The jump-scare by Silicon Valley Bank was not a shock for many, short sellers had been calling out SVB and many other lending institutions for a while, but what actually happened? How Banks Work The business model of banks is very simple. Imagine that you deposited your money in the bank, the bank pays you - the depositor, interest on your money. But the bank needs to make money too, so it deploys the depositors’ money by giving out loans, credit lines and other instruments at a higher rate than what it is paying you and pockets the difference. This is called ‘Net Interest Margin’ or NIM.
The bank however, cannot give out all of the depositors’ money, it has to have some liquidity in case of emergencies and withdrawals and the difference between the bank’s assets and liabilities which is the equity, acts as a safety net to fall back on. What Happened at SVB? Silicon Valley Bank had assets totaling $212 Billion while liabilities were at $200 Billion (FY 2022). This means that they had a safety net of about $12 Billion. Out of the $212 Billion in assets, deposits were $173.1 Billion; After the banking crisis in 2008, the FDIC made insuring some of the deposits mandatory, this insurance makes sure that depositors get part of their money back should the bank go under.
A meager 11% of the deposits were insured, this is a big red flag, as a depositor you want your money insured and as an investor the insurance acts as a checks and balance metric. Lending Practices & Business Model Investors who were concerned about the equity and bank’s collateral were already cashing out of the bank, SVB had to sell its liquid assets for a loss to cover this up. This leads to the bigger question, how were their collateral assets and what were their lending practices like?
More than half of the short term loans were given to Venture Capital and Private Equity endeavors, given the current macro setting, their profitability is questionable. So most investors assumed that the loans were essentially bad, which they were.
Why were they bad? Their business model explains it all. SVB issues something called ‘Venture Debt’ which they explain on their website: If you are a company that is raising $10 Million at a $50 Million valuation, giving up 20% equity and you are short $2 Million to the target. Instead of raising the $2 Million from investors for 4% equity, you can borrow the amount as Venture Debt for 0.25% equity in the form of warrants which is less dilutive than the former option.
SVB is very proud of their VC lending, they have to be given the statistics.So SVB’s business model is to lend to as many start-ups as possible to breakeven on their losses and then some on that one winning IPO. This is quite literally the modus operandi of Venture Capital firms.
But here is the fundamental problem where SVB falls behind even VC firms, at least VC firms get into the deal for equity. When you have equity in a business, if the business goes under or liquidates for profit or is even acquired, you as the equity holder will get your share of the pie, there is some form of recovery. But SVB is praying on warrants, and the warrants are only worth something when the companies go public via an IPO and the stock is trading at a premium to the warrants’ exercise price.
It is common knowledge that the ‘Tech Bubble’ had recently burst, companies like Google, Amazon and META were down more than 50%, one can only imagine what happened to ‘Tech’ companies that have never had positive cash flow, and the ‘Healthcare’ (vastly referring to BioTech) side was in even dire straits.
In such a market environment, no ‘Tech’ or ‘Healthcare’ company would file for an IPO which renders SVB’s collateral warrants worthless. This aspect should be reason enough to sympathize with both the fleeing depositors and shareholders. Interest Rates The Federal Reserve has been increasing interest rates, while the interest rates before mid 2022 were almost at zero, it was very easy for banks to profit; they were essentially paying nothing to their depositors, while lending out at a better rate which increased their NIM. Since the rates have now increased, the NIM has shrunk meaning the bank’s profitability shrunk.
In addition, as of Q4 2022, SVB purchased $82 billion worth of 10-year maturity MBS, which is the major asset SVB holds. The increasing rates at 5.2% conversely decreased the value of long term debt, which in the case of banks, are their assets.
Silicon Valley Bank’s financials looked right until one read between the lines and looked for ‘unrealized losses’ of securities ‘held-to-maturity’ (HTM).
SVB reported it had unrealized losses of $15.1 Billion, so let’s do some math here, they had equity of $12 Billion, but unrealized losses of about $15.1 Billion, this means that equity had and shareholders have been wiped out. You can refer to our last whitepaper on leverage to get a better understanding of the concept as well as the role it played during 2008.
Held-to-maturity accounting itself is not to blame here, the bank bought MBS when interest rates were at all time lows, their average yield was 1.56%, after the rise of interest rates, one could buy securities that yielded 4%-5%, since the current interest rates lead to better yielding securities, the securities with lower yield such as SVB’s MBS’ value on the open market has decreased. The decrease in their value is irrelevant because when held to maturity, these securities do not lose money.
HTM accounting allows the company to report changes in their interim value as unrealized losses or gains. This lets the investors get an idea of the underlying securities’ mark-to-market value and volatility. Management It should be noted that while SVB had negative equity and a really bad NIM outlook, they still did not have a Chief Risk Officer (CRO), which any bank should have. The reason for the most crucial role being vacant for 18 months is unknown. The CRO’s value in a bank is even more than that of the CEO because a Bank’s balance sheet in its entirety is nothing but risk.
The management team, while reassuring the shareholder, sold their own stake with the CEO personally unloading $3.5 Million worth of shares.
Ironhold's Prediction In October 2022, our Chief Investment Officer, Siddharth Singhai, already suspected some financial institutions' failure. In an email to MarketWatch, he shared that he hadn’t foreseen another financial crisis, but he believed that certain financial institutions might be in trouble. “Capital adequacy ratios have been strictly maintained across most big banks.” Singhai said. “The trouble would be derivative books: They represent hidden leverage, and these are very complicated black boxes…We do think it’s quite possible that derivative books will get some banks in trouble. It’s however impossible to say exactly since these books are black boxes and quite often the banks themselves can’t make sense of these contracts.” The Federal Government has started the process of auctioning some segments of SVB, the most recent one being their VC loan book. In the meantime, The FDIC is making sure the depositors get their money back. Ripple and Aftereffect It is clear that depositors’ trust in the banking system is fleeting. Below is a table that depicts uninsured deposits.
It can be seen that the three banks that failed, left most of their deposits uninsured, this only adds fuel to the fire and causes contagion. While the depositors have been saved for the time being because of the Federal Government and FDIC stepping in, it is unsure if such a scenario could repeat again.
This is precisely the reason why Banks as institutions are hard to gauge and why most investors tend to stay away from them. Today, AT1 holders of Credit Suisse have been wiped out during their acquisition by UBS even though AT1 takes precedence over equity, a small print in the prospectus that bondholders should read actually mentions that the AT1 could end up worthless in case of a write-off, case in point, black boxes and unconventional.
Banks are riddled with complex structures, derivatives and agreements that present a difficult time to any investor trying to understand them. In Closing In conclusion, lack of long-term foresight and eased interest rates over a decade allowed SVB to settle into an illusory comfort zone of buying a staggering amount of 10-year MBS while lending to VC and PE endeavors. As VC’s are inherently volatile high-risk borrowers, any negative change in market scenarios would strongly impact their performance. Additionally, SVB was not meticulous in ensuring that its deposits were majorly insured by the FDIC or judicious enough to hire a Chief Risk Officer.
While it may be easy to project the current successes into the near future, banks should always be prepared for bear case scenarios. Having a strong risk management department and a diversified portfolio is essential for a lender to survive the highs and lows of the market.
The entire situation is a very crucial lesson to investors and banks. Years of complacency have led to today’s sordid affairs and it is uncertain how long the contagion will last, fear makes people irrational, while some institutions might have deserved such contagion, some stand innocent victims to it. By Siddharth Singhai; Chief Investment Officer Nipun Alety; Analyst Aastha Aggarwal; Analyst John Kadiman; Analyst Huaxu (Eddie) Huang; Analyst Disclaimer This White Paper expresses the views of the author as of the date indicated and such views are subject to change without notice. Ironhold Capital has no duty or obligation to update the information contained herein. Further, Ironhold makes no representation, and it should not be assumed that past investment performance is an indication of future results. Moreover, wherever there is the potential for profit there is also the possibility of loss. This White Paper is being made available for educational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as an offering of advisory services or an offer to sell or a solicitation to buy any securities or related financial instruments in any jurisdiction. Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. Ironhold Capital Fund 1, L.P. (“Ironhold”) believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based.