To The Moon

An interest rate crisis

Silicon Valley Bank (SVB), which caters largely to tech startups in the Silicon Valley, has collapsed. This marks the biggest failure of a US bank since 2008.

 In less than a week, the share price of SVB Financial Group, the parent company of SVB, plummeted by 62% to $106.04 before a trading halt was implemented.

 Now, with the bailout by US government, SVB is effectively worthless.

 Here are some insights:

• Good news for SVB depositors

• SVB – a bank for tech startups

• What is the problem with SVB?

• Did SVB hide these losses?

• Bank run

• SVB fallout could mark the start of a systemic banking crisis

Good news for SVB depositors

Last week was a tense period for SVB depositors, especially for those with deposits that are not FDIC-insured.

However, there is some good news: the US Treasury has announced that all deposits, including those not insured by the FDIC, held in SVB will be protected.

In exchange for this protection, regulators have taken control of SVB and put it into receivership. Unfortunately, under the bailout terms, SVB shareholders and certain unsecured debtholders will not be protected.

SVB – a bank for tech startups

At its peak, SVB was the 16th largest bank in the US. It was doing business with nearly half of all US venture capital-backed startups and 44% of US venture-backed tech and health-care companies that went public last year. Prominent clients included Roku and Pinterest.

What is the problem with SVB?

SVB did not do anything illegal. It simply neglected interest rate risk.

Let us explain.

As of end Dec-22, SVB held around $173 billion of deposits, and this was backed by $117 billion of fixed income securities. These fixed income securities were mostly (92%) invested in U.S. Treasuries and securities issued by government-sponsored enterprises. So, they are mostly “safe” assets and this meant little credit risk.

What went wrong?

Despite holding a massive portfolio of $117 billion in bonds, SVB did not hedge the interest rate risks.

 In their 4Q22 earnings, SVB mentioned that it had entered into $550 million of interest rate swap contracts in order “to hedge against [their] exposure to decreases in the fair value of [their] AFS securities resulting from increases in interest rates.” This meant that 99.5% of its fixed income securities was unhedged and exposed to interest rate risk.

The interest rate risk would have been negligible if the bulk of its fixed income portfolio was invested into short-term papers. However, in SVB’s 4Q22 IR presentation, its bond portfolio had a duration of 5.6 years. This proved to be disastrous during a period of rising interest rates.

As of 4Q22, SVB had a low tax-effected yield of 1.76% on its bond portfolio. Based on a back-of-the-envelope calculation, this could represent unrealized losses of $15.2 billion, based on {5.6years *(4%-1.76%) interest rate difference *$121.5b bonds portfolio}.

The $15 billion losses were more than double the market cap of $6.3 billion of SIVB (before a trading halt was implemented).

Did SVB hide these losses?

Having read through SVB’s 4Q22 results and 1Q23 Mid-Quarter update, there was no mention on the “real value” (i.e. marked-to-market value) of its fixed income securities portfolio.

But SVB is not completely at fault here.

The regulators allowed special accounting treatment for Held-To-Maturity (“HTM”) and Available-For-Sale (“AFS”) portfolios.

For AFS assets, any unrealised losses are to be reflected in a separate component of shareholders’ equity. These losses are excluded from reporting in the P&L statement of the banks.

For HTM portfolio, the bonds are held at amortised cost. There is no marked-to-market value, and any deterioration of value can be ignored. Hence, without any recognition of market value, there is no unrealised losses and the banks’ balance sheet remain pristine.

In SVB’s books, the fixed income securities portfolio is categorized into 78% HTM and 22% AFS. Hence, through such regulatory loopholes, there is no need to mention any potential losses that SVB could incur if it has to sell part of its bond portfolio.

Bank run

Last week, SIVB announced that it sold $21 billion worth of securities (with duration of around 3.6 years) in the AFS portfolio. This resulted in a $1.8 billion loss. It intended to reconstruct the AFS portfolio towards short-duration US Treasuries and hedge with receive-floating swaps.

SVB recognised that the duration of its bond portfolio was too long, and it had incurred too much interest rate risks.

But these measures to decrease its interest rate risks had come too late.

Things really came to a crunch when SVB faced a bank run with customers pulling out $42 billion in a single day. This meant that SVB had to take more losses by selling its longer-dated HTM portfolio, and thereby incurring losses that could amount to $15 billion.

Such losses will wipe out the entire market cap of SIVB and cause it to go bankrupt. Hence, SIVB was forced to halt the trading of its shares and allow the US Treasury to take control of it.

SVB fallout could mark the start of a systemic banking crisis

In the near term, intervention by the US Treasury is likely to calm markets. At least, non-FDIC insured depositors can allay their concerns on their deposits.

However, the intervention has not really solved the underlying problems. This includes the drop in bond value brought about by the rise in interest rates. This problem is further exacerbated by the lack of visibility on the “amount of unrealized losses” if these HTM and AFS bonds are marked-to-market to current interest rate levels.

We have seen some data on the potential unrealized losses sitting on the banks’ books but that does not take into account the potential gains for the interest rate hedges. Hence, there is a lack of visibility

This problem could be glossed over if the US Fed embarks on an aggressive rate-cutting cycle. But with high inflation, this option may not be possible for the US Fed. The US CPI data is coming out tonight and this will provide some visibility on how much headroom the Fed has.[Surprised]

Stronger-than-expected inflation could create a systemic crisis. This is because the US Fed will be forced to push ahead with bigger rate hikes, and this will worsen the “unrealised losses” on the bonds portfolio held by the US banks. Furthermore, depositors may also pull out deposits from banks and place them into money market funds as they offer higher interest rates. This creates a vicious cycle of further bank trouble and will worsen the banking crisis.  

 So what are your views for the US CPI tonight?

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