On January 18, William C. Martin, a short seller and former hedge fund manager, warned his Twitter followers that they are missing something important about Silicon Valley Bank.
The SVB share lost about 65% of its value in the past 12 months. Investors are “justifiably fixated on the bank’s exposure to the corporate world,” he wrote.
“However, if you dig a little deeper, you’ll find a much wider range of problems,” he wrote.
What Martin saw was a plunge in the value of securities in the bank’s portfolio of bonds to maturity — government bonds and government-backed mortgage bonds that the bank held to repay its deposits.
Because the bank had no intention of selling the so-called HTM securities before maturity, it was allowed to value them in its books at the price at which they were purchased, rather than at their real-time value.
But the value of HTM shares fell as interest rates rose. It’s a natural phenomenon: fixed income bonds always lose value when interest rates rise and increase in value when interest rates fall.
If the bank were forced to sell those positions before expiration, Martin said it would be “functionally underwater.”
The SVB did not hide this problem. In its financial disclosure for the third quarter ended September 30, 2022, which Martin sourced, the company reported that its $93.3 billion held-to-maturity portfolio was worth only $77.4 billion in real time, with implied losses of $15.9 billion. That was significantly more than the bank’s total equity of $11.5 billion.
The bank’s situation did not improve significantly in the fourth quarter. It then reported that its HTM portfolio had shrunk slightly but still had unrealized losses of $15.16 billion. Accounting regulations require other securities marked “available for sale” to be valued at their current value, a process known as “marking-to-market.”
The fact that SVB’s problems were hidden from public view until the bank was acquired by California and federal authorities and closed on Friday will surely be high on the agenda as lawmakers, shareholders, customers and regulators weigh in on the disaster. to research.
As the bank’s primary regulator, it is the Federal Reserve’s responsibility to recognize the growing problems and ensure that it continues to meet standards of safety, soundness and financial stability, said Dennis Kelleher, CEO of Better Markets, a Washington-based regulator of financial institutions. and government regulators.
The bank’s operations are riddled with “screaming red flags,” Kelleher told me. These include a “hyper-concentration” of uninsured depositors from a limited sector of the economy – mainly high-tech and biotech start-ups – as well as a dramatic mismatch between assets (i.e. loans and investments) and liabilities (deposits) and the rising tide of unrealized losses in his books.
“It was visible to anyone who wanted to look,” Kelleher told me. “But apparently the Fed was AWOL.”
Kelleher notes that the Fed’s policy of keeping rates near zero during the pandemic has “created bubbles and reckless lending everywhere.”
The Fed made an unprecedented turnaround in interest rates in March 2022, raising rates by 4.5 percentage points in nine months. “Banks may not reposition their portfolios as quickly as the Fed changes policy.”
It was up to the Fed to scrutinize all the banks. Kelleher says Fed auditors should have asked last year for a plan from SVB management or the board of directors to reverse the large and growing disruption. It didn’t.
Another red flag for regulators should have been the bank’s rapid growth, which almost certainly strained management skills in the corporate suite.
Deposits rose from $49.3 billion at the end of 2018 to $189.2 billion at the end of 2021, before falling slightly to $173.1 billion at the end of last year.
The pullback was a sign that the venture capital-backed industry was slowing – venture capital firms were less able to free their money in the face of rising interest rates, which also created headwinds for their portfolio companies, which in turn had to scale back their deposits.
During the same period, the bank’s assets grew from $71 billion in 2018 to $211.8 billion at the end of last year. The vast majority of fixed-income assets appeared to have been purchased when interest rates were near zero, and were therefore vulnerable to depreciation if interest rates rose.
However, up to two-thirds of these holdings were in the held-to-maturity portfolio, so they were recorded on the bank’s balance sheet at purchase price rather than fair value.
It’s true that the banking rules that apply to institutions as large as the SVB were liberalized by President Trump in 2018, in part through lobbying by the SVB itself, but that doesn’t absolve the Fed from its obligation to review the bank’s operations says Kelher. .
The Fed was not alone in not noticing the magnitude of the SVB’s problems. Questions will certainly arise about the performance of the bank’s accounting firm, KPMG. The company gave the bank a clean bill of health, known as an “unqualified” audit opinion, in its annual report released Feb. 24.
KPMG expressed concern about the bank’s method of forecasting credit losses on some of its loans, but did not think it was inappropriate. Instead, it referred to the method as a “critical control issue,” typically dealing with matters that are “particularly challenging, subjective or complex” but do not warrant warning about an entity’s likelihood of failure.
It is true that the bank’s collapse developed after December 31, the end point of the KPMG audit. But the company could have been more explicit about the dangers lurking in the bank’s financial structure.
The role of venture capital firms and their portfolio companies also deserves attention. Many companies encouraged the start-ups they sponsored to bank with the SVB.
Indeed, a financial relationship with SVB was considered an honor for a start-up, a sign that it had real business potential. The terms of the loans SVB made to startups often required borrowers to do all of the banking with SVB, a mandate that concentrated the bank’s deposit file and exposed startups to the risks associated with the $250,000 limit associated with the FDIC for their deposit insurance. Some depositors had hundreds of millions of dollars in uninsured cash balances with SBV, an obviously reckless practice.
Complacency about the state of the SVB as its troubles mount is exemplified by stock market guru Jim Cramer, whose daily CNBC show is widely followed by amateur stock traders. On Feb. 8, Cramer named shares in SVB Financial, the bank’s parent company, as one of his “top 10 performers” for 2023.
Cramer called SVB a “commercial bank with a deposit base of which Wall Street is unduly concerned.” He argued that “long-term private equity and venture capital … will not go away, and being a banker of these vast resources of capital has always been a very good thing.”
Coincidentally, Cramer’s stock picks have such an inconsistent track record that an investment firm recently launched an exchange-traded fund that allows investors to take the other side of Cramer’s picks. Anyone who ignored Cramer’s advice about the SVB and shorted the stock instead of buying it would have made a hefty profit. Shares closed at $106.04 on Thursday and were practically zero the next day.
Source: LA Times