Quick Take: 3 things an investor must understand

Mar 31, 2023

Silicon Valley Bank was the second-largest bank failure in U.S. history.

Per public filings, SVB’s deposit base jumped from $49 billion at the end of 2018 to $189 billion at the end of 2021. Venture capital funding was at all-time highs during this period and startups receiving funding often put the proceeds into SVB bank accounts. SVB’s deposit base grew by approximately 57% per year in this period while industry deposit growth was only 12% per year, according to Morningstar’s research.

Close to half its deposit base originated from technology companies, and most of those were early-stage technology companies. Traditional retail deposits, which tend to be stickier and smaller than the $250,000 insured by the FDIC, composed a relatively small portion of SVB’s depositor base, making it more prone to a bank run.

As deposits grew rapidly at SVB, the bank increasingly purchased fixed-income investments. The bonds they purchased (predominantly mortgage-backed securities) were high-quality, but were long in duration, with the weighted average maturity over 10 years.

What you need to understand: An Asset-Liability mismatch

Shortly after making these investments, the Federal Reserve began one of its most aggressive rate-hiking periods in history. As interest rates rose, the value of these bonds fell.

What you need to understand: Bond prices and interest rates move in opposite directions

While in theory, the bond losses only existed on paper (if SVB held the bonds until maturity, it would get all its money back, plus interest), the “mark-to-market,” or unrealized, losses from these investments were significant, exceeding the company’s tangible equity capital. Observing this, depositors became skittish, started redeeming their money.

SVB did not have enough cash and liquid assets available that could be sold to fund deposit outflows. It became a forced seller of many of those bonds to meet redemptions. The paper losses turned into actual losses and laid the foundation for the rush to the exit by SVB’s depositors.

What you need to understand: A Paper Loss is an unrealised loss that gets converted into an Actual Loss if you decide to sell. So refrain from hasty, impulsive decisions. 

Eventually, a flood of withdrawals from depositors destroyed the bank. Some have made comparisons to gym memberships. If every gym member showed up at the same time, not everybody would be able to work out. Banks are similar: If every depositor wants to pull their money at the same time, not everyone can get their money back.

The SVB story has a lot of components - the growth trajectory of its deposit base, concentration of its customers, peculiarity of its portfolio, and the relative lack of risk controls around the portfolio. Despite all this, it ultimately boiled down to an old-fashioned bank run.

This has been extracted from a detailed write-up by Philip Straehl, global head of research at Morningstar Investment Management 

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