By Stuart Katz, CIO
March 10, 2023
What
Yesterday, bank stocks declined, triggered partly by an item on the list of SEC disclosures by SVB Financial (stock declined 63%), owner of Silicon Valley bank (the 16th largest bank in the US with $210 billion in assets). These disclosures included a substantial capital raise to shore up the balance sheet and material steps to strengthen liquidity, including selling $21 billion in “available-for-sale” bonds at a loss of $1.8 billion. SVB has more bonds it can sell at even bigger losses. The Invesco KBW Bank ETF declined by 7.6%. Even the largest financial service companies, such as JPMorgan and Bank of America declined between 6-7%. Other California-based banks, such as First Republic Bank, shares plunged 18.9%, where PacWest Bancorp declined 25.4%.
Catalyst: Thiel Spark
We believe the catalyst was sparked by SVB losing $1.8 billion on the sale of $21 billion of “available-for-sale” securities. It sold them to raise liquidity and “reposition” its balance sheet, according to SVB SEC filings. Its depositors include startups that once had significant amounts of cash on deposit at the bank that they’d obtained from venture capital investors. However, many of those startups are still burning cash, where we believe SVB and First Republic Bank have specialty lending arms to provide company financing and margin loans to entrepreneurs holding these illiquid holdings. According to Bloomberg, famed venture capitalist Peter Thiel and other prominent venture capitalists advised portfolio businesses to withdraw their money, draining their bank deposits. We believe the bank must fund those cash withdrawals.
Catalyst: FTX Spark
Crypto bank Silvergate collapsed in a more orderly manner on March 8, 2023, triggered by losses on bonds that it was forced to sell because of a run on the bank from its depositors, which were crypto companies, including FTX, that suddenly withdrew combined billions of dollars of their dollar deposits to help fund their own liquidity challenges. The losses on the sale of those bonds, part of a bank’s assets, impaired the bank’s equity capital cushion.
Catalyst: Fed Hikes
Chair Powell continues to raise rates to tighten financial conditions and weaken aggregate demand. We believe as the “risk-free” rates continue to rise, it puts increasing pressure on more speculative unprofitable long duration business models, including many recent IPOs, SPACs and private financings.
Consequences
We believe yesterday, investors began to extrapolate the simple bond math equation of “yield up, price down”. If banks are forced to sell bonds now, they will realize losses, even on perfectly good Treasury securities, because yields have risen and, therefore, bond prices have fallen. If they don’t have to sell those bonds but can hold them to maturity, they will not realize any losses, will be paid face value for those bonds at maturity, and will collect interest during the contractual period. Certain banks may need to or will be compelled by regulators to sell now due to the uncertainty of raising liquidity to fund the outflow of deposits. Today’s announcement that SVB was shutdown to protect FDIC depositors is typically the first step toward a forced sale to a larger better capitalized bank.
We believe if banks don’t offer competitive interest rates on their deposits, retail and business depositors sooner or later figure it out and move their cash from savings accounts that offer 0.2% or from transaction accounts and cash management accounts that offer 0% to brokered CDs and Treasury bills that offer over 5%, and to money market funds that offer between 4.5% and 5%. Banks can choose to retain those deposits if they raise their rates to competitive levels, but that would squeeze their net interest profit margins. To fund potential deposit outflows, banks can use the cash they have on hand and the cash they have on deposit at the Fed (what the Fed calls “reserves”). Banks have trillions of deposits at the Fed, and this is instant liquidity banks can use to fund deposit outflows. Banks currently earn approximately 4.65% on their cash on deposit at the Fed. SVB mentioned putting some of the cash from the bond sales on deposit at the Fed to earn higher income going forward. There are several ways for banks to address their liquidity and solvency concerns, including raising dilutive equity, borrowing short term from the Federal Home Loan Banks or at the Fed’s “Discount Window” at rates as low as 4.75%, borrowing at similar rates from other banks or they can borrow by issuing bonds. Finally, they can fund the deposit outflow by selling bonds and taking a loss each time they sell bonds instead of squeezing their profit margins quarter after quarter by borrowing at higher rates. Ultimately, they can do a combination, or if all else fails, they may be compelled to sell.
Yesterday, SVB announced in a series of filings with the SEC that it would raise $2.25 billion in equity capital in a three-pronged approach that would have been heavily dilutive for existing stockholders. However the FDIC shutdown the bank before the fund raising took place.
Contagion?
We believe the issue rests on the foundation that the only free money left for banks is from depositors, who have increasingly figured out there are better places to earn a return on cash. As a result, banks face higher funding costs or realized losses if they raise liquidity by selling securities to reduce or avoid those higher funding costs. We believe SVB depositors are pulling out their cash because of their perceived overconcentration to many cash-burning corporates and illiquid venture consumer clients. SVB said in one of its SEC filings, “we are taking these actions because we expect continued higher interest rates, pressured public and private markets, and elevated cash burn levels from our clients as they invest in their businesses”. Moody’s also downgraded its SVB rating outlook from “stable” to “negative,” meaning another downgrade might be next, “reflecting the uncertain macro environment and, specifically, the potential negative implications for SVB if the declining venture capital investment activity and high cash burn do not subside.” We believe Silvergate depositors were redeeming deposits due to concerns of collapsing crypto companies. These were somewhat unique circumstances where a liquidity issue turned into a solvency risk. Currently, we believe other banks (especially the majority of systemically important financial institutions) don’t face those issues; they face more traditional liquidity issues, including the need to raise interest rates on deposits to maintain “cheaper financing”. However, we will continue to monitor these matters and the increasing commercial real estate credit issues in the banking system that are likely to be more relevant systemic concerns during 2023.
Stay Tuned…
Sources:
Bloomberg
https://ir.svb.com/financials/sec-filings/default.aspx;
https://www.federalreserve.gov/releases/h8/current/default.htm;
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