Follow up to Silicon Valley Bank Bailout

 Matt Levine has followed up with commentary on the Silicon Valley Bank Bailout

The banking system is under pressure for what I feel is a "Failure to Supervise".

Bonds, Gold, Crypto have rallied as there is a search for a "store of value"

In reflection on the past 60 years of similar events the stock market collapsed, and investors also fled to real estate as the true store of value.

The rise in interest rates is like the Tide Going Out, you can see who was swimming naked!

Bailouts etc. I don’t think that anything interesting turns on whether or not this weekend’s resolution of Silicon Valley Bank was a “bailout,” so let’s not discuss that.[1] But when people talk about bank bailouts, what they often mean to talk about is moral hazard, the idea that if the government saves people from the consequences of bad bank behavior, that will encourage more bad bank behavior in the future. And that seems worth talking about. It is, I think, fair to say that Silicon Valley Bank took some bad risks, and that’s why it ended up failing. It is a bit harder to say exactly what SVB’s bad decision was. A simple answer is “it made a huge bet on interest rates staying low, which most prudent banks would not have done, and it blew up.” Yesterday Bloomberg reported that “in late 2020, the firm’s asset-liability committee received an internal recommendation to buy shorter-term bonds as more deposits flowed in,” to reduce its duration risk, but that would have reduced earnings, and so “executives balked” and “continued to plow cash into higher-yielding assets.” They took imprudent duration risk, ignored objections, and it blew them up. I think that answer is fine. A more complicated answer would be that they took duration risk, as banks generally do, but their real sin was having a concentrated set of depositors who were uninsured, quick-moving, well-informed, herd-like and very rates-sensitive in their own businesses: If all of your money is demand deposits from tech startups who will withdraw it at the slightest sign of trouble and/or higher rates, you should not be investing it in long-term bonds. This is a more subtle answer than “just hedge your rate risk bro,” and it is arguably more understandable that SVB’s executives would get it wrong,[2] but in any case it certainly ended up being a bad risk. So if SVB was rewarded for taking these risks that blew it up, that would be bad; that would be “moral hazard.” But the way the Silicon Valley Bank resolution worked is: SVB was seized by the Federal Deposit Insurance Corp. on Friday, and by Sunday night the FDIC and other regulators announced that all of SVB’s depositors — including those who were above the FDIC’s usual $250,000 insurance limit — would be able to get all of their money back on Monday. So the depositors were fully rescued. The shareholders, bondholders and executives were not: The executives were removed; the shares, which closed at $267.83 last Wednesday, are almost certainly worth zero[3]; the bonds are also probably impaired and possibly a zero. What lessons will rational actors take from this? I mean: If you are a depositor — in particular, a business that needs more than $250,000 of cash to operate efficiently — you should be much less concerned about risk-taking by your bank, because if your bank fails the government will probably rescue you. If you are a bank executive or shareholder or probably bondholder, you should be more concerned about risk-taking by your bank, because you have seen that it can lead to executives and shareholders and bondholders getting zeroed, and that the government won’t rescue you if that happens. And so the question is: Is that moral hazard? Well, not for shareholders and executives and bondholders. I suppose it is moral hazard for depositors, and a resolution of SVB that left depositors with losses would force depositors to pay closer attention to the risks their banks are taking. (Cliff Asness on Twitter: “The moral hazard here is we’ve greatly reduced the incentive for depositors of any size now … to actually give a moment’s thought to the riskiness of where they’re putting their money.”) But I think the modern bank-regulatory view is that the point of a bank deposit is that you shouldn’t have to worry about it, and that it is a failure of bank regulation if depositors of any size have “to actually give a moment’s thought to the riskiness” of a bank. (Bank deposits are meant to be “information insensitive.”) There are vast areas of life where we don’t worry about moral hazard. We don’t say things like “the moral hazard of food safety regulation is that we’ve greatly reduced the incentive for consumers to give a moment’s thought to the riskiness of their supermarket’s supply chain.” That’s not a thing you’re supposed to think about!  Similarly the riskiness of a bank’s asset/liability mix is absolutely a thing that lots of people — bank executives, bank directors, bank regulators, bank shareholders, bank derivatives counterparties — are supposed to think about.[4] But not, generally, in 2023, depositors. Opening a bank account, for an individual human but also for a business that needs more than $250,000 in cash to conduct business efficiently, is not meant to be a high-stakes investment decision that requires extensive due diligence.[5] It’s a bank account! It’s just supposed to work.[6] This is not a universal view. In the olden days, bank depositors did think more about their bank’s creditworthiness, and I suppose there is a market-discipline argument that, like, if depositors monitor creditworthiness then only the good banks will attract deposits and so the bad banks won’t be able to grow and take risks. But in practice I do not think anyone would much like a market where depositors evaluate banks on their creditworthiness. For one thing, doesn’t it sound exhausting? Don’t you have better things to do? For another thing, SVB’s depositors kind of did that: They woke up one day, noticed that SVB’s balance sheet was bad, and withdrew all their money at once, leading to a banking crisis. Why do we want more of that? For a third thing, the likely outcome of a rule like “only deposit money in banks you are sure won’t fail” would probably be to drive more deposits to giant too-big-to-fail banks, which is maybe a fine outcome economically but not likely to be popular. Still, there really is a moral hazard in banking and in information-insensitive deposits. Schematically, a bank consists of shareholders taking $10 of their own money and $90 of depositors’ money and making some bets (home loans, business loans, bond investments, whatever) with that combined pile of money. If the bets pay off, the shareholders get the upside (the depositors just get their deposits back). If the bets lose, the shareholders lose money (the depositors get their money back before shareholders get anything). If the bets lose really big — if the bank bets $100 and ends up with $50 — then the shareholders lose all their money, but the depositors get their money back: If the bank is left with only $50, the government gives the depositors the other $40. If you are a rational bank shareholder (or, more to the point, a bank executive who owns shares and gets paid for increasing shareholder value), this structure encourages you to take risk. If you bet $100 on a coin flip and you win, the bank has $200, and the shareholders keep $110 of that, a 1,000% return. If you lose, the bank has $0, and the shareholders lose $10 of that, a -100% return. The expected value of this bet, for the shareholders, is positive. The expected value for the depositors is neutral: Either way they get their $90 back, either from the bank or from the government. The expected value for the government is negative: If the bank wins, the government gets nothing; if the bank loses, the government pays the depositors $90. But the shareholders — really the executives — are the ones who get to decide what bets to take. (The finance-y way to say this is that the shareholders have a call option on the bank’s assets, struck at the face value of its deposits. An option’s value increases with volatility, so the shareholders should want the assets to be volatile. This is roughly true of every company — the shareholders always have an option on the company’s assets struck at the face value of its debts — but (1) most companies are way less leveraged than banks, so the option is less at-the-money and (2) at most companies the option is *priced*, because the debt comes from bondholders who are information-sensitive and won’t give the shareholders cheap debt if they’re taking wild risks. At banks, because of the (reasonable) social desire to make deposits information-insensitive, the deposits are cheap and the option is not priced.) This is all true of all banking, to the extent that deposit insurance and lender-of-last-resort mechanisms exist, but certainly it is more true when the government expands its protection of depositors. But it is true of all banking, which is why there is so much bank regulation. Because the  standard solution to this problem is regulation and government supervision: The government says to banks “look, we all understand that you are effectively making bets with government money, so we are going to keep a close eye on the bets you are making to prevent you from losing our money.” The modern view that bank deposits should be safe and information-insensitive kind of goes along with a modern view that banks are public-private partnerships, that a bank is sort of a business partner with the government in taking deposits and providing credit, and that the way the partnership works is that the bank’s executives make the day-to-day decisions but the government has a lot of input into and oversight over those decisions. On that view, you should probably draw two related conclusions from SVB: Regulators and supervisors probably should have stopped SVB from taking dumb risks, they missed something, and changes should be made so they don’t miss those same things again. The regulators’ response to SVB — guaranteeing all depositors, but also the Fed’s Bank Term Funding Program to finance other banks’ bond portfolios at par[7] — increases the value of other banks’ optionality, which encourages them to take more risk, because their deposits are safer. (I suppose this is the real moral hazard concern.) And so there should be more regulatory and supervisory changes to tamp down the other banks’ risks. The first conclusion seems sort of obvious. If the goal is to make it so depositors don’t have to think about the risks banks are taking with their money, somebody else — the regulators — have to think about those risks instead. I am not going to sit here and tell you what SVB’s regulators and supervisors should have done to prevent its meltdown last week, though I’m sure other people will. But a few points: “The Federal Reserve said Monday it is launching an internal reviewof its supervision and regulation of Silicon Valley Bank after its failure last week.” The report will be released publicly by May 1. So the Fed will eventually tell you what it should have done to prevent SVB’s meltdown. Bank regulators spend a lot of time thinking about liquidity requirements for banks. The idea of liquidity rules is that you think about how much money people might want to take out of the bank at once, and you try to make sure the bank has enough money to give them. Modern banking regulation has rules like the liquidity coverage ratio (LCR) and net stable funding ratio (NSFR) to try to measure and regulate that risk, but — as Dan Davies wrote in the Financial Times this weekend — the US decided not to apply those rules to even very large regional banks like SVB. I am not sure how much that mattered — most banks don’t have enough liquidity to cover all of their deposits leaving at once, and SVB might have met the requirements — but it’s something regulators will consider. (Raising the liquidity requirements, to account for the speed of modern bank runs, could also be on the table.) More generally, US financial regulation tends to draw a sharp distinction between “systemically important” banks (like JPMorgan Chase & Co.) and just regular banks like SVB. The systemically important banks are regulated and supervised much more strictly than the regular banks, and in recent years the difference has increased as some rules were rolled back for regular banks. This distinction has always struck me as sort of incoherent, because “systemic risk” is not really a property of one bank but of the system. When SVB collapsed, its venture capitalist depositors clamored for a rescue by threatening systemic risk, by arguing that allowing them to lose money would lead to broader panic across lots of banks: SVB wasn’t that big, but an uncontrolled failure at SVB would lead to many other failures at similar banks. They might well have been right! But the obvious conclusion to draw from this is that biggish regional banks like SVB, at least, need to be subject to stricter regulations — the sorts of rules that apply to the big banks — because they are in fact systemically important. Not due to their individual size, but due to the (well known!) fact that a run on one bank can easily lead to runs on other banks. Existing regulations do not seem to be particularly attuned to the risk of bad depositors. Bank regulators have historically given some thought to the question “what sorts of deposits are more likely to put a bank at risk by running all at once,” and they think about the risks of categories like brokered deposits, insured retail deposits, uninsured retail deposits, operational business deposits, etc. But last month US banking regulators put out a “Joint Statement on Liquidity Risks to Banking Organizations Resulting from Crypto-Asset Market Vulnerabilities” saying, in essence, that crypto companies are a particularly risky class of depositors and banks should watch out for them. I have argued that venture-backed tech firms are a similarly risky class of depositors, or at least they were for SVB. “Banking organizations are neither prohibited nor discouraged from providing banking services to customers of any specific class or type, as permitted by law or regulation,” the regulators hastened to add. But I wonder if future banking supervision will be more sensitive to things like industry diversification among depositors, or the volatility of depositors’ industries. If all of your depositors are in the same line of business, and if they are sometimes flush with cash and sometimes broke, then your bank is riskier. The second conclusion is … well, one way to put it is that the post-SVB actions have made bank deposits a lot safer, which is a nice windfall for the shareholders of every other regional bank that has a lot of losses on held-to-maturity securities. And so in exchange for that windfall the regulators should regulate those banks much more strictly, which will make them actually safer (and reduce the government’s exposure to their risks), but will also reduce their profitability. Another way to put it is: As a matter of moral hazard, rescuing SVB’s depositors is fine; As a matter of moral hazard, zeroing SVB’s shareholders is good; but As a matter of moral hazard, the right thing to do now is to punish other risky banks’ shareholders. This is tricky! You are sort of … prospectively punishing those shareholders? Punishing them in lieu of letting their banks fail? What does it mean in practice? Mainly it means what we talked about above, more strictly regulating risk-taking at regional banks to make sure that they don’t cause any systemic problems. Make regional banks do things — raise more capital, hold more short-term safe liquid instruments, turn down risky borrowers and depositors — that lower their risk, but also lower their expected returns on capital.  But we talked yesterday about the failure of Signature Bank, which is a strange sort of bank failure. It did not particularly seem to be insolvent or experiencing an ongoing bank run on Sunday, but it was seized by the government anyway. Bloomberg’s Max Reyes reports today: Signature Bank was seized by the government Sunday after regulators lost faith in management, according to New York officials. “The bank failed to provide reliable and consistent data, creating a significant crisis of confidence in the bank’s leadership,” a spokesperson for the state’s Department of Financial Services said in an emailed statement Tuesday. “The decision to take possession of the bank and hand it over to the FDIC was based on the current status of the bank and its ability to do business in a safe and sound manner on Monday.” They can just do that! What I said yesterday was: Every other bank’s shareholders and bondholders and executives will benefit from those measures [that the Fed and FDIC took to rescue SVB’s depositors]. If you are an uninsured depositor at a medium-sized bank that made some dumb rates bets, there is no reason to move your money now; the Fed has made it clear that it will support that bank. This (probably!) takes run risk off the table for those banks, making them less likely to fail, making their stocks and bonds more valuable than they would be if the Fed hadn’t acted to limit contagion. (In actual fact many bank stocks are down big today, though presumably they’d be down more without these measures.) The rescue of Silicon Valley Bank’s depositors comes too late for Silicon Valley Bank’s shareholders, but it’s good for every similar bank’s shareholders. As a matter of rough justice you could imagine the Fed looking at the most similar bank — arguably Signature, with its huge proportion of uninsured deposits and its exposure to fast-money crypto/tech customers — and saying “no, not you, your shareholders are getting toasted.” The way for bank regulators to reduce the moral-hazard impact of the SVB rescue is to take some other banks’ shareholders out and shoot them. Is that what happened? I don’t know! It’s possible that Signature was shut due to a traditional bank run. Reyes reports that “Signature lost 20% of its deposits on Friday”; Signature (and its board member Barney Frank) said that its outflows had stabilized and that it had enough cash, but the New York Department of Financial Services apparently disputes that. But DFS leads with “a significant crisis of confidence in the bank’s leadership.” If you are a bank regulator and you think that a bank is (1) poorly managed and taking bad risks but also (2) not going to disappear because you went and guaranteed all the deposits, you can make it disappear anyway, and arguably you should.  One other point on this subject. If you are a banking regulator and you think that the regional banks have taken too much risk and are now undercapitalized given their unrealized losses on held-to-maturity securities, then the most obvious next thing to do — after the weekend’s actions of promising to finance those securities at par, but before rewriting any regulations — is to make those banks raise capital to fix their balance sheets. This is good simply as a matter of sound banking: You don’t want your banks to be undercapitalized, so if they are — on whatever accounting measure you prefer — then they should get more capital. It is also good as a matter of punishing shareholders to avoid moral hazard: Bank stocks have been absolutely wrecked, and making banks raise more equity now at these prices will be a painful dilution for existing shareholders. On the other hand, it’s tricky: Silicon Valley Bank did (more or less) the responsible thing last week by trying to raise equity to shore up its balance sheet, and that’s what brought it down, as people saw the equity raise and panicked. I doubt anyone wants to be the next regional bank to go out with a marketed stock offering. And a bank regulatory climate that is too punitive for shareholders will make it hard for banks to sell more stock, which is the main thing they should be doing. I guess that is the tension now. Bank regulators want depositors to feel like they are not taking a risk by keeping their money in the bank. They want the banks and their shareholders not to take risks with those depositors’ money. But they do still want shareholders to take the risk of owning bank stock.  Banking as mystery I wrote yesterday about the Fed’s Bank Term Funding Program. Banks buy long-term bonds, mark them “held to maturity,” and then when those bonds lose value the banks ignore it for accounting purposes. But that only goes so far: The banks disclose the losses in footnotes to their financial statements, people sometimes notice, and when the losses get too big there are runs. The BTFP is a way for the Fed to take over the job of ignoring those losses instead: The Fed promised to lend against those bonds at 100 cents on the dollar, as though they hadn’t lost value. The Fed is not subject to bank runs. The Fed can credibly ignore those losses; banks can only mostly ignore them. I also wrote about Tether: Another possible understanding, though, is that banking requires mystery! My point, in the first section of this column, was that too much transparency can add to the fragility of a bank, that the Fed is providing a valuable service by ignoring banks’ mark-to-market losses. Byrne Hobart, whose Diff newsletter may or may not have played a role in bringing down Silicon Valley Bank, wrote today that “the frequency of Diff/Money Stuff cross-linking is a good ad hoc measure of financial conditions.” He quotes my point about Tether and goes on: This post by Interfluidity is a wonderful exposition on the theme, arguing that financial systems overcome the collective action problem that there just aren't that many projects with an attractive level of risk and reward to the person doing them, and that by disguising some of the risk, we can increase the positive externalities. This is an extreme view. Yes! I think that post (“Why is finance so complex?”) from Steve Randy Waldman at Interfluidity is a classic, I cite it often, and it was what I had in mind as I was writing yesterday. Waldman describes banking as, broadly speaking, an opacity mechanism for credit, a way for society to take a lot of credit risk without the people taking that risk quite knowing that that’s what they’re doing. My point yesterday was that it is also an opacity mechanism for interest rates, a way for society to borrow short and lend long. Sometimes you need to bulk up the opacity though. In other news, here is “Monetary Tightening and U.S. Bank Fragility in 2023: Mark-to-Market Losses and Uninsured Depositor Runs?” by Erica Xuewei Jiang, Gregor Matvos, Tomasz Piskorski and Amit Seru, dated yesterday: We analyze U.S. banks’ asset exposure to a recent rise in the interest rates with implications for financial stability. The U.S. banking system’s market value of assets is $2 trillion lower than suggested by their book value of assets accounting for loan portfolios held to maturity. Marked-to-market bank assets have declined by an average of 10% across all the banks, with the bottom 5th percentile experiencing a decline of 20%. We illustrate that uninsured leverage (i.e., Uninsured Debt/Assets) is the key to understanding whether these losses would lead to some banks in the U.S. becoming insolvent-- unlike insured depositors, uninsured depositors stand to lose a part of their deposits if the bank fails, potentially giving them incentives to run. A case study of the recently failed Silicon Valley Bank (SVB) is illustrative. 10 percent of banks have larger unrecognized losses than those at SVB. Nor was SVB the worst capitalized bank, with 10 percent of banks having lower capitalization than SVB. On the other hand, SVB had a disproportional share of uninsured funding: only 1 percent of banks had higher uninsured leverage. Combined, losses and uninsured leverage provide incentives for an SVB uninsured depositor run. We compute similar incentives for the sample of all U.S. banks. Even if only half of uninsured depositors decide to withdraw, almost 190 banks are at a potential risk of impairment to insured depositors, with potentially $300 billion of insured deposits at risk. If uninsured deposit withdrawals cause even small fire sales, substantially more banks are at risk. Overall, these calculations suggests that recent declines in bank asset values very significantly increased the fragility of the US banking system to uninsured depositor runs. Yeesh! Not now!

The Problems are the Path: SILICON VALLEY BANK..Higher Interest Rates Take No Prisoners

When the FED started raising rates, I stated that the inflation the FED saw was in realty Asset Inflation.  Yesterday March 9, 2023 we saw the results.

The seizing of Silicon Valley Bank, the 15th largest in the United States, was the largest such failure and seizure since the Washington Mutual seizure.  

There will be ramifications!  SVB the darling of the Valley has been one of the Prima's of our area.  One that WHO WAS ANYONE AND who wanted to be SOMEONE mentioned them as "Their Bank" during cocktail parties.  It was the bank that all funds from IPO's and formation funding that the Venture Capitalist put the new business proceed in to await to be drawn during the rise of the new company from birth to growth. 

My thoughts are that History Does Repeat Itself.  This happened in the late 70's and early 80's when higher interest rates caused the abandonment of venture capital funding.  Take a risk or leave your investment money in T-Bills the question is not easy to answer when the future of rates were higher. Now it will especially be the case in future VC promotions

In this case the very people who helped form and allowed SVB to prosper where the ones for its undoing.

Every morning I read the Bloomberg Opinion of Matt Levine.  An old habit as a stock trader, investor and investment manager when it was only on a Bloomberg terminal on my desk.  It was a must read by all Wall Street before the market's opening, just as much as the Wall Street Journal was a must as I sat  at my desk waiting for the Stock Market to open.

I am copying Matt's comments here for all of you to read to understand What Happened?

"Programming note: Money Stuff was supposed to be off today, but: bank run!

SVB

The lesson might be that there are some industries that are bad to bank. Imagine that it was 2021, and someone was like “do you want to start the Bank of Crypto? What about the Bank of Venture-Backed Tech Startups?” You’d be tempted, right? Those industries had so much money! They seemed cool. If you were their bank — if you were the specialized bank that exclusively focused on those industries — influencers on Twitter would tweet nice things about you, and you’d get invited to fancy parties. Also, as their bank, you’d probably find a way to get a cut of growing industries with lots of potential. Provide banking services to tech startups, get warrants in those startups, get rich when they go public. Provide banking services to crypto exchanges, start some sort of blockchain-based payment network, get rich through the magic of saying “blockchain” a lot. 

But the structure of being the Bank of Crypto or Startups was a bit rickety. Traditionally, the way a bank works is that it takes deposits from people who have money, and makes loans to people who need money. The weird problem with focusing exclusively on crypto or startups in 2021 is that they had too much money. If you were the Bank of Startups, the main service that you provided to startups is that equity investors  would give them a truck full of cash and they’d deposit it at your bank. Here is how SVB Financial Group, the holding company of Silicon Valley Bank, describes the vibe of 2021 and 2022 in its Form 10-K two weeks ago:

Much of the recent deposit growth was driven by our clients across all segments obtaining liquidity through liquidity events, such as IPOs, secondary offerings, SPAC fundraising, venture capital investments, acquisitions and other fundraising activities—which during 2021 and early 2022 were at notably high levels.

People kept flinging money at SVB’s customers, and they kept depositing it at SVB. Perfectly reasonable banking service. 

But the customers didn’t need loans, in part because equity investors kept giving them trucks full of cash and in part because young tech startups tend not to have the fixed assets or recurring cash flows that make for good corporate borrowers.[1] Oh, there is some tech-industry-adjacent lending you can do.[2] Tech founders want to buy houses, and you can give them mortgages. Venture capital and private equity funds want to manage liquidity and/or juice their reported return rates by paying for investments with borrowed money rather than drawing from their limited partners, so you can get into the capital-call-line-of-credit business. There are vineyards near Silicon Valley and you can develop an expertise in vineyard financing. And, sure, some of your tech-company customers do need to borrow money, and are creditworthy, and you lend them money and that works out. But there is a basic imbalance. Customer money keeps coming in, as deposits, but it doesn’t go out, as loans.

So you have all this customer cash, and you need to do something with it. Keeping it in, like, Fed reserves, or Treasury bills, in 2021, was not a great choice; that stuff paid basically no interest, and you want to make money. So you’d buy longer-dated, but also very safe, securities, things like Treasury bonds and agency mortgage-backed securities. We talked yesterday about how this worked out at Silvergate Capital Corp., the actual Bank of Crypto. And as of the end of 2022, Silicon Valley Bank, the actual Bank of Startups, had about $74 billion of loans and about $120 billion of investment securities.

Crudely stereotyping, in traditional banking, you take deposits and make loans. In the Bank of Startups, in 2021, you take deposits and mostly buy bonds. Again crudely stereotyping, corporate loans often have floating interest rates and shorter terms, while bonds have fixed interest rates and longer terms. None of this is completely true — there are fixed-rate corporate loans and floating-rate bonds, traditional banking tends to involve making lots of loans (like mortgages) with long-term fixed rates, you can do swaps, etc. — but it is a useful crude stereotype.[3]

Or, to put it in different crude terms, in traditional banking, you make your money in part by taking credit risk: You get to know your customers, you try to get good at knowing which of them will be able to pay back loans, and then you make loans to those good customers. In the Bank of Startups, in 2021, you couldn’t really make money by taking credit risk: Your customers just didn’t need enough credit to give you the credit risk that you needed to make money on all those deposits. So you had to make your money by taking interest-rate risk: Instead of making loans to risky corporate borrowers, you bought long-term bonds backed by the US government.

The result of this is that, as the Bank of Startups, you were unusually exposed to interest-rate risk. Most banks, when interest rates go up, have to pay more interest on deposits, but get paid more interest on their loans, and end up profiting from rising interest rates. But you, as the Bank of Startups, own a lot of long-duration bonds, and their market value goes down as rates go up. Every bank has some mix of this — every bank borrows short to lend long; that’s what banking is — but many banks end up a bit more balanced than the Bank of Startups. At the Financial Times, Robert Armstrong writes:

Few other banks have as much of their assets locked up in fixed-rate securities as SVB, rather than in floating-rate loans. Securities are 56 per cent of SVB’s assets. At Fifth Third, the figure is 25 per cent; at Bank of America, it is 28 per cent. 

For most banks higher rates, in and of themselves, are good news. They help the asset side of the balance sheet more than they hurt the liability side. … SVB is the opposite: higher rates hurt it on the liability side more than they help it on the asset side. As Oppenheimer bank analyst Chris Kotowski sums up, SVB is “a liability-sensitive outlier in a generally asset-sensitive world”.

But there is another, subtler, more dangerous exposure to interest rates: You are the Bank of Startups, and startups are a low-interest-rate phenomenon. When interest rates are low everywhere, a dollar in 20 years is about as good as a dollar today, so a startup whose business model is “we will lose money for a decade building artificial intelligence, and then rake in lots of money in the far future” sounds pretty good. When interest rates are higher, a dollar today is better than a dollar tomorrow, so investors want cash flows. When interest rates were low for a long time, and suddenly become high, all the money that was rushing to your customers is suddenly cut off. Your clients who were “obtaining liquidity through liquidity events, such as IPOs, secondary offerings, SPAC fundraising, venture capital investments, acquisitions and other fundraising activities” stop doing that. Your customers keep taking money out of the bank to pay rent and salaries, but they stop depositing new money. 

This is all even more true of crypto — I mean, the Fed raised rates once and the entire crypto industry vanished?[4] — but it is not not true of startups. But if some charismatic tech founder had come to you in 2021 and said “I am going to revolutionize the world via [artificial intelligence][robot taxis][flying taxis][space taxis][blockchain],” it might have felt unnatural to reply “nah but what if the Fed raises rates by 0.25%?” This was an industry with a radical vision for the future of humanity, not a bet on interest rates. Turns out it was a bet on interest rates though. 

Here’s Bloomberg’s Katie Greifeld:

Silvergate and SVB “in fact are victims of the same phenomenon as Fed tightening extinguishes froth from those parts of the economy with the most excess — and it’s hard to find more excess than in crypto and tech startups,” said Adam Crisafulli of Vital Knowledge.

And my Bloomberg Opinion colleague Paul Davies:

Both crypto and venture capital booms were children of the ultra-low rates of the past decade and a half. Now, rising rates and the shrinking of the Federal Reserve’s balance sheet have burst those industry bubbles and increased the competition among banks for funding. 

And so if you were the Bank of Startups, just like if you were the Bank of Crypto, it turned out that you had made a huge concentrated bet on interest rates. Your customers were flush with cash, so they gave you all that cash, but they didn’t need loans so you invested all that cash in longer-dated fixed-income securities, which lost value when rates went up. But also, when rates went up, your customers all got smoked, because it turned out that they were creatures of low interest rates, and in a higher-interest-rate environment they didn’t have money anymore. So they withdrew their deposits, so you had to sell those securities at a loss to pay them back. Now you have lost money and look financially shaky, so customers get spooked and withdraw more money, so you sell more securities, so you book more losses, oops oops oops.[5]

As Armstrong puts it, SVB had “a double sensitivity to higher interest rates. On the asset side of the balance sheet, higher rates decrease the value of those long-term debt securities. On the liability side, higher rates mean less money shoved at tech, and as such, a lower supply of cheap deposit funding.”

Also, I am sorry to be rude, but there is another reason that it is maybe not great to be the Bank of Startups, which is that nobody on Earth is more of a herd animal than Silicon Valley venture capitalists. What you want, as a bank, is a certain amount of diversity among your depositors. If some depositors get spooked and take their money out, and other depositors evaluate your balance sheet and decide things are fine and keep their money in, and lots more depositors keep their money in because they simply don’t pay attention to banking news, then you have a shot at muddling through your problems.

But if all of your depositors are startups with the same handful of venture capitalists on their boards, and all those venture capitalists are competing with each other to Add Value and Be Influencers and Do The Current Thing by calling all their portfolio companies to say “hey, did you hear, everyone’s taking money out of Silicon Valley Bank, you should too,” then all of your depositors will take their money out at the same time. In fact, Bloomberg reported yesterday:

Unease is spreading across the financial world as concerns about the stability of Silicon Valley Bank prompt prominent venture capitalists including Peter Thiel’s Founders Fund to advise startups to withdraw their money. …

Founders Fund asked its portfolio companies to move their money out of SVB, according to a person familiar with the matter who asked not to be identified discussing private information. Coatue Management, Union Square Ventures and Founder Collective also advised startups to pull cash, people with knowledge of the matter said. Canaan, another major VC firm, told firms it invested in to remove funds on an as-needed basis, according to another person.

SVB Financial Group Chief Executive Officer Greg Becker held a conference call on Thursday advising clients of SVB-owned Silicon Valley Bank to “stay calm” amid concern about the bank’s financial position, according to a person familiar with the matter.

Becker held the roughly 10-minute call with investors at about 11:30 a.m. San Francisco time. He asked the bank’s clients, including venture capital investors, to support the bank the way it has supported its customers over the past 40 years, the person said.

Nah, man, you don’t get to be a successful venture capitalist by taking a long view or investing in relationships or being contrarian. I’m sorry, I’m sorry, this is unfair. Of course they were right — Silicon Valley Bank did collapse, and if you got your money out early that was good for you — but that is largely self-fulfilling; if all the VCs hadn’t decided all at once to pull their money, SVB probably would not have collapsed.[6]

But it did:

Silicon Valley Bank collapsed into Federal Deposit Insurance Corp. receivership on Friday, after its long-established customer base of tech startups grew worried and yanked deposits. 

The California Department of Financial Protection and Innovation in a statement Friday said it has taken possession of Silicon Valley Bank and appointed the FDIC as receiver, citing inadequate liquidity and insolvency.  

The FDIC said that insured depositors would have access to their funds by no later than Monday morning. Uninsured depositors will get a receivership certificate for the remaining amount of their uninsured funds, the regulator said, adding that it doesn’t yet know the amount. 

Receivership typically means a bank’s deposits will be assumed by another, healthy bank or the FDIC will pay depositors up to the insured limit. 

SVB’s capital stack looked roughly like this, as of Dec. 31:

• A tiny sliver of insured deposits (that is, deposits under the $250,000 FDIC limit), something like $8 billion worth out of $173 billion of total deposits.[7]
• Roughly $165 billion of uninsured deposits. 
• Roughly $13 billion of “short-term borrowings,” meaning mostly Federal Home Loan Bank advances.
• Roughly $2 billion of long-term FHLB advances.
• Roughly $3 billion of long-term bonds.
• Maybe $4 billion of other liabilities, for a total of $195 billion of liabilities.
• About $3.6 billion of preferred stock.
• Common stock with a book value of about $12.4 billion and a market value, on Dec. 31, of about $13.6 billion.

It had assets of about $212 billion on that Dec. 31 balance sheet, though since then it has had to sell some assets and mark others down, and it’s not clear what they’re worth today. The California Department of Financial Protection and Innovation cited “inadequate liquidity and insolvency” when it put SVB into FDIC receivership, suggesting that the assets are worth less than the liabilities. The FDIC’s job, in receivership, is “efficiently recovering the maximum amount possible from the disposition of assets” to distribute to creditors.

One obvious question is: If you are “another, healthy bank” working through this weekend to buy SVB and assume its deposits, how much would you pay for the assets, which were worth $212 billion in December?[8] I am pretty sure the answer is higher than $8 billion, the amount of insured deposits: The FDIC will not be on the hook for the insured deposits. The $15 billion of FHLB advances are also quite senior and will presumably be no problem to pay back.

I would also guess — not investing or banking advice! — that the answer will also turn out to be higher than $188 billion, which is the total amount of deposits plus FHLB advances. I say this not because I have done a detailed analysis of SVB’s assets but because it seems bad for the FDIC to wind up a big high-profile bank in a way that causes significant losses for depositors, including uninsured depositors. There was a run on SVB in part because there hasn’t been a big bank run in a while, and people — venture capitalists, startups — were naturally worried that they might lose their deposits if their bank failed. Then the bank failed.

If it turns out to be true that they lose their deposits, there could be more bank runs: Lots of businesses keep uninsured deposits at lots of banks, and if the moral of SVB is “your uninsured transaction-banking deposits can vanish overnight” then those businesses will do a lot more credit analysis, move their money out of weaker banks, and put it at, like, JPMorgan. This could be self-fulfillingly bad for a lot of weaker banks. My assumption is that the FDIC, the Federal Reserve, and the banks who are looking at buying SVB all really don’t want that. If you are a bank looking at buying SVB, and you do a detailed analysis of its assets and conclude that they are worth $180 billion, and you come to the FDIC and say “I will take over this bank and pay the uninsured depositors 95 cents on the dollar,” the FDIC is going to look at you and say “don’t you mean 100 cents on the dollar,” and you are going to say “oh right yes of course, silly me, 100 cents on the dollar.”[9]

Maybe I’m wrong about that, but if I am it’ll be bad!

Above that, though, I have no idea. The stock closed at $106.04 per share yesterday (a $6.2 billion market cap, roughly 50% of book value), and was halted today. The preferred was trading at about 60 cents on the dollar yesterday, also closed today. Byrne Hobart wrote the bull case yesterday:

The simple way to look at SVB from an investing perspective is to separate the ongoing business from the balance sheet for a moment, and ask: what premium does SVB's business deserve to book value, in a hypothetical world where they didn't make a massive rates bet? Over the last twenty years, they've traded at an average of 2.3x tangible book value, and generally at a premium to their banking peers. So a simple way to value the business is to say that the fair value of the business is generally ~100 cents on the dollar in liquidating value and another ~130 cents on the dollar in franchise value. If that liquidating value has been vaporized by a rates bet, the surviving business is still worth a premium to book.

But that was yesterday, and the franchise value melts pretty quickly when you go into FDIC receivership. The bear case is … well, back in November, when crypto exchange FTX was still looking for a rescue (it never found one), I wrote that the traditional price for that sort of rescue is “we will buy your exchange, make sure that all your customers are made whole, and give you a Snickers bar in exchange for 100% of the equity.” That may be where this is heading.

More From Bloomberg Opinion

• Silicon Valley Bank’s Swoon Should Scare Us All.
• Why Is the US Regulating JPMorgan But Not SVB?
• SVB and Silvergate Tumult Has Echoes in Texas Bank Crisis.
• Crypto Carcass Will Attract Hedge Fund Vultures.
• Banks Throw Markets a Curveball.

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[1] Similarly in crypto, on 2021, crypto exchanges had tons of cash that they needed to park at a bank, but were not really in the business of taking loans from banks. There was a lot of lending in the crypto world, but it was all loans secured by Bitcoins and stuff and that is mostly too spicy for a bank; it was mostly done by crypto shadow banks (including exchanges themselves). Though Silvergate did some of it.

[2] Here I am sort of summarizing SVB's discussion of its loan portfolio on pages 70-71 of the 10-K.

[3] Oh it’s way too crude. Here is “Banking on Deposits: Maturity Transformation without Interest Rate Risk,” by Itamar Drechsler, Alexi Savov and Philipp Schnabl, in the Journal of Finance in 2021, making the case “that maturity transformation does not expose banks to interest rate risk — it hedges it,” even in a model where banks lend long at fixed rates, because depositors are not very sensitive to interest rates.

[4] Oh I am exaggerating for effect, please do not email me to be like “by summer 2022 there had been a string of actual and projected Fed rate increases” or “actually there is still crypto,” I know.

[5] This oversimplifies the mechanics of how you lose money, and I recommend Marc Rubinstein's explanation today. Basically SVB ended up with a large portfolio of held-to-maturity bonds with an average duration of 6.2 years at the end of 2022, “and unrealised losses snowballed, from nothing in June 2021, to $16 billion by September 2022.” These losses “completely subsumed the $11.8 billion of tangible common equity that supported the bank’s balance sheet,” meaning that SVB was technically insolvent. But mark-to-market losses on held-to-maturity bonds don't count for bank accounting purposes; the theory is that you will just hold the bonds until maturity, they will pay back par, and you won't have any losses. So SVB was still solvent and fine. “Sell even a single bond out of an HTM portfolio, however, and the entire portfolio would need to be re-marked accordingly”: If you have bonds in your held-to-maturity portfolio, you have to be really confident you can hold them to maturity. SVB’s bonds kept maturing, providing cash to pay out depositors who wanted their money back. But: “What neither the CEO nor the CFO anticipated, however, was that deposits might run off faster” than the bonds. They did, SVB sold its available-for-sale bonds, it wasn’t enough, and here we are.

[6] Other things might have prevented its failure. Daniel Davies points out that Silicon Valley Bank, though it is big, is not quite big enough to be subject to the Federal Reserve’s post-2008 liquidity regulations, which would have made it more, you know, liquid.

[7] The FDIC’s statement says “At the time of closing, the amount of deposits in excess of the insurance limits was undetermined,” and presumably the mix has shifted since Dec. 31.

[8] They were not: Again, that was the book value, and the unrealized losses on the held-to-maturity bonds would reduce that. On the other hand, maybe they've gone up since then? Byrne Hobart tweeted: "One irony of all this is that a flight to safety is disproportionately good for exactly the long-duration low/no-credit risk stuff that caused this problem in the first place."

[9] When IndyMac Bancorp failed in 2008, uninsured depositors got back 50 cents on the dollar, though they were relatively small. Since then, it seems to be an FDIC goal to get the uninsured depositors paid."

In the 70's and 80's more people invested in real estate than I ever experience.  It was the Real Estate!

The biggest loser, in my opinion, will be the stock market, crypto and other esoteric investments.  Real Estate and Gold the beneficiary.

As before, call or write for any question you may have and think of me of your "in the know real estate agent"

The Problems are the Path: Interest Rates a Useless Strategy?

There was a time in my past newsletters/commentaries I believed the rise in interest rates would dampen real estate prices and cause the affordability index to move in favor of buyers, which we had.  I then went to look at "Asset Inflation" to put down speculation and lower asset prices of Stocks, Bonds, Real Estate and Esoteric Assets, which we had.  

The rise in interest rates have had an impact, but far from what the FED expected, and many economic analysts expected.  The main reason, in my opinion, is that the Money Supply has not contracted.  Some +$9 trillion was pumped into the economy from 2020 to 2022.  Of that only a small percentage has been spent.  Goldman Sachs has stated that 65% of those saving will be expended by the end of 2023.  

What we have is a little below $9 Trillion in the FED's balance sheet.  The FED has not contracted Money Supply as they raised interest rates.  There could be some political reasons as higher interest rates bear down heavily on Technology Stocks and investments.  The technology bulls eye is a target that has united both sides of the political spectrum.  You be the judge.

If this is a political action without contraction of Money Supply, then why should there be a pressure on Home Prices?  From the Fidelity reports I have added to the past commentaries it is very clear increasing rates are not affecting the demand for low to mid value properties.  From East Palo Alto to Menlo Park, Los Altos, Redwood City, San Carlos and other SF Peninsula cites the demand for housing has not abated.  They are all in a strong seller's market.  

If there is something to be garnered from that observation is the examination of condition of the house for sale and the concurrent price action that follow.  Location, Location, Location are always the main driving force of real estate.  The next is Condition, Condition, Condition.  This last "3 C's" is what makes home sales distinguished from the first "3 C's".  

Buyer's have a unique ability to distinguish from what is for sale to what they want.  What they want is a "Move in condition home". Not a fixer upper, not a contractor's special. It is my observation buyers want a disclosure package that is clean of any future work needed; along with, a matching  interior and exterior.

With the "Condition" quotient  the buyer's have distinguished what they will pay.  Now here comes the key element.  Their cash reserves are in liquid, safe investments that have no risk of capital and return a handsome rate of return that pays increasingly larger amounts of interest as the FED increases interest rates.

The result is the multiple offers and over bids for those properties with "condition, condition, condition" and "location, location, location".  For those properties that are over priced with missing parts to the two "3 C's" there are price cuts, no offers and under bids.  

On a daily basis I watch the 7-day results of Atherton, Menlo Park, Los Altos, Palo Alto, Redwood City, San Carlos, South San Francisco, Woodside and Portola Valley.  I see very little change in the daily new listings, but do note that those properties that go pending and sold have the two "3 C's" and those that do not, linger and have price cuts!

I also have Zillow, Realtor.com send me results of "move to locations" of the California/SF and Bay Area Exodus.  Those areas show a distinct drop in home prices, more new  homes for sale by developers, and greater number of homes for sale with longer duration of Days on the Market.

We may be in a market in which there is the "Willing buyer and the Willing Seller' meeting more evenly, than the past of "make me an offer I can't refuse" 

That could be the reason that Fix and Flippers, contractors and investors are able to pick up homes and turn them around into move into condition homes and turn a handsome profit.

It also could be a reason the rental prices are dropping and the new level of buyers come from this frustrated market made by reason of abusive landlords and the realization of renters that they are not building equity.

Outlook For 2023:

From my experience in Listings, Buyers and Broker Price Opinions I see: 

1.    Demand and interest rates moving in reciprocal condition.  As interest rates on 30-year mortgages approach 7%, Real Estate sales decline.  As interest rates on 30-year mortgage approach 6% the Location and Condition houses move quickly.

2.  I do not see any drastic movements in average home prices unless there is a surprise of increases in listing inventory.  I expect a return of listings in the next few months from those properties that were taken off the market in December.  Once moved the inventory should remain light.

3.  The "Black Swan" is the FED's action on inflation control.  The FED may see a move to reducing Money Supply.  That occurred in the mid to late 70's.  It drove down Stock and Bond values and the seekers of store of value, income and appreciation went to real estate.

Again as always, if you have any question and or need assistance; do not hesitate to call, email or text me.

Gary

The Problems are the Path: Statistics and Probability

One of the most enjoyable classes I had in college were in the Statistics and probability classes.  I must admit my greatest source of successes from these classes in my formative days was Black Jack.  A colleague of mine named Tony, who looked like Tony Soprano and was from New Jersey, and I were so successful at in that in the mid 70's we were told not to come back to Las Vegas.  So it became a rather humorous endeavor when I listened to Economists talk about the various forecasts they had on the economy and where the future was going.

Another  benefit  was in viewing the FED and their attempts to use interest rates to solve and economic situations.  The Federal Reserve of St, Louis published an economic report which detailed the past actions of the FED with interest rates.  I can say, that my interpretation was the FED was alway Behind the Ball.  They either failed to cease their interest rates cuts until inflation started and ceased to act fast enough to stop inflation without aggressive interest rate rises that eventually affect the economy and employment.  They always had the rhetoric that it was being done to stop inflation and its affect on the economy.  Of course, I saw the economy as my neighbors, my parents, my relatives and those I knew who needed to work to earn a living and support a family.  I could never see how some overly educated members of a Federal Reserve, appointed by politicians, who were wealthy and in no need of earning money to support their families.   If they were laid off or unemployed.  They either went back to Wall Street, or an endowment their family established or the academia to write books.  

When the failure of their actions resulted they went back on an Economic term that bailed them out.  We simply know it as "the past is no guarantee of the future".

Through all my years on this planet I too looked at the various formula's and computer devices to forecast the economic future and profit from the forecasts.  "Too Soon Alt and Too Late Smart" is a Milwaukee German emigrant saying.  

The brain we have been given with is far more able to quickly adapt than any computer, silicon chip or formula.  

As we started 2020 the forecasts were for a advance in home prices, then as interest rates rose no growth.  By the time we were into the 4th quarter a negative performance after athe first 6 months had a double digit return.  We ended up with double digit decline.  Some areas in the peninsula had 11% decline in the last two months; while others had no decline for the entire year.  As I look at the Fidelity reports on various towns and cities in the Peninsula I see 25% declines, year on year.

So where does that put us for 2023?  One thing to remember is that stocks, bonds and real estate are not in the same bucket.  Again, going back to college and "Money and Investing", Real Estate is called that because it is your "real estate".  It is the estate you leave in your will.  Stocks and bonds are store of value assets.  Real estate is purchased not for a store of value.  It is shelter, a home, a source of income; something we can see and feel.  We don't need to sell it because interest rates went up because our mortgage is fixed, if we have one.  The rise in interest rates is matched with a rise in income from the  income producing real estate owned.  We use it to grow flowers, vegetables, food products. maybe even entertain ourselves, family and friends.  Shares of companies and bonds pay dividends, interest and are there when we need money for emergencies or planned expenses as retirement, household emergencies and our children's education.  Inflation is great for real estate as it creates increased value from inflation and the income rises due to inflation.  So why is it so BAD?

So where are home values going?  First, I do not see the supply and demand changing since last letter.  I watch the MLS statistics on "new listings". "contingent", "pending" and "sold" on a daily basis.  We started out a week ago at 37 new listings went to 51 and dropped back to 46 as of Sunday  February 26th.  

Homes that were taken off the market in November and December have not come back on the market.  Once we get past St Patrick's Day we may know where we will be heading.  Right now home prices will not be a run away.  More homes will be over priced as owners refuse to admit or realize and or real estate agents are more interested in getting a listing; than being honest with there clients on the real market value of the owner's property.  Home prices are less now than they were last year.  What is useful is that with each decline, no matter how minuscule, the level of prices bring in another level of buyers.  Irrespective of what interest rates are.  Buyers will see the lower price of a home as a good entry point to buy their life time shelter.  Unlike stocks lower prices do not breed lower prices, they breed new buyers!

For those of you who think that I will wait until a bottom occurs you live in a fantasy land of denial.  Homes are unique, they fit individual likes and dislikes. Neighborhoods are also likes and dislikes.  Some neighborhoods are listed very seldom have a limited supply.  The neighborhoods are so enjoyed by owners that the sales are only from divorce, death and relocation.  All three are rare in occurrence.

Yes, there are those who would like to move to another "neighborhood".  They are cautious as the extra money needed to move up are in cash accounts with substantially higher returns than anything in the past 15 years.  Then they need to rationalize to themselves the capital gain taxes, the higher mortgage rate and higher property taxes.  To make that move there must be a very advantageous situation.  The additional consideration is amount needed to make the exterior and interior to the buyer's liking.

Now the interior and exterior liking is the next step in a healthy housing market.  Most buyers DO NOT WANT to remodel, paint and landscape.  This is the opportunistic investor/contractor known as the Fix and Flipper.  As long as the Fix and Flipper are active in the real estate market there is a "Seller's Market".  So far, that has not changed since interest rates have risen. It does not appear it will end soon.

To summarize, do not believe in the statistics and probability of real estate professionals.  Use your intuition, if you like it buy it.  If you want to sell, do not let taxes influence you.  I have too may times found in my life time in investing when a client did not want to sell due to taxes and lost as a result.

I recall a client I had as a stock broker who bought Warrants in Atlantic Richfield at the time of the Alaska Oil discovery.  About a $100,000 in warrants which were the right to buy shares at a set price by a set date.  Any time between now and then they were tradable on the New York Stock Exchange.  Within months his return was over 50%.  I advised to sell as the warrants had only a few month to last.  He refused due to sort term capital gain's taxes.  The warrants expired worthless!  

As stated in my last letter, if you have questions, need help buying or selling property.  Do not hesitate to call, email or text me.

Thank you

Gary McKae