WHAT HAPPENED AT SILICON VALLEY BANK?
What caused a run on the bank’s deposits? The short answer is, a liquidity problem caused by mis-marking asset values used for loan collateral in a climate of rising interest rates.
Here is a quick review…
-Silicon Valley Bank is in the business of providing debt financing to hundreds of tech startups. (See, Crunchbase).
– SIVB’s internal financings come from public offerings and HTM (hold-to- maturity) and AFS (available-for-sale) securities trading. (See, SIVB 10-K.)
– In 2021, SIVB converted a significant value of “available-for-sale” securities to a “hold to maturity” securities. “Available for sale” (AFS) securities are marked to market daily, like mutual fund assets, and are therefore highly liquid. Conversely, “hold-to-maturity” securities must be held to maturity and are therefore not liquid and, may require asset write-downs in the face of rising market interest rates.
– 2022-23 put a liquidity crunch on SIVB in three ways:
…clients (VC companies) burned through cash at a rate higher than expected (so client deposit assets decreased)
…the “available-for-sale” securities pool had decreased (because of the transfer of asset in 2021 from AVS to HTM), dropping liquidity
…the “hold-to-maturity” (HTM) securities pool increased in 2021, but but lost value, since interest rates rose in the same period. Critically, the only way to use HTM securities as collateral for repo and other borrowing was to mark the assets to market–which would require a significant asset write-down.
– As result of the above, SIVB was unable to finance operations through the usual treasury functions, so it was forced to sell assets to finance operations.
– Peter Theil caught wind of asset sales and panicked, telling his portfolio companies to withdraw deposits.
– Everyone in the Theil universe did the same, so Friday (March 10, 2023) started a bank run.
THE AFTERMATH
Over the following weekend, the US Treasury announced the extraordinary measure of backstopping any and all US bank deposits, irrespective of deposit amount. The Treasury explained that the SIVB failure created “exigent circumstances” requiring the system-wide backstop. Under the new facility, banks can pledge assets for a 1-year loan, irrespective of underlying value of the pledged assets. So, once more, Treasury and the Fed delay the day of valuation reckoning for bank alternative assets used for collateral.
But can the day of valuation reckoning be postponed on a broader scale across the entire economy? That seems unlikely, without causing a system crash.
The most vulnerable market is the massive repo market that trades $4 trillion in short-term lending each night, using securities assets as collateral. The non-bank portion of the repo market (half of the total, or $2 trillion per night) is made up of illiquid assets valued at net asset value (“mark-to-model”) instead of fair market value (mark-to-market). To the extent repo traders require fair value of non-bank assets pledged as collateral for repo loans, the repo market will almost certainly seize up again, as it did in Sept. 2019.
At some point, the Fed and Treasury will be unable to backstop trades made with mis-marked asset collateral, and the entire edifice built on net asset values will collapse. In our view, that day of reckoning is likely arrive later this year, in September, after collateral problems have worked through a broader range of securities trades.
CONCLUSION
The SIVB liquidity squeeze forebears problems in treasury operations for all large corporations and banks. Too little attention has been paid to the quality of underlying assets; assets valued at net asset value, such as “hold-to-maturity” securities, have been favored by asset managers over assets valued at fair market value. But valuations at net asset value are misleading, to say the least, since assets designated “hold-to-maturity” are not regularly marked to market and, as a result, actual asset value is unknown.
Many asset managers and corporate CFO’s like the ambiguity of net asset value (NAV) valuation just fine–it gives them room to (mis)represent asset values, delaying the inevitable mark-to-market reconciliation required for asset sale or collateral pledges in a down market.
But the combination of a decreasing pool of liquid securities, in favor of an increasing pool of hold-to-maturity securities, takes away a critical tool for cash management. Likewise, the hold-to-maturity securities have a lower value, and therefore require a higher haircut when pledged as collateral against corporate borrowing.
Unfortunately, this liquidity squeeze was just the beginning. We should expect more liquidity events like this one–particularly in the repo market.