Banking On Success 

 Wait, is it true? Did you hear correctly? Did a large, well-known bank just… fail? Come on, that kind of stuff only happens in the movies these days. Lehman Brothers, Bear Stearns, Merrill Lynch, MF Global? Those were not banks, they were risk-taking investment banks. When is the last time a bank-bank failed? Actually, more recently than you would think. In 2020, there were 4 bank failures, and another 4 were shuttered in 2019. You probably didn’t know about them because they were relatively small institutions. The last large bank failure in the US was Washington Mutual which failed in 2008, and it also happened to be the largest bank failure in US history. That should not surprise you given what you probably remember as The Global Financial Crisis. 

But this is 2023, we have Artificial Intelligence and cars that drive themselves. Besides interest rates are higher than they have been in over 2 decades, so banks should be making more money on their loans, right? I won’t answer that question, just yet, but we will get to it. SVB Financial was the well-known parent company of Silicon Valley Bank, a California-based commercial bank. As its name suggests, the company catered to the Silicon Valley startup elite. Think of all the unicorns and decacorns that banked with the company over the years. Not to mention the venture capitalists themselves, who were also depositors. If you didn’t know, you would probably assume that VCs are not big risk-takers, nothing akin to the more well-know whippers and drivers in the hedge fund world. No, VCs invented casual dress in the workplace where facial hair is encouraged along with open-toe shoes. These were not the always-crunchy, mostly-Ivy League guys and gals we had to worry about, and SVB sat on top of that sturdy infrastructure. That is probably why most average folks would not have expected any kind of trouble out of them. In fact, it would appear that even some above-average folks, namely bank regulars, did not expect the bank to unravel in 48 hours, making it the second largest bank failure in US history. 

 How do banks make money? 

 At the highest level, banks earn money by lending money. I know that you are probably quipping that they also make money by charging all sorts of obnoxious fees, but all kidding aside, those fees came into existence over the lean years in which banks struggled to make money in their core business of lending. Let’s focus on that. Banks lend money to consumers like you and me in the form of auto loans, home mortgages, and personal credit lines. They lend money to companies for short term liquidity, commercial loans, bridge finance, and pretty much for anything companies wish to use the proceeds for so long as the company can pay it back. Debt is critical for not only large going concerns, but also startups, and smaller businesses. You have most likely borrowed money from a bank in one form or another, so you know that when banks charge higher rates, you pay them more. Interest rates were quite low in the wake of The Great Recession, so a common misconception was that banks made less money in that environment. They did make less, but not for the reason you may think. Remember that banks borrow short-term money and lend it long-term. An example would be you taking out a 6-month CD, which is equivalent to you lending the bank money for 6 months. They pay you interest for that loan. They then take that money and lend it to your neighbor in, say, a 15-year mortgage. The difference between the interest on the CD and the mortgage is what is referred to as net interest margin (NIM). As you might guess, the larger the margin, the more profitable the bank, and hence the more desirable the stock. Therefore, a steep yield curve is 

highly desired by a bank. A steep yield curve is when short-term interest rates are significantly lower than longer-term interest rates. Under normal circumstances, that yield curve is positive, though the magnitude of its slope changes with economic conditions and monetary policy. The following chart is the yield spread between 2-year and 10-year Treasury Notes. You will notice that it is currently negative, which means that the yield curve is inverted. Yes, you get higher interest rates for shorter maturities. You can read more about yield curves in my March, 2022 newsletter “Curvaceous Curves” here https://www.siebert.com/blog/2022/03/30/curvaceous-curves/. You will see on the chart that the curve only inverted 3 time since 2007, and each time a recession followed. That is why many strategists follow the yield curve so closely. But in this case where we are talking about banks, an inverted yield curve makes it more difficult to maintain healthy net interest margins. 

What Happened to SVB? 

In our discussion about banks, the direction of the spread is also quite relevant. You will see on the previous chart that the curve has been getting shallower, on average for many years. Since briefly spiking in the pandemic, you can see how rapidly the curve flattened and inverted. This was due to the Fed’s aggressive rate hiking. You can visually see the effects of that on the following chart which details SVB’s net interest margin. 

This put a lot of strain on the bank’s business, but in the case of SVB, there were additional challenges. Though I joked about fees up top, SVB does, indeed make transaction fees, and in times when there is lots of commercial lending activities, banks gain significant revenues. With last year’s market turmoil, banking activity slowed down significantly and with it the lucrative fees that come with. The plot thickens even further. Remember that SVB targeted the Silicon Valley venture community. As the stock market rallied in late 2020 and 2021, venture capitalists deployed significant amounts of investment dollars to startups, who would deposit proceeds in the bank to be used to pay for things like payroll and bills. You can see in the next chart how total deposits swelled in 2020 and 2021. You can also see how they declined through 2022. With the venture market drying up, ventures were spending down their funds. This presented SVB with a completely different challenge. 

If you’ve watched It’s a Wonderful Life, you probably remember that banks don’t keep all the cash you deposit in a safe (there are 267 days until Christmas). Those funds are invested in other opportunities, but bank regulations require banks to keep a certain amount of funds in reserve to make sure that you can get your cash when you need it. Many banks keep their reserves in interest bearing instruments in order to constantly make money on deposits. Due to the sensitive nature of reserves, banks will invest capital in US Government-backed bonds like Treasuries and Agency-backed Mortgages. While those bonds have no credit risk (theoretically), they do have interest rate risk. If interest rates and yields go up, the values of the bonds go down. If those bonds are held to maturity, all ends well, but here is where things got really bad for SVB. As deposits swelled in late 2020, management invested significant amounts of reserves in longer-maturity bonds which it intended to hold to maturity, while it only held a slightly elevated amount of short-maturity bonds. In banking terms these are known as “held to maturity” and “available for sales”. The latter can be converted quickly and are held in shorter-term bonds which are not as sensitive to moves in yield. The former are typically held in longer maturity notes whose values are more sensitive to moves in yield. In investment terminology that is referred to as duration risk. If a bond has a high duration, its price is very sensitive to swings in yields. Bank’s risk management teams’ prime function is managing the duration risk of their bond portfolios. You can see from the next chart the extreme growth in SVB’s high duration “held to maturity” portfolio. 

You can see how the level of those sensitively priced bonds peak… JUST BEFORE THE FED STARTED TO RAISE RATES FASTER THAN THEY DID IN DECADES, causing yields to spike, and… you guessed it the value of SVB’s reserves to tank. That is a bad enough scenario under normal circumstances, but it was made far worse when the bank’s deposits were being pulled out. 

In Just 48 Hours 

By the first quarter of 2023 some investors began to quietly worry about the bank’s health and started pulling deposits. The bank was forced to liquidate its “held to maturity” securities realizing a $1.8 billion after-tax loss, which it announced to the public along with plans to raise another $1.3 billion in cash through a securities offering. The announcement caused the stock to sell off by -60.41% in a single session, which was not good for investors, but that was not the worst of it. 

Peter Thiel is a well-known venture capitalist and a founding partner of the Founders Fund. After the loss and funding announcement, Thiel advised his portfolio companies to withdraw their funds from SVB. He did this very publicly and the news traveled fast. It is estimated that depositors requested to withdraw as much as $45 billion on the day of the announcement leaving a -$1 billion cash balance. The bank’s negative news combined with Thiel’s very public admonition caused a classic bank run. 

In a different era, the bank run may not have occurred. While the bank’s mismanagement of its risk can be blamed for the losses to shareholders, the bank run, which ultimately caused the bank to fail, was surely helped along by a Silicon Valley influencer, and… the mobile phone. Word can travel fast through social media which is a mainstay of the venture community. Further, moving funds can occur within seconds by the stroke of a key… no lining up to wait for a teller. 

In retrospect 

Of course, it is easy to see the very basic errors that led to SVB’s demise when looking back on it. But a burning question remains. How can something like this happen under the watch of regulators? Come to think of it, who is responsible for bank oversight? The answer is, unfortunately, not that simple. Foremost, banks are regulated on the Federal and State levels. At the Federal level banks are regulated by: 

• The Federal Reserve System, more affectionately known as The Fed 
• The Federal Deposit Insurance Corporation (FDIC) 
• The Office of the Comptroller of the Currency (OCC), a division of the US Treasury 

Ok, wait, “the Fed,” you ask? The very same Fed that raised rates that sparked the problem? The Fed is well-known for its duel mandate of keeping unemployment low while keeping inflation down. That mandate falls under its monetary responsibility, but the Fed is also responsible for bank regulation. Most of the banks in the US Banking system are, indeed, regulated by the Fed, certainly the largest ones. As you are well aware, the Fed has been a bit busy controlling the US economy lately. Unlike many other countries, bank regulation is not the sole responsibility of 1 authority. The Fed shares responsibility with the others on the aforementioned list. 

The FDIC is a government agency which was created by the Emergency Banking Act of 1933, enacted after The Great Depression, which produced quite a wave of bank failures. The FDIC is responsible for state-chartered banks and regional banks that are not member of the Federal Reserve System. 

The OCC regulates national banks and has been around since 1863. That means either one or a combination of more than one of The Fed, FDIC, or OCC always has a weather eye on the US banking system, principal amongst them is The Fed. Yes, the same Fed that raised the rates to intentionally tighten up the monetary system… which ultimately caused banks to struggle to maintain profit margins, and which also caused longer-maturity bonds to lose a great deal of market value… all of which led to SVB’s failure. 

In conclusion 

It is hard to place the blame on any one person, group of people, or agency. Clearly, SVB mismanaged its duration risk and was unable to calm its depositors’ nerves. Peter Thiel’s well-placed and public call to withdraw funds ignited the bank run. It is important to note that most banks, no matter how well they are managed, could not likely survive a bank run. Finally, regulators claim that they were aware of the mounting risks at SVB, but why they did not act is not clear. Consistent with DC culture, the agencies are looking into the reasons for failure and lawmakers have pledged to increase regulation and oversight. Similar to how in the end of It’s A Wonderful Life, the very bank regulators seeking to shut down Bailey Brothers Building and Loan, threw their own money into the collection basket to keep the bank open, the Fed and Treasury stepped in to backstop depositors. Though much hardship came of SVB’s failure and a similar failure by Signature Bank just days later, we can get cold comfort that regulators are once again awake at the wheel. Beyond them, a quick glance at a bank’s balance sheet, income statement, and cash flow statement may be the best telltale of all.