March 2023 - Silicone Valley Bank (SVB) Receivership
What happened?
On Friday 10th March, the US government's banking regulator shut down the normal operations of the 'Silicon Valley Bank' based in California. This is a regional bank that is ranked 18th amongst all the banks in the US with a market share of 1.5% of all US banking assets.
Source: Statista
SVB is now a failed bank and the regulator, Federal Deposit Insurance Corporation (FDIC), has transferred all of SVB's assets and deposits to a newly created bank called the National Bank of Santa Clara. The new entity will be operating from Monday morning and the checks issued by the failed SVB bank will continue to clear for government-insured cash deposits up to $250,000.
Those with deposits over $250k are uninsured and at risk of losing their deposit, these depositors will get the dividend payment from the failed bank and will just have to cross their fingers and hope that the regulator can find a major bank to buy SVB/The National Bank of Santa Clara and make all uninsured depositors whole. Certainly, at this stage it appears, SVB's shareholders and debt holders are likely to lose out entirely. SVB's +8000 employees will continue to work under the new banking entity for now.
As of December 31, 2022, Silicon Valley Bank had approximately $209.0 billion in total assets and about $175.4 billion in total deposits. As of Friday, the amount of deposits in excess of the insurance limit was undetermined. The amount of uninsured deposits will be determined once the FDIC obtains additional information from the bank and customers.
Silicon Valley Bank had 17 branches in California and Massachusetts. The main office and all branches of Silicon Valley Bank will reopen on Monday, March 13, 2023. The regulator will maintain Silicon Valley Bank’s normal business hours.
What could happen next?
Readers of this note are unlikely to have a direct interest either as uninsured cash depositors in SVB which are at risk of being lost and or owned shares in SVB which are now likely to be zero value.
The most likely scenario here is that in the near future, a big Wall Street bank will acquire Silicon Valley Bank out of receivership. The big bank will assume SVB’s assets and liabilities and make its depositors whole, and nobody will suffer catastrophic losses. (Except SVB's equity holders). The acquiring bank will likely have to be a big-name bank to regain the trust of depositors to leave their excess funds with the bank.
A fast, orderly transfer of SVB's assets and liabilities to a new bank would be a best-case scenario. A worse scenario — one in which no buyer emerges, the bank’s depositors have to wait weeks or months to access their money and the entire start-up companies ecosystem that banked with SVB in Silicon Valley collapses because many cannot make payroll — could be catastrophic but we see it as unlikely that the Feds will let that happen as that then leads to systemic risks!
Broadly speaking, this is the second-largest bank to fail in US history. The biggest-ever bank failure was of Washington Mutual (see below how that played out) during the Financial Crisis of 2008, with $300 billion in assets.
So this is not the first bank to have failed in the US and it certainly won't be the last. Since the early 1970s, there have been over 80 banks that have failed in the US. In the last decade, there have been 7 banks that failed. During the GFC and in the immediate period after it (2008-2010), more than 50 banks failed in the US.
So it is fair to say that the banking regulator FDIC has been there many times before and has well-framed response mechanisms to deal with failed banks. Usually, the regulator swoops on the failing bank on a Friday to have the weekend to work through the transition of assets and liabilities and even sound out the interest of potential acquirers.
How did the regulator deal with the failure of Washington Mutual in 2008 which was comparable to SVB in size and was the largest failure in US history?
In 2008 it was clear that Washington Mutual (WM) was running out of cash and might have to close on short notice and that it represented a potential crisis as WM was nearly 10 times larger than any bank the FDIC had ever closed.
As of June 30, 2008, WM had 2,300 branches and $188 billion in deposits, an estimated $45 billion of which was uninsured. FDIC was concerned that refusing to protect WM's uninsured depositors would be devastating to an already fragile public confidence due to the GFC. But, by law, the FDIC must handle failed banks in a manner that represents the least cost to the deposit insurance fund. The only exception is if the FDIC's board of directors, the Board of Governors of the Federal Reserve System, and the secretary of the Treasury (after consultation with the president) all choose to make a systemic-risk determination, an authority that had never been used since Congress had granted it in 1991. Such a determination would be an acknowledgment that a bailout was needed to prevent significant damage to the broader financial and economic system. Such a decision also would be saying that WM was too big to fail.
The FDIC did not believe that WM was too big to fail. Its preference was protecting WM's uninsured depositors against any losses without violating the least-cost test. FDIC did not care to bail out WM's bondholders, since they were sophisticated investors who understood the risks they were taking.
FDIC devised a resolution strategy for WM. It proposed that potential acquirers would be told they had to acquire all of WM's assets. This would reduce the FDIC's cash outlay and relieve the agency of the costly and time-consuming task of separately having to sell $300 billion in assets. However, bidders would be given greater flexibility in determining which of WM's liabilities they would be willing to absorb.
Their options essentially would be to assume all of the bank's liabilities less
(1) all preferred stock; or
(2) all preferred stock and subordinated notes; or
(3) all preferred stock, subordinated notes, and senior debt; or
(4) all preferred stock, subordinated notes, senior debt, and certain liabilities; or
(5) all preferred stock, subordinated notes, senior debt, certain liabilities, and uninsured deposits.
The liabilities assumed decreased from the first to the fifth option. Any liabilities assumed by the winning bidder would be protected against any losses—costs that would have to be absorbed by the acquirer. Any liabilities the winning bidder did not assume responsibility for would be exposed to losses, and represented costs the acquirer would not have to cover.
Prospective bidders were left with a difficult decision. Protecting a larger group of creditors against losses would have the desirable outcome of calming those customers and making the transaction less disruptive. However, it also would raise the cost of the transaction for the winner.
FDIC had reasoned that no one would want to choose categories 1 or 2, as they would not want to absorb the costs associated with protecting WM's preferred shareholders and senior and subordinated debt holders. This was fine from FDIC's point of view since these private-sector creditors, rather than the FDIC's deposit insurance fund, should be first in line (after common equity
shareholders) to bear the cost of the bank's failure. FDIC also had reasoned that an acquirer would not want to choose categories 4 or 5. since they would not want the disruption associated with failing to protect uninsured depositors and other general creditors.
This left category 3, which fit with what FDIC wanted as well, since it had no desire to see a run from depositors at WM's numerous branches around the country.
FDIC met with prospective bidders, Citigroup, Wells Fargo, JP Morgan, and Santander which were on their list. JP Morgan was the winning bidder and paid the FDIC $1.8 billion to acquire the bank. As expected, they chose to exclude from the transaction the preferred stock, subordinated debt, and senior debt. These groups would be left unprotected and had to absorb a large part of the cost associated with the bank's failure. JP Morgan assumed the obligation to all depositors and other creditors.
Why has SVB failed?
SVB was the bank of choice for silicon valley startup companies and their venture capital funds. The silicon valley companies deposited their funds with SVB and in return, the bank gave mortgage and personal loans at good rates to Silicon Valley employees. The bank also lent money to Silicon Valley companies. So the relationship between the bank and its niche of silicon valley technology industry customers was mutually beneficial. Which was fine and great and a model that worked well from the early 1980s until now.
Readers would appreciate that banking is a business of taking deposits from households and businesses and lending these deposits out to borrowers for a higher interest rate. The whole system works on the confidence of depositors to not want to collectively withdraw all or most of their money (otherwise known as a bank run).
Why would a bank run occur? Well, it can occur for two main reasons, one, that depositors all of a sudden need to have cash in hand to pay for goods and services because inflation is running rampant so they are looking to hoard goods before they become more expensive. The second reason may be, the bank has invested the deposits in assets that are likely to significantly decline in value and depositors are fretting that they best take their cash out before the bank's assets lose too much value and it is unable to return the deposits in full. In the case of SVB's failure it was more the latter with a bit of the former also.
The US banks over the past three years slowed down their traditional lending to borrowers due to lack of profitability due to record low interest rates and instead started investing in higher yielding fixed income securities just like investors like you and I, you know the bonds and credit? Yep!
SVB, was a particularly heavy user of the above strategy of investing in fixed income securities: more than half of its assets were invested in securities.
As investors of diversified investment portfolios would very well know from the experience of the past year that bonds and credit investments have lost 10-15% in value, something that was totally unexpected. And the risk-free government bonds were the worst offenders!
Well, SVB with half of its depositors' funds invested in fixed interest had a similar experience and these fixed interest exposures lost paper value as interest rates rose. Normally, the investments in government bonds that SVB would have purchased in 2021 earning 1% yield on $100 face value for 5 to 10 years of maturity would be fine if they hold these to maturity. But, if too much of the deposits are invested in these low-earning, long-dated bonds which are now also sitting on paper losses then it is a recipe for trouble if depositors need to call on their cash. The bank would need to sell these bonds at a loss to make good on the cash call from depositors. The losses may be large enough to lead to insufficient cash being available to return to equity holders, debt holders, and depositors. This is effectively what shut down SVB.
Starting in April 2020 and peaking two years later, nearly $4.2tn in deposits poured into US banks, according to data from the FDIC. But just 10% of that ended up funding new lending. Some banks just held those new deposits in cash. But much of the money, some $2tn, was funnelled into securities, mostly bonds. Prior to the pandemic, banks had just over $4tn in securities investments. Two years later those portfolios had risen by 50%.
What may have made low-yielding bonds more attractive than new lending, at least low-yielding government, or government-guaranteed bonds, was a perception of low credit risk. And for a time those new bonds did end up juicing bank profits. But in retrospect, it now appears that banks may have been buying at the top of the market. And that is what is now causing the problem. Last year, the lenders’ bond portfolios plunged in value, creating some $600bn in losses, though since banks do not regularly sell their bonds, much of those losses have yet to be realised.
Large banks can avoid taking losses by drawing on wholesale markets to raise debt to cover extra cash call from depositors and where the losses in fixed-interest securities are not significant compared to the overall size of their lending book. So, large banks should be fine. But for small regional banks such as SVB, it can lead to a death knell, as has been the case.
The fact that the chief admin officer of SVB was previously the COO of Lehman Brothers up until a year before it went belly up in 2008 is not an insignificant lowlight - some lessons are never learned!
What should you the investors do in response to this bank failure?
Stay invested, look for opportunities to invest if there is a market sell-off due to the near-term negative sentiment and volatility in share prices.
Any real prospect of contagion is likely to be thwarted by the action of the regulators. Use the volatility as an opportunity to pick up solid, quality companies that you have been waiting to invest in but the valuation was not right for you.
