Argonaut has been short Silicon Valley Bank (SVIB) for the last six months, with an average entry price of $260. On Wednesday evening, the bank announced a $2.5bn equity raise and a $21bn sale of held-to-maturity Treasury and Agency securities (which realized a $1.8bn loss). Subsequently, its share price fell 60%. Today, it has been reported that the capital raising has failed, and the bank is working on a sale, which in our view will not recover any value for its equity investors. After falling another 40% pre-market, the stock has been suspended from trading.
SIVB is a business (as opposed to retail) bank focusing on venture capital clients in California. With $211bn of assets it is the 16th biggest bank in the United States. Since 2018 its balance sheet has grown exponentially as the bank took cash raised by its clients in Silicon Valley as deposits (See Fig 1: SIVB Balance Sheet). Instead of making loans with this funding, the bank bought Mortgage (MBS) and Treasury securities. Assets increased from just $57bn to $211bn in just three years. As recently as its Q4 2022 results in January, the bank claimed theirs was an example of a “high-quality balance sheet” with only 43% of its assets in customer loans (the lowest in its peer group). In an investment world where duration risk has become a bigger problem than credit risk, these “high-quality” assets ironically become more risky than conventional bank loans.
Fig 1: SIVB Balance Sheet1
Deposits increased from just $52bn in 2018 to $190bn by 2021. Additionally, over half of its deposits did not pay any interest, and whilst Fed Funds were near zero, the rest didn’t cost much either. With all this free money, SIVB entered into what it believed to be a “high-quality” carry trade, investing in a securities portfolio with little default risk but which had in fact locked in a measly average yield of 1.6%, at the top of the bond market. At the end of last year, the bank’s agency mortgage assets had increased by just $13bn to $99bn in the space of just a few years.
Our analysis of SIVB’s balance sheet 6 months ago suggested it was already insolvent. Its last 10-K Form lodged with the SEC included disclosure of a $15bn “unrealized loss” on its “high quality” securities portfolio, caused by rising interest rates, which if realized would wipe out the company’s entire $11bn of tangible equity (See Fig 2: SIVB Unrealized Losses). In other words, the “high-quality” carry-trade which the bank had entered with its “free money” customer deposits had already blown-up spectacularly.
Fig 2: SIVB Unrealized Losses2
Banks are allowed to hold security portfolio assets as “hold to maturity” and not market them to market, so none of these losses were reflected in SIVB’s recent results. If SIVB could continue to fund the assets, it could hold them to maturity without taking a hit on its P&L or shareholders’ capital. But SIVB was losing deposits (not only because their clients were burning cash but also because they couldn’t afford to be competitive in bidding for new deposits because of the incrementally negative spread on their liabilities versus their assets). They were also already maxed out on their borrowing from the lender of last resort, the San Francisco Federal Home Loan Bank, and had already pledged much of their high quality collateral to secure this funding.
On Wednesday night SIVB announced it had been forced to sell some 20% of their securities portfolio. This crystallized some ($1.8bn) of their market-to-market loss on its securities portfolio but also meant they needed to raise new equity to plug the realized hole in their balance sheet. However, since investors knew there was also a potential $13bn of further unrealized losses, enthusiasm for committing to new capital was understandably limited. Moreover, since nearly all of the bank’s deposits were uninsured against losses (not retail deposits) their Silicon Valley business customers were highly incentivized to cash out their deposits as fast as possible. Replacing $2bn of tangible equity was tricky but replacing billions of “return free risk” deposits to fund an unprofitable carry trade proved impossible.
The FDIC has just announced that the bank has officially failed. The bank’s assets will now likely be liquidated. We would expect equity holders to be wiped out, bond holders to suffer losses, with there also being some risk for uninsured depositors. There is likely to be some contagion: banks with similar business models, mark-to-market losses and unstable funding, where Argonaut also has short positions. However, we believe that the big banks and global financial institutions will emerge largely unscathed, since their securities portfolios are a smaller proportion of their balance sheet, they do not share SIVB’s funding issues, nor is this “silicon rupture” a reflection of deterioration in the credit cycle.
1 Source: Company Presentation, Jan 2023
2 Source: SEC Form 10-K 31st Dec 2022 P125