SVB Collapse: Liquidity Is Always Correlated
The magnitude of the situation is not alarming by any means. However, the financial system is not always about numbers.
"As long as the music is playing, you've got to get up and dance."
These were the famous words of Citibank Inc. CEO Chuck Prince after the June quarter earnings in 2007 when the bank reported its best-ever quarterly earnings due to the mortgage book showing its highest profits. In one year, things changed, and the bank lost 90% of its equity value and had a significant write-down in its book value—by 54%.
In every liquidity driven bull market, the sentiment and behavior are mostly similar, just that the participants vary.
On Friday, Silicon Valley Bank, which had its headquarters in California, filed for receivership and was taken over by the Federal Deposit Insurance Corp.—an independent agency created by the Congress to maintain stability and public confidence in the nation's financial system.
SVB is the sixteenth largest bank in the US with $210 billion of assets as of financial year 2022. To put this in perspective, the first Troubled Asset Relief Program that the Federal Reserve released towards the beginning of 2009 post the Lehman Brothers bankruptcy was $400 billion.
So, the magnitude is not alarming by any means. However, the financial system is not always about numbers, but about sentiment, availability of capital and the ramifications of the second-order effects which our human mind does not easily extrapolate.
So What Got Us Here?
Let's quickly go through the SVB balance sheet as of FY22, which looked pristine.
The bank had customer deposits of $173 billion and other debt worth $22 billion. Against this, it had $17 billion of cash and other securities, $26 billion of available for sale securities (think of them as short-term funds that the bank could sell in a day), $91 billion of hold-to-maturity assets and $74 billion of loans they had given. ($208 billion of assets against $195 billion of liabilities, giving a book value of $13 billion).
The bank had a loan mix where 10% was invested in venture deb—the risky part of the loan book. However, the U.S. regulation does not require you to MTM the hold-to-maturity assets, which are Treasuries and mortgage-backed securities.
As the funding environment tightened, the bank lost some of its customer deposits against which it had to sell its hold to maturity assets. Unfortunately, for SVB, there was a big duration mismatch between the two and when rates went up by 3%, this was a 25% write-off on its asset book. The aspect that added to its problems were the loan book, which was illiquid and was going through a markdown in its own regard.
This is not a problem with SVB alone, but this has an impact on the broader financial system today. While SVB is one of the most prominent regional banks in the U.S., the equity value of the Regional Bank ETF In the U.S. has eroded 20% this year.
More importantly, since the assets and cash in SVB has frozen, it has caused multiple issues around the flow through of money as SVB has been one of the most important banking partners to the VC ecosystem. A filing from the SEC shows that SVB is the custodian to more than 1,500 VC funds and to all the marquee VC funds in the U.S.
More importantly, freezing of assets and cash means that well-run startups and Silicon Valley companies have lost access to their cash and assets, which has knock-on ramifications to their payroll, processing and funding of company cash flows, including working capital.
What Implications Does It Have To Broader Risk Markets?
When liquidity gets cut-off, it creates panic in the mind of investors. This is not just about liquidity but about sentiment.
Assets being stuck means there is no clarity on how and when this is going to be released. There are grey-market transactions being quoted for bidders willing to pay 60 cents on the dollar for receivables from SVB, considering there is a deposit guarantee of $250,000 only from FDIC.
This has created a loss of confidence in the system as companies and the funds whose accounts are frozen need to figure out how to manage working capital.
While there is always a belief, led by what the Fed has done in the last 10 years, that it will step in to create an emergency programme and act as a lender of last resort. Or the Fed creates a backstop of liquidity taking the assets on its balance sheet.
While there will always be an expectation of the two scenarios above, I do not believe the Fed will step in just yet considering where the markets are today, and their recent flip-flop on inflation and interest rates. Moreover, even if they do, there is a risk of the domino-effect of how many more banks have to deal with this issue.
Today, the markets need clarity from the Fed, regulators and policy makers and my odds continue to believe that they do not give it right away. If this does become the base case, I believe that the path for risk assets in general from here is lower from here.
Private investors are going to have to take markdowns on their assets as VC funds look to shore up capital for some of their well-run portfolio companies, who find themselves in a difficult situation as their assets are frozen. Investors would be in a risk-off sentiment as access to liquidity and capital will remain tight. While we have been talking about significant dry powder in the markets waiting to deploy money,
I believe that dry powder is always a function of positive sentiment. Things change dramatically during markets like this.
While I am talking about a non-trivial probability of a significant risk-off scenario across the board, I do not believe it's all doom here. I believe the markets globally require a significant reset in valuations, balance sheet focus and businesses focusing on cash flows.
I believe this risk-off scenario will give much-needed discipline for some of the best businesses to continue doing this and gaining market share from those businesses which grew on easy money. This means that this should create an opportune time for deploying capital in the markets if the valuations do get reset.
While it will not be an easy time to invest (volatility never is), I believe investors constructing portfolios this year into the next few quarters will be doing it for strong returns next year. I do not believe that this will lead to a financial crisis, but instead will lead to a financial reset. This is how markets move forward and so does growth.
In the meanwhile, it is unfortunate that if the Fed and the regulators are not decisive, it will create a roadblock to some of the well-run companies who are making significant progress in innovation—be it in healthcare or climate control or medtech. This is the price we have to pay for the easy money we have seen over the last few years.
Naveen Chandramohan is the founder and fund manager of ITUS Capital.
The views expressed here are those of the author, and do not necessarily represent the views of BQ Prime or its editorial team.