March Madness again?

It seems like crazy things tend to happen in March, and this March is no exception.  Last Friday, the 16th largest bank in the U.S., Silicon Valley Bank (SVB), failed in spectacular, breathtaking fashion.  Two days prior, by all outward appearances, this was a stable bank, whose stock price finished Wednesday at $267.83, up a half buck on the day.  Then on Thursday, the bank announced that it had sold a large chunk of its treasury bonds in order to meet deposit withdrawals (bank customers taking money out of their bank accounts).  SVB was planning to issue some stock in order to plug the hole left behind by the deposits.  What ensued next was a classic bank run, without the people standing in line at bank tellers or ATMs (this is Silicon Valley, after all).  Its stock fell 60% on Thursday, and on Friday it never opened, and by mid-morning, the FDIC had rendered the bank insolvent and taken over.  Treasury Secretary (and former Fed Chair) Janet Yellen continually declared this to be an unusual, non-systemic situation, even up until Sunday morning.  Then Sunday evening, the Fed declared the bank to be systematically important and decided to bail out SVB’s uninsured depositors, AND ALL OTHER BANKS if they faced a bank run.

There’s a lot to unpack in that chain of events, and a lot of questions about how this could happen.  And then, what is next in the chain of events, and who might be collateral damage?  And how might you and your investments be affected?  We’ll get to that….

First of all, SVB has a unique business model, in that the vast majority of depositors were not individuals like you and we, but startup companies and venture capital funds.  This worked dramatically in their favor, as deposits shot up in the last few years as Venture Capital (VC) funds were writing a lot of checks to fund the startups, investors shoveled money into VC funds, and startups were going public via IPOs and SPACs.  Here is SVB’s end-of-year deposits since 2019:

2019 $61 billion

2020 $101 billion

2021 $189 billion

2022 $173 billion

They more than tripled in 2 years!?  SVB has been in business for 40 years, and has become a magnet for banking business by marketing itself as the bank of the tech industry, and also by making a lot of loans to startups, which traditional banks wouldn’t touch.  When these startups were collecting new funding from VC funds, they simply deposited them into their SVB account.  Were they oblivious to the fact that FDIC insurance covers only $250,000 of deposits per financial institution?  Surely they were aware, but likely they saw the risk as minimal.  But also there are reports that the bank coerced many loan clients into keeping all their deposits with the bank.

The boom in tech funding hit its apex in 2021.  But notice the droop in deposits in 2022…fewer startups could go public, and funding from VCs dropped.  Startups are notorious for “cash burn,” meaning that they use up cash through the ordinary course of business, so they are always in need of more external funding from investors.

In a normal market, the $16 billion of shrinking deposits would be funded with $16 billion of sales in the bank’s securities or loan maturities.  The problem is that most of the bank’s securities were long-maturity treasury bonds, whose value dropped dramatically last year as interest rates rose so quickly.  Reportedly, SVB had recently (since the end of 2022) seen a huge outflow of deposits, which prompted the bank to sell $21 billion of treasuries, and book a $1.8 billion loss.  This was a realized loss, which meant that the bank’s book value was worth $1.8 billion less. 

The bank felt it prudent to raise some capital, in the form of stock and convertible preferred shares, with the goal of assuaging investors who might have gotten nervous to read of the $1.8 billion realized loss.  In other words, the new capital would “plug” the hole vacated by the loss of capital from the sold treasuries.  Let it be known this is not exactly routine for banks to be selling stock.

Investors were not soothed and quickly understood that deposit flight was a real risk.  VC funds started telling their portfolio companies (the startups) to quickly withdraw their uninsured funds and put them somewhere else.  As it turns out, the bank saw redemption requests of $42 billion in one day, last Thursday.  That’s one-quarter of the bank’s deposits.  SVB could not raise funds that quickly, the FDIC intervened to try to find another bank to buy SVB, and when no buyer materialized, FDIC had no choice but to stanch the bleeding and close the bank.  This was the 2nd largest bank ever to fail in the U.S., after WaMu in 2008. 

On Sunday, the Fed stepped in to essentially backstop all uninsured depositors, not just at SVB (or the other large bank that failed over the weekend, Signature Bank of NY), but at any bank.  Obviously, the Fed hopes that by merely providing the backstop, it will prevent any bank run at any bank, so they won’t need to pay anything out.  In addition, the Fed is opening a loan program, such that banks can borrow from the Fed with the par value of their treasuries portfolio as collateral.  This should allow the banks to hold their bonds to maturity, rather than need to sell them at fire-sale prices, and thus incur no losses.  Just like if you own a bond whose paper value has dropped in value, if you hold it to maturity, you get the yield to maturity that you signed up for when you bought the bond, not a penny less. 

So, to summarize, what were the ingredients that led to SVB’s bank run?  The bank grew too quickly.  Then the bank invested too much of its assets, not foreseeing that the tripling of deposits might unwind at some point.  Then they invested too much of the assets into securities that lost as much as 20% of value as rates rose.  Finally, depositors are guilty of having way too many uninsured deposits at the bank, and not considering that that was true of most other depositors, and thus the possibility of a bank run was real.

Even as we have nothing to do with SVB, it is important that we consider the potential effects on the banking system, the financial markets, and economy.  How about the bank stocks you hold?  We would have said this would almost certainly not happen to them before the Fed stepped in to backstop uninsured depositors, but now with this in place, the odds are even less.  Still, you never know.  Banks that are considered most vulnerable have the least amount of insured deposits as a percent of total deposits.  Depositors are now much more “aware” that their excess funds are at risk, and will be eager to withdraw them in the interest of safety.  Will those withdrawn excess deposits find their way to another bank, and thus the banking sector won’t see a big loss of deposits, but rather just a sloshing around of money between banks?  Surely some will, but surely a very large chunk will seek out government-securities money market funds or treasury bonds, because short-term government securities are the ultimate safe asset.  Plus, yields in bank accounts have been slow to rise over the last year, if only because many bank customers aren’t aware of how much more yield they could be earning elsewhere.  Now that there is such publicity and another reason to move excess funds, a lot of bank customers will “discover” alternatives to bank products, which we have been talking about since last year.

So, you can see how banks most vulnerable to a bank run should be the ones with the most uninsured deposits.  The two banks that have failed were, in fact, among those with the lowest percent of insured deposits.  Other vulnerable banks are those with significant exposure to the tech sector.  Thus, the banks you own in your Monarch accounts don’t seem too vulnerable on either front.  We suspect that USBank is down more than it should be because it is a candidate to buy SVB, which admittedly is a really risky-sounding endeavor, but USBank has successfully bought many banks out of insolvency before, notably in the Great Financial Crisis.  We highly doubt, though, that USBank would buy SVB since they just closed a large acquisition at the end of 2022.

As for the cash in your accounts managed by Monarch, it is invested entirely in a money market fund that owns only government securities.  Thus, it does not matter whether you have more than $250,000 of cash in your accounts. 

We all suspected that the sheer speed with which the Fed was raising rates and draining money supply from the economy last year could cause something to break.  Investors will be spending a lot of time wondering whether SVB is the proverbial canary in the coal mine.  Is it this cycle’s Enron (2002) or Orange County (1994) or the oil sector (2015), which saw failures because of bad overleveraged bets as markets moved against them?  None resulted in contagion which spread to the economy or wider financial markets.  Or is it this cycle’s Bear Stearns, the first large bank to nearly fail (it was acquired by JPMorgan in a fire-sale) in 2008, a few short months before the whole banking sector was enveloped by fear of the after-effects of the housing bust.  We all hope for the former, but we are on red alert now, watching like a hawk.