Did you hear about the tweet that collapsed a bank?

Like yelling fire in a crowded theater, everyone rushes for the door. In this case $42 billion ran for the door and out of Silicon Valley Bank. Bryne Hobart writes the Diff newsletter, which is read by almost every Venture Capital principle in the US. Hobart Tweeted on February 23 saying that Silicon Bank was insolvent, and when the bank announced a loss and a plan to raise capital, Peter Theil and other venture capitalists notified their companies to pull their money from SVB. In a classic “bank run”, SVB collapsed.

There were eleven things, in my opinion, that went wrong for Silicon Valley Bank.

• The CEO of the bank, Gregory Becker, has apparently not studied history. The key to stopping a bank run is to assure depositors that their money is safe. When money is deposited in a bank, it does not simply sit in a vault, it is loaned out. Bank runs were not uncommon prior to the implementation of the FDIC in the 1930s. The father of one of my professors at Carnegie Mellon University owned a bank in Nebraska, and he spoke of a potential run faced by that bank in the 1920s. Overnight, he drove to all the other banks and borrowed their cash. When the bank opened in the morning, as owner of the bank he stood on a desk and welcomed the depositors, telling them they could all get their money out. The depositors took their money, but many deposited it again when they saw that the bank remained solvent. Becker didn’t go above and beyond to ensure that depositors felt safe.
• The FDIC insures bank deposits of up to $250,000, but many of SBV clients were tech companies with millions of assets at the bank. Roku had over $400 million on deposit. To give such companies reassurance that their deposits are “insured”, banks typically buy “repos”, which are collateralized debt obligations, like mortgages. You are likely familiar with this concept; they were the investments which caused the 2008 Great Recession. Those repos generally had a 10-year maturity, but when the Federal Reserve began to raise rates. The value of those repos began to fall.
• Banks can designate holdings like repos as “hold to maturity”, meaning that they do not have to “mark to market”. By choosing to hold to maturity, the bank does not have to show on their balance sheet if the repos have lost money. However, it also means the bank could not hedge against the loss in value. In essence, SVB had overstated their assets and financially the bank and its shareholders were in worse shape than the financial statements related.
• Wall Street analysts and most investors tend to focus on income statements when assessing a company. SVB was aggressive in the way it portrayed its growth. I am a balance sheet guy, and had SVB been considered for our client portfolios(and it was not), I would have been alarmed by the deceptive way the repos being held to maturity covered up the real loss of value. Most, if not all, of the analysts missed that important detail or didn’t give it the weight it deserved.
• SVB was the bank of choice for many of the tech companies that had raised money from venture capital firms. The number of IPOs and merger deals peaked in early 2021, and in tandem the number of new deposits being made dropped dramatically. Simultaneously, many tech firms had not reached profitability and began to draw on their deposits. So, new deposits were dwindling, and old deposits were being reduced. The net affect is that SVB deposits had peaked at the end of 2021 and had been declining for over a year.
• The uninsured depositors at SVB were highly concentrated in emerging technology companies. For most large banks, fewer than 40% of their depositors are uninsured. Most of SVB’s depositors were uninsured.
• Coming out of the Great Recession, congress passed the Dodd Frank Bill, one aspect of which was the requirement that banks perform annual stress testing. The banks pushed back on that, and in 2018 there was bipartisan support to reduce the amount of testing, which President Trump signed into law. A stress test would probably have shown the impact of the Federal Reserve’s interest rate increases on the solvency of SVB.
• Bank regulators seemed to be missing in action. Regulators should have realized the risks SVB was taking and should have put them on an elevated oversight. SVB was fast growing with a concentrated set of depositors, and most of the deposits were uninsured.
• For about eight months in 2022, as deposits were in decline and the Federal Reserve was raising interest rates, SVB had no risk manager. The value of the treasuries and repos were declining and deposits were dropping. A risk manager was not appointed until January 2023.
• Since SVB had designated their repos as held-to-maturity, the bank had treasuries with low yields to sell. They sold at a loss of $1.8 billion and needed to replace that capital loss.
• Goldman Sachs was employed to raise capital to cover the loss plus some cushion. Goldman is a bank and should be very aware of how to not frighten the depositors, and yet Goldman placed only $500 million in new capital with a private firm. Goldman was ready to place an additional $1.75 billion through a stock offering. How could Goldman not have seen that SVB had concealed losses in the repos? They needed to place the entire capital raise with private investors.

These are the eleven  red flags I see. If I can see eleven, there are probably a dozen more that are not visible to the public.

My guess is the collapse of Silicon Valley Bank is a game changer for the stock market.

• Although there had been questions raised about the government guaranteeing the uninsured depositors, there is probably close to enough value in the repos and other capital to make depositors close to whole without government guarantees. Stockholders in SVB will very likely lose everything. There is a reason it is dangerous not to complete full due diligence on the stocks in your portfolio.
• The Federal Reserve will probably reassess additional interest rate increases. In 1994, when Alan Greenspan was chairman of the Federal Reserve, he dealt with inflation by raising interest rates seven times, for a total increase of 3%. The impact of those increases led to Orange County California to file for bankruptcy because their investments lost $1.6 billion. The Fed made one more interest rate increase and then stopped, soon reversing to lower rates. The current Fed, under Jerome Powell, almost has to assess the risk of further rate increases to the banking system.
• The Taylor Principle says that to reduce inflation the central bank, the Federal Reserve needs to have a higher interest rate than the rate of inflation. Currently, the rate of inflation measured by the Consumer Price Index (CPI) has been dropping for months, but the Personal Consumption Expenditures (PCE) is holding pretty steady at five percent (5%) per year. The PCE is a better indicator of true inflation and is the index that the Fed follows. If interest rates remain lower than six percent (6%), inflation is probably going to continue for years.
• Inflation, for the stock market in general, is not good. The DOW hit 1,000 in 1966, then dropped 20%. It recovered to 1,000 and then fell 30%. The DOW bounced back to 1,000 only to collapse 40%. It revived to 1,000 and then dropped 20% before beginning a climb that took the DOW to 1,000 in August 1982. For 16 years the stock market struggled.
• During those 16 years, there were stocks that did well. It was a stock picker’s market. We believe there will be those companies whose revenues and earnings will continue to do well when most companies and their stocks will have a tough time weathering the storm. We identified this in previous newsletters and on the radio.
• For the last seven years, we have been warning the readers of this newsletter, attendees at the Money Show, and listeners to our radio program that inflation would probably rear its head and last for a decade or more. We have been growing client portfolios during that time, anticipating drops and recoveries for our portfolios.
• We believe these inflationary times will see more volatility, and although we were surprised by the magnitude of the drop in 2022, we are already seeing a solid recovery underway for certain stocks, those in our client portfolios among them.