A Classic Black Swan

It’s often said that the risks that will matter to the market are those we least expect. After all, the market is designed to fool the majority. And boy, did it do that this week… 🫢

Coming into the week, the bank people were watching was The Federal Reserve, as Jerome Powell testified in front of Congress on Tuesday and Wednesday. Naturally, the focus was on inflation and the central bank’s policy path.

However, the bank news that had a wider impact on the market was Silvergate Capital and Silicon Valley Bank, which we first covered yesterday. 📰

Since then, the story has escalated, culminating in the second-largest bank failure in U.S. history. As we discussed in yesterday’s newsletter, confidence is the name of the game in the financial sector. And right now, confidence has fallen sharply across the board.

Now, some of that concern is definitely warranted. But with people acting first and asking questions later, we’ve got a situation where the impact of one bank failing is spreading to other institutions, not necessarily because of direct exposure, but because people are acting out of fear that their money is unsafe wherever they’re holding it. 😨

First, we’ll try to quickly summarize what we know now. And then, we’ll discuss some of the impacts we’re seeing across the market. 📝

So what happened? Silicon Valley Bank services early-stage businesses and is the banking partner for a broad swath of venture-backed companies. 

During the pandemic, when technology companies were growing like crazy and receiving massive valuations in the public and private markets, Silicon Valley Bank saw its deposits grow significantly (as did the entire U.S. banking sector). They grew from $61 billion to above $200 billion in a few years. As a bank, they’re in the business of taking deposits and loaning them out to make money. But, the demand for loans was much lower than the sheer amount of deposits they had.

So, to keep profits going, they decided to increase the amount of deposits they invested in securities. But since yields were so low, they had to invest in long-dated securities to earn any meaningful yield. As a result, they invested a large portion of their cash in mortgage-backed securities (MBS) and treasuries, many of which they intend to hold until maturity. And while rates remained low and the growth machine was humming, things worked out fine. 👍

However, when inflation began to rear its ugly head, and interest rates started rising, the bank was hit with a double whammy. Its business is extremely levered to long-dated, interest-rate sensitive assets. And now the investments it held were too. 👎

Many of the bank’s customers saw a significant slowdown in their business growth, valuations, and funding ability due to rising interest rates. That means they were depositing fewer funds into the bank and burning more of their cash on hand. Plus, fewer companies were raising money, which reduced the number of new customers Silicon Valley Bank was receiving.

Then, on the long-dated asset side of its balance sheet, the value of its investment holdings was also going down. And so, they reclassified a large portion of their “available for sale” securities into “held to maturity” securities so that they could take a one-time loss and not continue to reflect the unrealized losses in their financials each quarter. 🔻

The straw that broke the camel’s back was Wednesday when crypto-focused bank Silvergate Capital said it planned to wind down its operations and voluntarily liquidate. That started the market’s worry about the financial sector, which made Silicon Valley Bank’s announcement that it was raising $2 billion in additional capital and had sold some of its securities at a $1.8 billion loss a lot less palatable. Combine that with the CEO coming out and basically saying, “stay calm” and “don’t panic,” and you’ve got a market that completely lost confidence in the bank. 😱

How much confidence was lost? Well, about $42 billion was pulled from the bank by the close of business on Thursday. 😮

After shares of $SIVB fell over 70% on Thursday, they were set to open down another 60%+ on Friday. That was until the California Department of Financial Protection and Innovation announced it closed the bank and named the Federal Deposit Insurance Corporation as the receiver. Ultimately, it marked the second-largest U.S. bank failure and the biggest since Washington Mutual in 2008.

The lack of confidence spread throughout the financial sector, hitting many west-coast regional banks the hardest. PacWest Bancorp, Western Alliance Bancorp, First Republic Bank, and Signature Bank all fell sharply today, extending this week’s already steep declines.

Meanwhile, the 97% of startups and other depositors with more than the FDIC-insured $250,000 balance at Silicon Valley Bank are left picking up the pieces. It’s unclear how much of their money they’ll get back and when, so they have to figure out how to operate their businesses in the meantime. And others with money at related banks are left worrying about whether their deposits are safe where they’re at. 😟

So, that’s a quick summary of how we got here. Now, what happens next?

That’s a great question and one many are trying to figure out as we speak (type). The situation has left a lot of stakeholders in its wake, all facing unique issues of their own, including:

1. Silicon Valley Bank’s customers (now unsecured creditors)
2. Employees, vendors, and other stakeholders of impacted companies
3. Investors with direct/indirect exposure to these institutions or affected parties
4. Other financial institutions/the broader financial sector
5. Regulators and government officials (including the Treasury & Fed)
6. And many, many more.

In the short term, regulators are working out what’s left of the bank’s financials and how much they can pay out to customers. They recognize how fragile things are and want to get people answers as quickly as possible, but there’s a lot to unravel here. Meanwhile, other financial institutions and exposed companies will be working hard to shore up the confidence of their stakeholders. 💰

Confidence remains the name of the game. For now, people are acting first and asking questions later, exacerbating an already fragile system. Until people have enough information to feel confident that their money is safe, pressure will likely remain on the overall financial system. What will ultimately restore that confidence remains to be seen. 🤷

Needless to say, it’s going to be a long weekend for a lot of folks. This situation and the Federal Reserve’s next rate decision on March 22nd will be the main focus for the coming week(s).

And we’ll keep you updated as the story develops. 📝