Don’t Put All Your Eggs in Two Baskets!

Surprised? This is what has led to collapse of Silicon Valley Bank (SVB). On Friday 10 March, 2023, SVB Financial Group (SIVB.O), a bank focused on startups, became the largest bank to fail since the 2008 Global Financial Crisis (GFC). This sudden collapse caused disruptions in global markets and left companies and investors with billions of dollars stranded. California banking regulators shut down the Silicon Valley Bank. The Federal Deposit Insurance Corporation (FDIC) was appointed to take over and sell the bank's assets.

The two baskets

I am talking about Mortgage-backed securities (MSB)* on the asset side and large deposits made by startups on the liability side here. Usually, banks of all financial institutions are famous for diversifying their exposure. But it was a different case for SVB. Let’s look at the events on the timeline

*Mortgage backed Security: These are investment instruments that represent ownership interests in pools of mortgage loans, which are bundled together and sold to investors.

2021

SVB saw a massive influx in deposits, which jumped from $61.76bn to $189.20bn at the end of the year. As their deposits grew, SVB wanted to generate higher yields from their capital, but they couldn't grow their loan book fast enough to do so.

To maximize its profits, SVB decided to purchase a large amount of mortgage-backed securities (MBS) with their deposits. They invested over $80bn in MBS for their hold-to-maturity portfolio, with 97% of them being 10+ year duration with a weighted average yield of 1.56%.

2022-2023

Unfortunately, as the Federal Reserve raised interest rates in 2022 and continued to do so through 2023, the value of SVB's MBS plummeted. Investors could now purchase long-duration "risk-free" bonds from the Fed at a 2.5x higher yield than SVB's MBS.

2023

Although SVB maintained its deposits, the decrease in the value of its MBS posed a problem. To make up for their losses, SVB announced that they had sold $21bn of their Available For Sale (AFS) securities at a $1.8bn loss, and were raising another $2.25bn in equity and debt.

People were surprised when SVB sold their AFS portfolio, as they believed the company had enough liquidity. SVB had focused on managing excess cash and services, stretching their assets too far into the risk spectrum. VCs panic messaging caused a morbid bank run.

SVB is a classic case of asset-liability mismatch where a bank has to pay its liabilities in the long term but has to pay for short-term reasons because the bank has booked the deposit as a long-term asset, but the liability needs to be paid in the short term.

SVB learned the hard way that they shouldn't put all their eggs in two baskets - in this case, asset and liability - and should diversify their investments to mitigate risks.

Why has Y Combinator sent a petition to the US government seeking relief?

Y Combinator has petitioned the US Treasury Secretary over the collapse of Silicon Valley Bank, freezing deposits of hundreds of startups. 40 Y Combinator-backed Indian startups have deposits with SVB, with over 20 having over $1 million each. Gaming company Nazara Technologies informed the exchanges on Sunday that two of its step-down subsidiaries had cash balances aggregating to $7.75 million held at SVB. Other Y Combinator incubated startups such as Khatabook, Zepto and OkCredit have not yet disclosed the amount.

In the petition, Garry Tan, CEO of Y Combinator urged the US government to make small business depositors at SVB whole and to conduct a backstop of depositors.

The petition urges the US government to help small business depositors at SVB and prevent payroll-related furlough or shutdown. The situation highlights the need for stronger regulatory oversight and capital requirements for regional banks.

After SVB's sudden closure, many companies lent a helping hand. Razorpay and AngelList are providing emergency services to startups affected by the closure. Razorpay offers zero transfer charges on its platform, while AngelList has developed a product called the Lifeline Agreement to help access banking and loan agreement documents. Investors and founders are also providing short-term loans. However, some banks may increase fees due to the influx of funds.

White or black knights?

SVB Financial, the company that owns Silicon Valley Bank, is looking to sell some of its other assets such as investment bank SVB Securities, wealth manager Boston Private, and equity research firm MoffettNathanson. The potential buyers of SVB's assets, including venture investors and even Elon Musk, have stirred up speculation about their intentions. As per latest development in this matter, HSBC bought UK arm of Silicon Valley Bank for £1 or ₹99, gets deposits worth US$ 8.1bn.

While some may see them as white knights coming to the rescue, others may question whether they are black knights looking to capitalize on an opportunity. The discounted rates (70 to 50 cents for a dollar) at which some investors have offered to buy SVB's deposits may provide some immediate relief but the full impact on depositors remains to be seen. Only time will tell whether these buyers will ultimately be viewed as heroes or opportunists.

Is the Fed really forced to pivot?

Despite the similarities in terms of asset value, opinions remain mixed on the chances of these failures sparking a crisis similar to 2008. But the failure has made the Fed cautious about market play. Around the world, the market crashed. Trading was halted for many US banks due to volatility. Trading was halted for stocks including PacWest Bancorp, Zions Bancorporation, First Republic Bank, Regions Financial. The sector is once again selling off sharply in early trading Monday.

Investors betting on a sudden shift in the Fed's approach from raising rates to cutting them due to a shift in the economy is unrealistic as macro data takes time to unwind. The Fed is more concerned about making a dovish mistake and letting inflation take hold than a hawkish one. A true pivot would require a danger to financial stability, and the Fed may change course now that something has broken.The current market conditions have led the experts to predict a change in the course of interest rates now that there is trouble brewing in the banking sector. Only time will tell what course of action the Fed will take.

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