As I am sure all of you are aware at this point, on Friday, March 10, 2023, the California Department of Financial Protection and Innovation took possession of Silicon Valley Bank, citing inadequate liquidity and insolvency. The Department of Financial Protection and Innovation appointed the Federal Deposit Insurance Corporation as receiver of Silicon Valley Bank, and the Federal Deposit Insurance Corporation in turn created the Deposit Insurance National Bank of Santa Clara, which now holds the insured deposits from Silicon Valley Bank. Given Silicon Valley Bank’s prominent position in the technology ecosystem, this began causing ripples throughout the industry.
Over the weekend regulators moved swiftly to try and contain any potential contagion. According to the Federal Deposit Insurance Corporation, insured Silicon Valley Bank depositors had access to their funds Monday morning. In a joint statement from Treasury Secretary Janet Yellen, Federal Reserve Chair Jerome Powell and Federal Deposit Insurance Corporation Chair Martin Gruenberg, federal regulators announced they would roll out emergency measures to backstop all depositors. The Federal Reserve has gone one step further and stated under a new “Bank Term Funding Program” that it is making additional funding available to banks (beyond Silicon Valley Bank) to ensure they have the ability to meet the needs of all depositors. This program will offer loans of up to one year to banks that pledge US Treasury, mortgage-backed securities and other collateral.
For perspective, Silicon Valley Bank is the sixteenth largest bank in the United States and the second largest to ever fail. Its ~$210B in assets are roughly two-thirds of Washington Mutual (not adjusting for inflation,) which failed in 2008 and is the largest bank to fail in the United States.
Similar to a hypothetical story that is used to explain exponential thinking (or threats) involving lily pads covering a pond, the pace and timing of Silicon Valley Bank’s failure can be best described as gradual then sudden. It was over the course of several years that Silicon Valley Bank’s financial position deteriorated, but just two days elapsed between its March 8 announcement that it was seeking to raise $2.5B of new capital to shore up its balance sheet and the March 10 declaration by regulators that it had failed and was being placed in receivership.
To illustrate the point, imagine a large pond that is completely empty except for a single lily pad. Assume that the lily pad will grow exponentially covering the entire pond in three years. In other words, after one month there will two lily pads, after two months there will be four, etc. The pond is covered in 36 months. When asked when the pond would be half filled with lily pads, the normal temptation (and knee jerk response) would be to say 18 months or half of the 36 months. On the contrary, in fact, the correct answer is 35 months. Merely one month (or compounding time period) before the pond is filled, it’s only half filled. This is because it doubles the next month. Although the correct answer is relatively straightforward to understand, our brains tend to work more linearly than exponentially. It is not necessarily obvious before knowing the answer that the pond is 1/64 full in month 30, only six months before it is completely full.
What Happened?
The short answer is, an old-fashioned run on the bank. The much wordier answer is that Silicon Valley Bank carved out a distinct but riskier niche than many of its competitors, which set it up for large potential capital shortfalls in a rising interest rate environment, deposit outflows and forced asset sales.
Silicon Valley Bank is known as a bank for start-ups. It would open up accounts and start a relationship with these young companies often before larger lenders would consider it. It also lent to them, something other banks are reluctant to do, and used this product as a way to get the whole banking relationship with these young companies. That is, it was not uncommon for Silicon Valley Bank to require all banking business be conducted with it in order for the company to secure a line of credit. Silicon Valley Bank had an unusually high reliance on corporate venture capital deposits. Of Silicon Valley Bank’s ~$173B of customer deposits, $~150B were uninsured (i.e., over the $250,000 Federal Deposit Insurance Corporation insurance limit) and only ~$5B were fully insured.
Between the last quarter in 2019 and the first quarter of 2022, deposits at US banks rose precipitously (by $5.4T, yes trillion with a “T”) but because of weak loan demand only 15% was lent out as traditional commercial loans. The rest was invested in securities portfolios, primarily US Treasuries and mortgage-backed securities. Silicon Valley Bank experienced this to an even greater extent. As the venture community boomed over the last handful of years so did Silicon Valley Bank’s deposit accounts, as its clients were flush with cash and needed somewhere to put it. Silicon Valley Bank’s deposits grew more than 4x from $44B at the end of 2017 to $189B at the end of 2021; however, its loan book only grew from $23B to $66B. Since the bank model is predicated on making money on the spread between the interest rate paid on deposits and the rate paid by borrowers, having a deposit base that is outsized versus a loan book causes issues. This drove Silicon Valley Bank to acquire other interest-bearing assets, or more specifically $128B worth of mortgage-backed securities and US Treasury by the end of 2021.
Banks can either designate these securities as being “available-for-sale” or “hold-to-maturity” portfolios. The primary difference being that available-for-sale portfolios are regularly marked to market and hold-to-maturity portfolios are only marked to market when a sale occurs. However, if even a portion of the hold-to-maturity portfolio is sold then the entire portfolio must be marked to market. This makes selling hold-to-maturity securities complicated because it results in larger portions of the portfolio being suddenly marked to market, which can then result in the need to raise capital. Silicon Valley Bank was one of the banks that relied heavily on hold-to-maturity treatment for its growing securities portfolio. From 2019 to the end of 2022, Silicon Valley Bank grew its available-for-sale book from $14B to $27B but grew its hold-to-maturity book from $14B to $99B.
Given its need to sell securities and what interest rates did during 2022, you can imagine what that mark to market looked like on Silicon Valley Bank’s books. At the same time, those same soaring interest rates slowed the boom in the venture capital community. This left Silicon Valley Bank uniquely exposed. Its deposits had grown significantly when interest rates were low and its clients had plenty of cash. Since the bank also made investments during this time, it purchased bonds at their peak price and lowest rates. As venture-capital fundraising dried up, Silicon Valley Bank’s clients drew down their deposits to fund operations. Deposits fell from $189B at the end of 2021 to $173B at the end of 2022. Silicon Valley Bank was forced to sell off its liquid bond portfolio at substantially lower prices than it paid. The $1.8B in losses it took on these sales left a hole and hence the need to raise $2.5B of equity capital to plug a hole in its balance sheet. When it went under on Friday, the bank held $91B of investments, valued at their cost at the end of last year.
Once word of the needed capital raise became public, depositors across the venture capital ecosystem descended upon Silicon Valley Bank like the townspeople of Bedford Falls on George Bailey’s Building and Loan. A classic run on the bank.
The information in this presentation is for educational and illustrative purposes only and does not constitute tax, legal or investment advice. Tax and legal counsel should be engaged before taking any action. Oxford Financial Group, Ltd. is an investment advisor registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. More information about Oxford Financial Group’s investment advisory services can be found in its Form ADV Part 2, which is available upon request. The above commentary represents the opinions of the author as of 3.14.23 and are subject to change at any time due to market or economic conditions or other factors. The information above is for educational and illustrative purposes only and does not constitute investment, tax or legal advice. No offers to sell, nor solicitation of offers to buy any securities are made hereby. Solicitations of investments and any offers to sell securities, if any, will be made only through an offering document clearly identified as such. Certain of the statements in this document are forward‐looking which cannot be guaranteed. These statements are based on current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results or future performance to differ materially from those expressed or implied in such statements. OFG-2303-9
**As of 12.1.21
***As of 8.1.22
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