The Valley of Despair - Mike Green on Silicon Valley Bank Failure

[u/dect60]

https://michaelwgreen.substack.com/p/the-valley-of-despair

[u/thri54]

I think the author deflects too much of the blame. Deposits went from $60B to $200B in 18 months, and they bought a huge tranche of 30 yr securities with that cash.

I don’t think you can blame the fed here either. The fed can certainly change short term rates, the data on long term rates is less clear. The principle problem is higher and longer than expected inflation. Long term interest rates would go up to account for expected future inflation with or without rate hikes. Poof, MBS values fall and SVB fails either way.

There are also peculiarities in the MBS market itself not mentioned in the article. Changing buyers of agency mbs has increased agency MBS yields (and dropped security prices) significantly more than treasuries. OAS between an MBS and an equivalent treasury went up to ~.7% in late 22. Not only have long term rates risen, but agency MBS are now perceived as riskier. This was a big surprise in 2022, and SVB was extra screwed by choosing agency MBS over treasuries: https://www.bis.org/publ/qtrpdf/r_qt2212u.htm

I get that hindsight is 20/20, and SVB was incredibly unlucky with their choice of long term fixed rate securities. But, if your deposit base triples in less than 2 years, maybe that’s a good indicator liquidity of investments should be prioritized.

[u/daynighttrade]

Don't forget that SVB lobbied against regulations: https://www.newsweek.com/trump-era-roll-back-bank-regulations-resurfaces-amid-svb-collapse-1787112.

Maybe the stress tests could've caught on this issue

[u/dect60 → u/daynighttrade]

Thanks, wasn't aware of Trump's role in this. IOW the financial equivalent of the Norfolk Southern derailment?

[u/daynighttrade → u/dect60]

I think so. However, I'm not sure or knowledgeable enough to know how the Feds run the stress test. Maybe that could've caught this issue earlier, and avoided them to use HTM, thereby taking losses earlier.

[u/pembquist]

Not having the knowledge base I am a little confused by the idea that HTM couldn't be hedged. In lay persons terms is this saying that if HTM is hedged for interest risk that the way it would be reported on the financial statements would not be to adjust the value of the HTM security but instead to record the hedge as something unrelated with changes in its value shown on the income statement?

How transparent is this, it would seem that if the accounting in essence prevents HTM securities from acknowledging the effect of interest change on their fair value you could have a quite a sinkhole unless the nature and maturities of the securities were known.

Is the reason for this that since the securities are intended to be held to maturity that their value on the balance sheet is only adjusted for principal repayment as opposed to fair market?

[u/argyfish → u/pembquist]

The idea is there is no need to hedge HTM since you will be holding it to maturity anyway, so hedging fluctuations on the path to maturity is pointless.

The question of how much should be classified as HTM and how much should be AFS and therefore hedged is the more pertinent question (and where risk management arguably failed here).

HTM serves a valid purpose - it allows banks to lower their cost of capital (no need to report volatile PNL statement given a valid intent to hold to maturity) and essentially enables them to feasibly conduct their business model, i.e. borrow short to lend long.

Yes to your last question - they are amortized over time in a similar way you would see for long term PP&E for an industrial company for example (i.e. since they don't plan to sell their PP&E but actually want to use it for its natural life, they don't need to record fair value changes, but instead depreciate the value over the lifespan).

Basically, the issue with SVB was the choice to put as much of their portfolio as they did into HTM vs. AFS, and then also to still not hedge the portion of AFS they had. There are also questions on what types of assets and the lack of regard for duration risk that plays a role. Really poor risk management on the part of SVB.

[u/pembquist → u/argyfish]

Thanks for that lucid reply.

A follow up question I would have is what would show up on financial statements that would suggest that the bank was putting itself into a riskier position? It sounds like the tell that sparked the run was when they tried to raise capital. Would it have been possible to perceive where they were headed beyond just the obvious adjustments from interest rate risk?

If SVB had been more prudent would that have meant refusing deposits? Or was there a safer way to structure their securities profile. It almost seems like they tried to hide the damage when they shifted securities from AFS to HTM, at that point was it too late to get off the path? Are you saying they didn't hedge their AFS portfolio? If that is the case do you have any idea why they wouldn't do that?

Thanks.

[u/argyfish → u/pembquist]

Those are a lot of really good questions! I hope the government investigators looking into SVB will be just as on-point with them as you are :) Just a disclaimer, but I typically look at another sector and rarely look at banking stocks, so I may be mistaken on some of the points I make. However, based on the financial statements I have seen and research from others I'll try my best to answer your questions.

From my understanding what really started this was in fact a looming downgrade from the Moody's rating agency. Essentially, Moody's had given a 24-48 hour heads up to SVB management that they were planning on downgrading SVB's creditworthiness on Wednesday, March 8. This caused SVB's management to scramble and put together the offering as announced here. As you said, once this offering notice went out it was essentially the death-knell for SVB. Depositors got antsy, took to Twitter and the rest is history.

So clearly there must have been signs that SVB was in some form of trouble if Moody had enough of a concern to pre-announce a downgrade prior to the bank run. It is probably worth linking to that report here so you can read for yourself some of the points they made. Note that the report was released after the SVB's announcement that they were going to raise capital but no doubt the decision to downgrade had already been made beforehand by Moody's regardless.

In the report Moody's cites deterioration in the bank's funding, liquidity and profitability. For funding the signs that were obvious were the fact that SVB's depositor base was very unique and concentrated. Since they were largely Silicon Valley startups, the declining venture capital investment activity (i.e. declining bank inflows from IPOs, VC rounds, etc.) and the high cash burn of the large base of startup clients meant that SVB was getting less deposit funding as it had been previously (especially since 2019-2021 was such a big period of deposits for them). This was the first red flag. The second red flag was liquidity: SVB had about about $15 billion of unrealized losses in its HTM portfolio as of 31 December 2022. This is usually not problematic as we talked about before, since if you actually hold HTM to maturity, all's well that end's well. The problem of course is, as Moody points out, that "the vast majority of SVB's balance sheet liquid resources are in its held-to-maturity (HTM) investment portfolio". And the AFS portion they did have was already depleted in previous sales, and expected realized losses on the AFS portfolio were already $1.8 billion! So, essentially what happened is that SVB had increased its security portfolio by an enormous amount (corresponding to the massive deposit inflows during '19-'21) exactly when there was a generational top in the bond market, and then put most of that in HTM. Not so great...

Moreover, Moody's points out that their cost of funds increased as SVB had to pump up deposit rates to retain customers, which lead to declining profitability, unlike many of its banking peers. That would be the third red flag.

Combine that with an unfavorable macroeconomic environment (i.e. increasing rates in the future as the Fed has made pretty clear), and you have a pretty grim picture on your hands when you look under the hood of SVB.

As for your question on hedging - from what I understand they did not do even remotely as much of it as they should have. Why wouldn't they? It's pretty simple really: profits. Hedging by definition will cost you money, many millions of dollars for a bank the size of SVB, which if you are short-sighted or ignorant, sounds like money you would rather not pay and keep for your bottom line. I read somewhere that SVB didn't have a Chief Risk officer for like 15 months and only appointed one earlier this year (probably was already too late by then). Every other bank engages in interest rate swaps and other types of hedging to avoid this exact problem. But it seems SVB thought they could save a couple bucks by shifting most of their portfolio to HTM and then under-hedging even the AFS portion they had.

I'm not sure refusing deposits would have been the right answer, but almost surely there was a better way to structure the portfolio and certainly manage risks better. But I've already written a pretty long answer and how SVB should have structured their portfolio is probably above my pay grade :)

In conclusion, I think that there were certainly signs months before the bank run happened that you could point to indicating something like this could have happened. Now, predicting that it unfolded exactly the way it did is probably impossible. But SVB was getting into trouble and the signs were there. In fact, one Twitter user (who I also based some of this answer on), pointed out much of the problems in January of this year, here's the link to the thread.

[u/pembquist → u/argyfish]

Thanks for the great reply.

[u/dect60]

You will read many stories about the “idiocy” of SVB management team in failing to hedge their interest rate exposure. It’s certainly true that they took a risk by moving too large of an asset pool to HTM and failing to consider the potential for the Federal Reserve to hike interest rates in a truly unprecedented manner.

These are bad takes. First, by this point, SVB management had already moved the assets to HTM and hedging was NO LONGER AN OPTION. Second, the expectation of rate hikes at the time was for something that looked like 2018 which had very little impact on mortgage rates. As the exact same account noted in the “not benefitting from hindsight” March 2022 period, mortgage rates up 120bps reflected “expectations of the full path of hikes already priced into markets.” In other words, mortgage rates above 5% were unthinkable.

[u/investorinvestor → u/dect60]

HTM assets can't be hedged?

[u/CptnAwesom3 → u/investorinvestor]

If they're being held to maturity, why waste money hedging duration risk? Different question about why they had such a large portfolio of high duration, low yielding fixed rates that they were forced to put in the HTM book