and charge-off rates, and a rise in loan loss reserve coverage ratios. Furthermore, the banking sector has also seen a significant improvement in capital ratios, with many institutions maintaining strong Tier 1 capital ratios that far exceed regulatory requirements.

While the overall picture is positive, there are still some areas of concern, particularly around the impact of rising interest rates on borrower behavior. As seen in the recent case of the Silicon Valley Bank, sudden and significant interest rate hikes can lead to a wave of deposit withdrawals and put substantial pressure on bank liquidity. SVB's equity is wiped out, causing huge losses for investors who had put their faith in the financial stability and contingency planning of the bank. This highlights the importance of diversifying one's portfolio and not relying too heavily on any single stock or company.

Contingency planning

Contingency planning is key for any financial institution, and Silicon Valley Bank was no exception. The FDIC and Federal Reserve have stringent regulations in place to ensure that banks have sufficient capital and liquidity to withstand any shocks to the system. In SVB's case, it appears that the bank may have underestimated the severity of the market conditions and failed to take appropriate action to mitigate the risk. While the bank did attempt to reposition its balance sheet, it ultimately failed to raise the necessary capital to cover its losses. The bank's assets fell from $212 billion at the end of December 2022 to $175 billion at the end of February 2023.?

Last Friday, the bank was taken over by the FDIC and insured deposits were promised to be paid to customers on Monday, ultimately halting the bank run. However, the FDIC only covers customer deposits up to $250,000. Customers holding balances exceeding this amount make up $157 billion of the bank's deposit base, with an average of $4.2 million per account. Although there are 106,420 customers with fully insured deposits, they only control $4.8 billion of the total deposits. In comparison to more consumer-oriented banks, Silicon Valley Bank has a deposit base that is significantly skewed towards uninsured deposits, with $152 billion of its total $173 billion deposits being uninsured as of the end of 2022.

Is History Repeating Itself?

It is not just the SVB that is facing these challenges. Many anticipate that there could be more bank failures in the near future since some smaller banks and credit unions are already struggling with large write-offs on their securities holdings. The potential consequences of these bank failures could be catastrophic. If customers lose confidence in the banking system, there could be a run on the banks, leading to a banking crisis similar to what we have seen in 2008.

Both Lehman Brothers and Silicon Valley Bank took on risky investments in pursuit of higher returns, and both ultimately paid the price for those decisions. It’s also a reminder that liquidity is key – without it, even the strongest institutions can collapse in a matter of days.

While there are indeed similarities between the collapse of Lehman Brothers and the recent demise of Silicon Valley Bank, there are also crucial differences that we must consider. The Lehman Brothers bankruptcy served as a wake-up call for the financial industry, prompting a renewed focus on risk management and liquidity. Regulators worldwide have implemented a plethora of new regulations to prevent such catastrophes from occurring again in the aftermath of the Lehman Brothers bankruptcy.

Risk management and diversification are critical factors for banks to consider, in addition to regulatory oversight. Silicon Valley Bank's recent crisis resulted in the cancellation of a capital raise to cover its available-for-sale portfolio losses, leaving the bank undercapitalized. This highlights it is just not enough to depend on one source of income, such as deposits or loans, as it can leave a bank vulnerable to market fluctuations.