Newsflash: Even if Silicon Valley Bank (SVB) was stress-tested by the Fed, their problems would not have been unearthed, though they were more than understood by Goldman Sachs. SVB’s problems were, in fact, used by Goldman to “help” SVB, which immediately buried the bank and grossly enriched the great vampire squid. (It’s my analogy for Goldman – I’ll explain in a minute.)
The run-up to the end-story on SVB is they took in a ton of deposits during the pandemic, which they mostly used to buy Treasury bonds and mortgage-backed securities, which all fell in value as the Fed raised rates, while at the same time depositors were drawing down their balances.
From March 2020 to March 2021, Silicon Valley Bank’s deposits doubled, going from $62 billion to $124 billion, thanks to inactivity due to the Pandemic. Venture capital firms parked newly raised funds in SVB, as did their portfolio companies from startups to unicorns, and not just in the United States. SVB’s reach was global. By the way, SVB wasn’t the only bank taking in tons of deposits.
Your first note to self here, people, is that deposits are “liabilities,” not assets. They can exit as quickly as they entered an institution. Those deposits are used to finance “assets.”
In the case of SVB most of the assets the bank purchased were safe assets, boring stuff like U.S. Treasuries and agency mortgage-backed securities, and of course they had a loan portfolio.
But, because there was no yield on bonds on account of the Federal Reserve manipulating interest rates lower, as in down to zero on overnight fed funds, SVB bought longer-dated bonds, like 10-year Treasuries. That’s because the only “decent” yields, if you call 1% to 2% decent, the bank could get were on longer dated maturity bonds.
So, that’s what they bought. (By the way, SVB wasn’t the only bank buying longer maturity paper for their piddling but decent yields.)
Then the Pandemic subsided, and things got back to some semblance of normalcy, except for what the Fed called a bout of “transitory” inflation. And to combat that inflation, the Fed, starting in March of last year, began raising interest rates. Of course, once again the Fed got it wrong, and inflation wasn’t transitory but more embedded in the economy. So they kept raising rates, lifting the fed funds rate in a year from zero to a range of 4.50% to 4.75% today.
Your second note to self here, people, is that when rates rise, prices of bonds that pay a lower rate of interest always fall. That’s because no one buying a bond today is going to buy a bond yielding 2% when they can get one that has the same maturity and now yields 4%. So, anyone trying to sell 2% yielding bonds has to sell them for a lot less than what the price of a 4% bond costs. Mathematically, the price of the lower yielding bond will fall to where the total yield or return is equal to 4%, by virtue of the price being discounted.
As interest rates rose, the assets on SVB’s balance sheet, its 1% and 2% yielding bonds, fell in price, even though they didn’t plan on selling them. By the way, SVB isn’t the only bank sitting on assets that have been marked down dramatically.
While theoretically SVB parked those assets in a bucket labelled “held-to-maturity” (meaning they planned on keeping them), as depositors withdrew money, partly because startups were burning through cash and VC firms weren’t raising more money and pulling money for various reasons, deposits became real liabilities. As more deposits left SVB, deposits which financed all those low yielding assets on the bank’s balance sheet being marked down, SVB decided to sell a chunk of its portfolio of bonds.
Enter Goldman Sachs, the vampire squid.
What was happening to SVB’s balance sheet surfaced at fiscal year-end 2022 when the bank revealed an almost $15 billion mark-to-market loss on its held-to-maturity portfolio, meanwhile its equity wasn’t much more than $16 billion. The trouble the bank was in looked like it came out of nowhere, only it was developing all year.
The Federal Reserve Bank of San Francisco oversees SVB, but they didn’t flag the bank for its problems. Even if SVB was subject to the Fed’s stress tests for systemically important banks, which given SVB’s size it wasn’t considered systemically important, the bank would have passed.
That’s because, as inane and frightening as this sounds, the Fed’s 2022 stress tests’ adverse scenario on interest rate risk had banks calculate losses if “Ten-year Treasury yields increase from around 1.5 percent to around 2.5 percent at the end of the scenario.” I’m not joking. Towards the end of October 2022, the 10-year Treasury was yielding 4.24%, 70% more than the Fed’s worst case scenario.
How’s that for Fed expectations? And they were the ones raising rates. So much for the Fed getting anything right, anything.
But stress tests and Fed incompetency are stories for another day.
Meanwhile, Goldman Sachs, as SVB’s adviser helping the bank manage its problems, which were suddenly about more deposits being withdrawn and a badly dented portfolio of assets, offered a solution. Goldman would take some of the bank’s impaired portfolio off its hands and then help SVB raise $2.25 billion in fresh equity capital in the form of a sale of new shares.
So, on Tuesday of last week, March 7, Goldman bought a portfolio of SVB’s bond assets, with an average yield of 1.79%, with a supposed book value of $23.97 billion, for a “negotiated price” of $21.45 billion. The next day, March 8, SVB announced a planned share raise of $2.25 billion to fill a hole of $1.85 billion in its balance sheet, a hole just caused by Goldman, and everyone freaked out.
Suddenly being told SVB needed fresh equity capital on account of a recent $1.85 billion hole in its balance sheet was frightening to equity investors, who started selling their shares, and to depositors who started furiously withdrawing money from the bank to the tune of $42 billion the following day, March 9th.
And that was GAME OVER for SVB.
But not for Goldman Sachs, who I’d bet my bottom dollar shorted SVB stock as soon as they bought their bond portfolio, and in a matter of a few days reaped a windfall on the new portfolio it just bought as bond prices spiked in a “flight to quality,” on account of some black swan banking crisis supposedly no-one saw coming.
Your third note to self, people, is that someone always knows something, especially the party causing the something.
I hope you noticed the “by the way” comments in here, if you didn’t reread this, because by the way what happened to SVB is happening to all banks in the U.S. and most global banks.
Note to self #4, people – the whole world’s dealing with the repercussions of central banks artificially manipulating interest rates too low for too long, the resulting stockpiling of low yielding assets on banks’ balance sheets bought with leverage because short-term financing money was practically free, and the marking down of those balance sheet assets as those same central banks raised rates, which is causing depositors to withdraw money from banks that don’t pay interest on deposits to park in 3%-4% yielding money market funds and juicy yielding risk-free Treasury bills, notes and bonds.
That’s what markets are freaking out about.
If bank equity prices keep falling it means their tier-1 capital is shrinking and they’ll have to add more equity capital or reduce their balance sheets to meet reserve requirements. Trying to raise equity by selling more shares when your share price is falling is a fool’s errand. Selling balance sheet assets that are already underwater to just about anyone who already owns bonds that are themselves underwater is a recipe for engendering an ugly negative feedback loop.
The stock market is especially vulnerable here on account of rising rates, stubborn inflation, and now a potentially global banking crisis.
Either buy put options on benchmark index ETFs like the SPDR S&P 500 ETF Trust (SPY) and Invesco QQQ Trust Series 1 (QQQ), or stay on the sidelines until bank stocks stop declining, or the Fed and Treasury pull out more bazookas and fire liquidity lifelines to banks and bondholders.
I like buying the too-big-to-fail giant banks on dips here on account of them being, well, too big to fail.
And if the market breaks hard to the downside, I’d be looking for great companies selling for bargain basement prices, as this might be the shakedown and shakeout smart investors have been waiting for, for a decade now.