Silvergate Capital Corp announced they would close their banking subsidiary, and the FDIC took over Silicon Valley Bank. Now there is a one-two punch that few people saw coming.
Silvergate Capital Corporation operates as a bank holding company for Silvergate Bank that provides banking products and services to business and individual clients in the United States. The company accepts deposit products, including interest and noninterest-bearing demand accounts, money market and savings accounts, and certificates of deposit accounts. Its loan products comprise one-to-four-family real estate loans, multi-family real estate loans, commercial real estate loans, construction loans, commercial and industrial loans, mortgage warehouse loans, reverse mortgage loans, consumer loans, and other loans secured by personal property. But their core business is to provide cash management and payment services for digital currency-related companies Silvergate Capital Corporation was founded in 1988 and is headquartered in La Jolla, California. La Jolla is one of the wealthiest neighborhoods in the United States.
Silvergate suffered a run on the bank as they were the banker for the crypto industry. Many feared that they may have been unwitting accomplices to FTX and, therefore, may be subject to legal action by the justice department and regulators. As a result, bank depositors decided to pull $8 billion from the institution, leaving them with just $6 billion find deposits. The company invested these deposits into short-term securities. To meet customer withdrawals, the company had to sell these short-term securities. Under normal circumstances, this would not be a problem. But in this case, the company had to sell that at over a $1 loss as their prices went down due to sharply rising interest rates. This left the company with just $0.6 billion in equity capital. Management felt the only responsible action to take was to liquidate the bank in an orderly fashion and distribute money to depositors as their short-term securities came due.
The loss is Silvergate will be devastating to the crypto industry. Most established banks do not want to deal with the crypto industry as the regulations are unwritten, and it is unclear how traditional bank regulations might apply. As with the cannabis industry, it will be difficult for these firms to hold cash balances, pay bills, payroll, etc. Life is about to get much more complicated for these folks.
SVB Financial Group, a diversified financial services company, offers various banking and financial products and services. It operates through four segments: Silicon Valley Bank, SVB Private, SVB Capital, and SVB Securities. The Silicon Valley Bank segment provides commercial banking products and services, including credit, treasury management, foreign exchange, trade finance, and other financial products and services. This segment also offers traditional term, growth capital, and equipment loans; asset-based loans; revolving lines of credit; warehouse facilities; recurring revenue and acquisition finance facilities; mezzanine lending, corporate working capital facilities, and credit card programs; treasury management products and services; business and analysis checking, money market, multi-currency, in-country bank, and sweep accounts; receivables services, which include merchant services, remote capture, lockbox, and fraud control services; wire transfer and automated clearing house payment services; business bill pay, credit and debit cards, account analysis, and disbursement services. In addition, it offers foreign exchange and trade finance products and services, letters of credit, and investment services and solutions. The SVB Private segment provides mortgages, home equity lines of credit, restricted and private stock loans, capital call lines of credit, and other secured and unsecured lending products; planning-based financial strategies, wealth management, family office, financial planning, tax planning, and trust services; and real estate secured loans. The SVB Capital segment provides venture capital investment services. The SVB Securities segment offers investment banking services, products, and services, including capital raising, merger and acquisition advisory, equity research, and sales and trading. The company was founded in 1983 and is headquartered in Santa Clara, California.
In short, SVB was the venture capital bank. Ventures firms held money there. The portfolio companies had money there, and the employees of both did the same. The loss of this bank will devastate the startup business. SVB stock was in freefall. It fell from $268 to $106 on Thursday. The stock dropped to $63 in premarket, and the FDIC took over the bank on Friday. When a bank goes south, it is remarkable how fast it falls.
SILV suffered the same fate as SI, a bank run. The company held $91 billion in securities and accounted for them on a “held to maturity basis.” This means the company does not mark them to market on their accounting statements. Instead, they sit on the accounting statements at book value, which does not reflect a loss in value due to the rise in interest rates. Investors got nervous about the bank, and Peter Theil told his portfolio companies they should take their money out of SILV and deposit it elsewhere. $42 billion of deposits were pulled, and the company took a loss of $1.8 billion from the sale of investments. They announced a capital raise the stock went into free fall. SIVB is the 18th largest bank in the US, so this is a big deal. Furthermore, the banks provide the financial infrastructure for the country’s startup and venture capital industry. They are one of the few banks that lend to startups.
Banking collapses are scary because they happen so fast. For most of our careers, we have argued that banks use too much leverage. That is to say; they operate with too little equity capital. Both companies discussed above missed a golden opportunity to raise equity as super higher stock prices. They failed corporate finance and risk management 101. “Raise capital when you can, not when you need to.”
So who is next? Many people worry about derivatives. This link shows the derivative’s open interest with various US banks. The numbers are enormous. But what about unrealized losses at banks? The following chart shows the cumulative unrealized losses at US banks as of 12/31/2022. You read this correctly; about $600 billion of losses have not flowed through the income statements. Since rates continued to rise in 2023, we suspect the losses are more significant now.
As a point of reference, the reported net income for the banking industry is about $280 billion for 2022. Said another way, if bank assets were marked-to-market, they would have reported a cumulate loss of $1.7 trillion in 2022. The takeaway is that the banking industry is not as healthy as advertised. Banks are dealing with this problem by refusing to raise deposit rates. But here in lies the problem. It creates the potential for a bank run. If you can earn 5% on a US T-Bill mutual fund, why hold assets at a bank that pays 0.1%?
Banks are losing deposits at a rapid pace, and we are wondering who will be next. Pick the regional bank of your choice, and it just might be them. Market Watch pulled together some data from Fatset and produced the following exhibit. It shows a list of companies with high Accumulated Other Cumulative Income (AOCI) in absolute terms and relative to bank capital. A bank must report these losses if they mark their bond portfolios to market. Since they bought them with the intention of holding them to maturity, regulators allow them to report their positions at book value.
But as SI and SILV found out, they have to report the losses if there they are forced to sell them when depositors ask for their money back. This caused investors to focus on the Held to Maturity Book. Now all banks are under scrutiny. The Federal Government issued trillion of debt during the long down. The Fed bought most of it, but banks were also encouraged to jump in. The helicopter drop of free money resulted in deposit growth. Banks then invested that money in US Treasury, notes, corporate bonds, and mortgage securities. Then the Fed did a rug pull. They raised short-term trades from near zero to 5.00+%, causing the market price of those securities to plummet in price. Clearly, the Fed and the government still have no idea how to conduct monetary policy. They do not provide stability. Instead, they introduce chaos by printing money and trapping banks and people in debt.
We think there is a very good chance the Fed does not change rates at the next meeting. Two weeks ago, investors thought 0.25% was on its way. After JPo’s testimony to Congress, consensus moved to 0.50%. Now that a system event is at the doorstep of the banking industry, we think they might sit on their hands as they orchestrate some kind of bailout. This is what we believe the US Treasury Bond market is signaling.
The stock market is not reacting well to the bankruptcy of a few important financial instructions. Small-cap stocks, in particular, are breaking down. Small-cap stocks have a higher cost of capital (i.e., borrowing) than large-cap stocks simply for their size. They are hurt by rising interest rates more than large-cap stocks. Furthermore, the index has exposure to small and regional banks. It is telling us to beware.
We are now in the part of the cycle where things start to break. The employment number was very strong on Friday, and new jobs topped 311,000. According to mainstream economists, this will likely keep the Fed in tightening mode. While a 25 bp increase in short-term rates was a slam dunk a few weeks ago, the inflation and employment picture has people thinking the Fed will do 50. We do not believe both are inappropriate. We think the Fed should sit on its hand and do nothing. The banking industry is sitting on losses, and the Fed should help banks earn their way out of their problems. This lets banks make a nice net interest margin by writing off their bond portfolio losses.
In the final analysis, we think Fed should do nothing at its next meeting in a few weeks. This is the first time we have held such a position. We believe the Fed threw gasoline on the inflationary fires by purchasing $5+ trillion of Treasuries during the C19 lockdown. To correct that error, they need to sell assets. It is easy for banks, insurance companies, finance companies, and hedge funds to lever up their portfolios. But it takes ten times longer to unwind that leverage. This requires them to sell assets. The problem is… sell to whom? We think investors must be on guard. Crash risk is high.
