Silicon Valley Tank(s)

Uh, hey . . . are bank stocks supposed to do this?

That’s SVB Financial, the holding company for Silicon Valley Bank, in post-market trading on Wednesday. Shares fell 31 per cent* after hours, according to FactSet.

Our colleagues at mainFT covered the news that it’s raising $2.25bn of capital (in a $1.25bn common share offering, a $500mn placement with General Atlantic and a $500mn mandatory convertibles sale).

SVB also did something odd, as mainFT noted. It sold nearly all of the securities it held that were available for sale: around $21bn. It will take an $1.8bn after-tax loss on that.

The maths whizzes among us will notice that $2.25bn is a little more than $1.8bn. That makes it seem a tiny bit like the bank could have diluted its shareholders, in part, to cover the loss from liquidating its bond portfolio.

MainFT sharply observed last month that the bank’s securities holdings face significant interest-rate risk — especially its $91bn (as of Dec. 31) of held-to-maturity bonds. SVB didn’t say anything about reclassifying and liquidating held-to-maturity bonds Wednesday, though, and the size of the sale fits pretty well with its available-for-sale bond portfolio at year-end 2022.

In an investor deck, press release and letter, SVB includes lots of colour about how it wants to reinvest its cash and shorten the duration of its bond portfolio, which is on its face reasonable.

But even so, blowing out an entire $21bn portfolio’s worth of securities at high speed seems like a . . . suboptimal way to do that??

Interest rates are rising, but they aren’t expected to rise that much more from here. Why take a 8-to-9-per-cent haircut to sell highly liquid and credit-risk-free Treasuries and agencies?? According to SVB’s latest annual report, more than half of those bonds would mature in one to five years anyway:

For more detail, the bank says in a footnote to its investor presentation that the liquidation was “executed on March 8, 2023”, while the press release says the sales were “completed” Wednesday. We have contacted the bank to see if it can clarify the timeline, or provide further comment. We’ll update if they respond.

Anyway, SVB’s equity issuance, along with the kinda-sorta-maybe fire sale of its sellable bonds, certainly leaves an impression! (We should make clear that impression isn’t of another Silvergate; SVB’s asset base is more than 10 times larger than Silvergate’s was in late 2022.)

The news also left an impression on Moody’s, which cut SVB’s credit rating by one notch to Baa1. The analysts also downgraded the bank’s credit outlook to negative, because of “the potential negative implications for SVB if the declining venture capital investment activity and high cash burn does not subside”.

Moody’s’ full downgrade note is worth a read, but some parts stand out. For one, the analysts ding SVB’s management with a “governance” rating downgrade:

The significant change in SVB’s funding and profitability profile over a short time suggests higher tolerance for risk in its financial strategy and risk management than Moody’s had previously incorporated . . . these financial profile changes followed by a significant balance sheet restructure indicate that SVB’s risk governance, risk limits, and balance of shareholder and creditor interests posed higher than average governance challenges.

They also take a look at the bank’s funding sources (and costs):

Rising interest rates and increased macroeconomic uncertainty coupled with declining venture capital investment activity and high cash burn among SVB’s clients have created challenging conditions for the firm. This led to a significant increase in wholesale funding in the second half of 2022 . . . 

SVB’s financial profile benefits from an abundance of client funds, which includes on balance sheet deposits and off balance sheet client investment funds. Its average client funds were a high $348 billion in Q4 2022 and almost evenly split between on and off balance sheet. However, these average balances declined about 11% from a year earlier, with most of the decline in off balance sheet funds. Meanwhile, the cost of deposits increased to a high 1.17% for Q4 as SVB paid up to retain deposits, which is almost twice the 0.65% median of large US peers.

In other words, it’s not just about bond prices (and returns) going down when yields and interest rates go up. That’s just why the sale brought a loss that needed to be covered.

The more important question is why the bank needed to liquidate its bond portfolio so quickly in the first place. That steers us towards its funding, deposit base and client funds (both on- and off-balance sheet). As Moody’s says in the quote above, SVB’s average client fund balances are declining and deposits are getting more expensive to hang on to.

SVB blamed cash burn (read: not a run) for the outflows in its Wednesday presentation:

In its most recent 10-K, SVB reported a couple of other reasons for the deposit decline last year. With our emphasis:

The decrease in deposits of $16.1 billion compared to December 31, 2021, was primarily driven by slowdown in public and private fundraising and exits as well as increased client cash burn, partially offset by flexible liquidity solutions that shifted off-balance sheet client funds on-balance sheet, all of which reduced the proportion of noninterest-bearing deposits.

Also, if anyone is wondering what an “off-balance-sheet client fund” is, you can find a breakdown in SVB’s Wednesday presentation:

The off-balance-sheet “managed funds” seem interesting! To be generous, that 27-per-cent could be invested solely in money-market funds run by third parties. Or it could be invested elsewhere. ¯_ (ツ)_/¯

Another way SVB offset its 2022 deposit decline was by getting short-term loans (called advances) from the San Francisco Federal Home Loan Bank. SVB had at least $15bn of FHLB advances on its balance sheet at the end of last year, with $13bn of that maturing within a year.

The short-term advances, for example, were costing SVB about 4.3 per cent at the end of last year. These higher funding costs have cut into SVB’s all-important net interest margin, Moody’s says, which is another factor contributing to the firm’s downgrade.

There are other interesting bits to pull from SVB’s latest 10-K filing after of the equity-raise news and the Moody’s downgrade. For example, on the question of off-balance-sheet commitments (different than off-balance sheet funding, we suppose, but still interesting):

Excluded from the tables above are unfunded commitment obligations of $164 million to our managed funds of funds and other fund investments for which neither the payment, timing, nor eventual obligation is certain . . . we make commitments to invest in venture capital and private equity funds, which in turn make investments generally in, or in some cases make loans to, privately-held companies. Commitments to invest in these funds are generally made for a 10-year period from the inception of the fund. Although the limited partnership agreements governing these investments typically do not restrict the general partners from calling 100% of committed capital in one year, it is customary for these funds to generally call most of the capital commitments over 5 to 7 years; however in certain cases, the funds may not call 100% of committed capital over the life of the fund.

Oh, and we haven’t even gotten into Moody’s warning about “double leverage”, which occurs when a bank holding company’s equity stake in its subsidiaries is larger than its own outstanding equity:

Moody’s also noted that SVB’s double leverage has become elevated. Moody’s believes this double leverage exposes SVB holding company creditors to higher credit risk, including increased structural subordination and the holding company’s greater reliance on common dividends from its bank subsidiary to service its holding company debt obligations. If this double leverage is not reduced, it could result in wider notching of holding company ratings.

In a helpful note from last year, Fitch says “high double leverage could signal difficulty in the [bank holding company] meeting its debt obligations without upstreaming capital from its operating subsidiaries.”

But all of this largely backs up one broad view: Silicon Valley Bank’s profitability and now share price are becoming casualties of rising US interest rates.

Or, to mangle a bank fundraising deck into meme-speak: SVB Financial’s “We have excellent capital and funding!” T-shirt has people asking lot of questions already answered by its shirt.

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*OK, part of the stock’s decline is just from expected dilution, since SVB plans to issue equity totalling about 14-per-cent of its closing market capitalisation on March 8. But the deal hasn’t closed! So we’re using the absolute number. We also feel comfortable calling it a sell-off because, as you can see, 31 per cent is quite a bit larger than the proposed dilution.