At the end of this week we saw increased volatility. VIX has spiked in last two days amid anxiety over Silicon Valley Bank (SVB) default risk and potential implications for the regional banks and private equity sectors, and overall increase in systemic risk. VIX has spiked 45% this week, and 20% alone on Friday, when it temporary touched 28.97 – highest reading since October’22 sell-off, with option volume 3.7x the typical daily volume. Calls made 70% of volume and the put-call ratio was at 1.3 compare to average of 1.5 over 2022.

SVB had billions in deposits of his Venture Clients, and last year invested them into longer-term bonds, while the rates only started to go up. SVB’s miscalculation was made on two fronts:

• SVB underestimated FED’s commitment to hiking rates further and locked in their funds at rates which soon became unattractive, pushing their bond’s portfolio value down.
• SVB also underestimated significant increase in deposit withdrawals, caused increased capital calls by private funds and by the pressure on PE valuations, amid last-year’s tech sell-off in the public markets.

After the announcement of bank struggles, VC community created run on the SVB bank by announcing that everyone who can should be withdrawing their money. Amid this run on bank, Federal Deposit Insurance Corporation halted its trading and put it in the receivership on Friday. As per the early estimates, depositors will be made whole, senior bond holder should recover 0.4/1$ and junior debt and equity holders will be wiped out.

 

Financial sector perspective

SVB is the 16th largest banks in US, and it’s failure is the biggest failure since GFC. It’s failure may call depositors into questioning safety of their assets in other smaller banks, putting whole sector at stress. This risks causing significant repricing in financial sector, which lost 8% of the market cap this week, with most significant impact on the smaller banks.

This is a second bank who failed this week. Although Silvergate Bank failure was due to crypto market issues, it also had a mismatch between asset and liabilities. This situation brings financial stability issue back on the table for the FED, and may reduce their appetitive for 50 bps hike in the upcoming meeting.

The danger of not acting fast enough is that businesses may reconsider banking with anyone but “too big to fail” banks (associated with perceived, additional regulatory protection). This could strengthen position of  big 4 banks and put a significant pressure on the regional banks. Size of this opportunity is huge, and applies to about third of all business deposits in US.

 

Private Equity sector perspective

Specifically for the Silicon Valley investors, this is a Lehman Brothers moment, and probably the most significant financial event in 20 years, including GFC and Covid crash. Recalling the GFC; back in 2008 regulators thought that best course of action is to let Lehman Brothers bank to fall for bankruptcy, but this lead to the cascading effect. In comparison SVB is smaller and concentrated with less links to the rest of the economy. It collapse mostly affects private equity sector, small tech companies and venture capital community.

SVC served half (or about 65,000 out of 130,000 according to PitchBook) of US VC-backed startups. The reason for this concentration is that startups are usually loss making entities which had a difficult time taking credit cards or loan from a regular bank. This was an opportunity for the SVB which tapped into this niche and begin to specialize in providing banking services tailored to the startups needs. SVB collapse could result in a thousands of startups not being able to fund their operational over next few weeks, as their cash reserves are tight up in the bank under the receivership (more details on FDIC website). Prominent Silicon Valley investor, Garry Tan called it “extinction level event” for startups.

Time required to sell off assets and recover funds is too long to keep those companies alive. FDIC has guaranteed access to up to $250k by Monday, but any amount above that would only be accessible much later through conversion of the receivership certificate (which could be sold to Hedge Funds at heavy discounts). It’s important to acknowledge that FDIC guarantee might be insufficient to address needs of venture community, as only 4% of deposits are below $250k.

Even with relatively small size, SVB collapse may have a lasting impact on GDP. Startups are the power, that made California the richest state responsible for over 15% of US GDP, and world’s 5th biggest economy with it’s $3.36t GDP (in comparison, Germany – the Europe’s largest and world’s 4th largest economy, produced $4.22t GDP in 2022). Startups are vital for the future growth. They are the innovation engine that ensures US superpower status.

 

Conclusion

SVB case also highlights that amid such aggressive rate hikes, even long-dated treasuries becomes a risky investment. Even if SVB was not a subject of liquidity convergence ratio and was targeting very specific part of the economy, it is a first significant example of something is breaking. SVB collapse was caused by duration mismatch, but with monetary regime change and record rate hikes duration mismatch must impact of other financial firms. As of now most US banks are still paying below 1% to the majority of their deposits, while treasuries offer close to 5%. In the short run, they pushed savers into money market funds and leads to one of the largest withdrawals on record. In the long run deposit rates would need to be raised to ensure sufficient banking reserves and capitalization rate. On surface, this relatively conservative deposit rates reflect lack of demand for extra reserves, but they may as well signal concerns about duration mismatch in banking sector.

Also it is likely US economy has far more hidden credit risk which in contagion scenario, may start to surface and affect broader economy. This crisis should also have a negative effect on the corporate bond market, which until the last week traded at the lowest spreads since 2007 (see last week’s article). At the end impact of SVB depends on response of regulators and the FED and their ability to contain this risk and isolate its impact.