The Collapse of SVB - What Happened (First Domino to Fall)

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1. The Collapse of SVB - What Happened (First Domino to Fall)

Good morning and happy Monday - let's get smarter

The Collapse of SVB - What Happened (First Domino to Fall)

What a wild week in markets

The collapse of Silicon Valley Bank has created a wide spread panic across the financial system

Many startups I am involved with luckily do not bank with SVB, but are still looking to move money to larger institutions like Bank of America or JP Morgan due to concern over smaller regional banks ending up with the same fate

There are lot of articles, posts, etc, on this topic

In order to properly understand what actually happened, it's important to understand how banks make money

Banks make money from a variety of different ways including:

1. Investment banking fees (success based fees for advising on IPO’s, capital raise, M&A)

2. Lending fees

3. Investment gains

4. Card income

And various others. But their biggest source of income?

Net interest income

What is net interest income? The difference between the interest rate a bank pays to depositors or lenders (for their loans/debt) and the interest rate it receives from loans to consumers (you)

 Aka (interest income - interest expense)

Banks typically take out short term loans, and loan that money to you long term

Example: JP Morgan takes out a loan of $1m at 5% interest and loans it to you for 10 years at 8% interest

They collect the difference between the 8% - 5% as net interest income

So... what would make banks hurt? When the fed raises interest rates (remember the fed impacts short end of the yield curve, not the long end. I explain this in detail below)

So if they raise the 2 year interest rate and JP Morgan now has to pay more interest on the loan they took out than the interest on the loan they gave you…. Uhhhh ohhh

Now.. they aren’t making money

You can see below how big “net interest income” is on JP Morgan’s 2021 income statement below $52 billion out of $122 billion comes from net interest income or 43%

JP Morgan highlighted this as a risk to their business: If central banks introduce interest rate increases more quickly than anticipated, this results in a misalignment in the pricing of short-term and long-term borrowings

Banks generate most of their income from taking on liabilities/debt at lower interest rates than the interest rates they are collecting on cash that they loan out to others as discussed above

Your deposits represent liabilities for the bank

If you want to pull your money out, they owe you that money. So it's a liability to them

Banks are taking deposits from people like you and I or what they could call retail deposits, similar to the term retail traders for Robinhood traders during COVID

They are also taking deposits from companies that are a much larger base of their deposits

Silicon Valley Bank had 52% of their deposits coming from startups

One of the main differences between deposits from you and I versus a startup isn't likely large swings in these deposits/account balances. Our deposits are "sticky"

We also aren't actively pulling out cash, our balances are relatively stable

Startups deposits are generally considered higher risk to a bank than retail deposits due to several factors, including:

Uncertainty of cash flows: Startups are typically in the early stages of business and may not have an established cash flow or revenue stream. This can make it difficult for the bank to assess the startup's ability to repay the deposit.

Lack of collateral: Startups may not have the assets or collateral to secure the deposit, which can increase the risk of default.

Higher failure rate: Startups have a higher failure rate than established businesses, which can increase the risk of default and loss to the bank.

Limited credit history: Startups may not have an extensive credit history or credit score, which can make it difficult for the bank to evaluate their creditworthiness.

Higher interest rates: Startups may be required to pay a higher interest rate on their deposits to compensate for the higher risk.

So Silicon Valley Bank had over half of their customers deposits with high risk startups who's cash balances are decreasing, making it harder to understand the potential liabilities they would have to payout customers deposits with the wide variability of startup cash balances

These represent Silicon Valley's liability section of the balance sheet - money owed to their customers when they withdraw

On the asset side, or how SVB would make money, due to a decreasing demand for bank loans (remember, banks make a significant portion of their money loaning out money and collecting interest income), SVB's assets were mostly in something called HTM (held-to-maturity securities), such as bonds and notes that are longer-term

Held-to-maturity securities are investments that a bank intends to hold until they mature, and they are classified as such on the bank's balance sheet. These securities are typically fixed-income investments such as bonds, notes, or other debt securities that have a specific maturity date and a fixed interest rate.

Banks purchase held-to-maturity securities with the intention of earning interest income over the life of the investment and holding the securities until maturity. Unlike trading securities or available-for-sale securities, held-to-maturity securities are not subject to the same level of market fluctuations, as they are not intended to be sold before their maturity date.

The interest income earned on these securities is recognized over the life of the investment (so slowly year over year) and is included in the bank's income statement

SVB's assets and the income they were generating from these assets was 1.5%

Today - you and I could buy a bond and get 5% interest, but they had longer-term, fixed interest income assets, so their interest income wasn't moving with changes in interest rates

So they are generating extremely low interest income with their assets that are held on average for 6.2 years, so not readily available/liquid

So now - in an environment with an inverted yield curve where banks are not making money on the net interest margin, having their assets in longer term/longer duration bonds that aren't liquid and having a large amount of customer deposits/liabilities that customers went to withdrawal in the short term, they didn't have the assets to cover their liabilities/customer deposits.

Losing income on net interest margin + mismatch on duration between their assets and liabilities = disaster 

Long dated illiquid bonds, losing money, with highly volatile startup customer deposits/liabilities = the collapsing of banking

This is only the first domino to fall, there is more chaos to come

Don't chase risk assets like tech stocks or crypto, now is not the time.

Be prepared

- Dev

DISCLAIMER: None of this is financial advice. This newsletter is strictly educational and is not investment advice or a solicitation to buy or sell any assets or to make any financial decisions. Please be careful and do your own research.