What is going on in the banking world? Today, I want to take a look at what just happened with Silicon Valley Bank – The second largest bank failure in US history. Signature bank is in the same conversation – The third largest bank failure in US banking history. So let's take a look at it.
To frame this conversation, I just want to look at the last couple years of Silicon Valley Bank and their growth rate over that timeframe. Their deposits more than tripled from 2019 - 2022. Banks can take those deposits make loans or buy securities with them. So that's what they ended up doing with a large portion of these deposits is buying securities.
Knowing that, I want to give a quick rundown here of how a bond works. When rates go down, the value of a bond goes up. Also, longer bonds fall more than shorter duration bonds when rates rise.
Now, on their balance sheet, they have a lot of bonds that they've purchased because of that high growth rate or high increase in deposits over this timeframe. Banks can classify these bonds on their balance sheet in two different ways, one of which is called available for sale (AFS). If you put that on your balance sheet, it causes your assets to move up and down because you have to mark those to market.
Contrast that with held to maturity bonds (HTM). A bond, if you give $100 to somebody in the form of a bond and they pay you maybe $2 twice a year, so you're getting 4% on your bond, and at the end, how it works is they pay you back the $100. So they pay you the interest along the way, then they pay you back the $100. So if you think of a bond that's held to maturity, the price risk in the meantime doesn't matter as much. So as a way to help banks, they allow for that option.
During this timeframe, their available for sale bonds grew from $14 billion to $27 billion, basically doubling. But their held to maturity book of bonds went from $14 billion to $99 billion. So you can see a lot of these bonds were marked as held to maturity.
The problem with this is that with the sharp increase in rates that we showed, the actual value of these bonds are listed on the balance sheet closer to the principle amount of that bond. But if you were forced to sell them today, you would receive much less. This causes a problem when you're forced to liquidate these, because you say something's worth $100, and when you sell it, you only get $85 or $90, so you lose that $10 or $15.
All this flows into the actual problem that occurred. In that 2022 timeframe, withdrawals start to occur from client accounts. And what can happen if you have enough withdrawals, is that you may be forced to sell some of those held to maturity securities on your balance sheet. When you do that, you immediately realize that loss. And that's what happened is they had to raise a fair amount from those held to maturity securities and realize a loss, and then they tried to go do a capital raise for that loss amount. This triggered concerns for the people that were depositors at the bank. They all wanted to withdraw their funds. Basically, when they all tried to do it at the same time, it doesn't work. They'd have to sell all of these securities. And so that's when the government stepped in and said, "Hey, we're taking over the bank." The second largest bank failure in US history occurred.
This is largely due to a super high growth rate during a short-term timeframe and then investing these securities in bonds at low rates right before a fast rate hike cycle by the Fed. Now, when I say it that way, it sounds like it's not their fault. I want to be careful here, multiple people had a hand in this, but Silicon Valley Bank, they reached for a little bit of return in those bonds that they were purchasing.
So if we just look at a chart here, I want to illustrate this point. If we look at their Tier 1 capital ratio, and then we adjust that, we say, "Hey, these held to maturities securities, what if we assumed that all of these were marked to market? Then what would your capital ratio look like?" And you see pretty comparable drops in most banks.
But the decline from the stated Tier 1 capital ratio on the balance sheet versus what would happen if you realized all of it that you see in Silicon Valley Bank, it takes it to a capital ratio of effectively zero. This is largely because of reaching a little bit longer in those bonds that they're holding in their portfolio. So I want to read a quote here. This is from a JP Morgan, "Eye on the Market" article. I'll put a link to it here. But it says, "SIVB was in an investment duration world of its own as of the end of 2022, which is remarkable given its funding profile and elevated share of uninsured depositors." So basically they're saying they leaned into these bonds, took a little bit of risk in the security side, potentially also on the loan side of the portfolio, and this bank had a little bit more risk exposure than what you'd find at most traditional banks that have been around for a long time and haven't had that high growth rate and aren't frankly based out of the Silicon Valley, where there's a lot of tech startups and things like that going on.
It's difficult to say how they should’ve avoided this. It's a bad time, however, to have your head of risk leave the firm in April of '22 and then wait eight months to fill that position. It doesn't help make you look any better.
It’s also an unfortunate sequence of events with the Fed rate hike cycle. You could argue that they've started too late and they're partly at fault. But you could also argue that they're doing what they want to do because they've made it pretty clear they're going to go until something breaks to fight this inflation. So something broke and now we'll see where this goes and what that means for future rate hikes. But that's effectively what happened in the bank.