We thought it may be helpful to our readers to share our initial thoughts after the SIVB bailout. As we write this, CSFB has reported material weakness in its financial reporting so we’ll see if this will create further stress on the financial system.
In response to the SIVB collapse, the Fed had no choice but to take decisive action to further stem deposit outflows and the potential risks to the banking system. The Fed’s response was a comprehensive pledging of cash in exchange for all Treasuries, agency debt and mortgage-backed bonds without any discount being applied to face value. Commentators have described these actions as akin to quantitative easing on demand for the financial system.
Below is a chart of the Fed Funds rate dating back to the 1950s. As recent history shows, the Fed had embarked on a policy of ultra-low interest rates – brought on by the GFC and again by the Covid pandemic – that were unprecedented in scale and duration. This created unintended consequences and fueled asset bubbles and inflationary pressures throughout the economy.
Similarly, as the Fed aggressively raised interest rates in 2022, this has also created unintended consequences. The collapse of SIVB. While SIVB’s demise seems not to pose a systemic financial risk at the moment. Its overnight collapse is a reminder that the banking sector remains vulnerable to sharply rising funding costs after years of operating in a low rate environment.
SIVB’s demise has been well covered in the financial press, we’ll touch upon some salient details. There were red flags, a couple that were somewhat unique to SIVB.
- Greg Becker, SIVB’S former CEO, served on the board of the Federal Reserve Bank of San Francisco until the day of the collapse. He had lobbied that that banks of SIVB’s size should not be subject to as much regulation as the mega banks
- In 2018, a bipartisan bill was passed that exempted banks with $100 billion to $250 billion in assets – Silicon Valley's size – from requirements that included regular examinations of how they would fare in tough economic times, known as 'stress tests.'. The 2018 law also provided the Fed with more discretion in its bank oversight. The central bank subsequently voted to further reduce regulation for banks the size of Silicon Valley. In October 2019, the Fed voted to effectively reduce the capital those banks had to hold in reserve.
- The bank had grown rapidly. Its assets quadrupled in five years to $209 billion, making it the 16th-largest bank in the country. And roughly 94 percent of its deposits were uninsured because they exceeded the Federal Deposit Insurance Corporation's $250,000 insurance cap. That percentage was the second highest among banks with more than $50 billion in assets, according to ratings agency S&P. Signature had the fourth-highest percentage of uninsured deposits – which uncoincidentally also failed. Signature had large exposure to crypto clients.
- According to analysis done by UBS. SIVB had 52% of its deposits from venture capital and private equity related businesses and funds. First Republic Bank, another California-based lender that dropped more than 60% in pre-market trading on Monday, only 8% of its deposits to those types of clients.
Ultimately SIVB’s risk management, or the lack-thereof, proved it’s undoing. It’s not uncommon for banks to have unrealized losses due to their bond holdings. According to Bloomberg, US banks had booked $620 billion in unrealized losses on their available-for-sale and held-to-maturity portfolios at the end of last year, according to filings with the FDIC. But SIVB’s investment portfolio had swelled to 57% of its total assets. No other competitor among 74 major US banks had more than 42%. It was this toxic brew of a very large unrealized losses on Treasuries and mortgage bonds combined with a concentrated depositor base that proved fatal.
This was exacerbated by SIVB’s failure to hedge the interest rate risk on these holdings and an upcoming credit downgrade. Once it was made known to the market that SIVB may raise equity to pre-empt the downgrade, this was the catalyst for deposits to be withdrawn which worsened their credit standing. It became a self-fulling prophecy.
So as technology focused investors, how do we assess the current situation?
Let’s start with the macro. I have written extensively on concerns over the broad market from both a technical and macro perspective. The latter namely due to the Fed’s inability to combat super-core inflation and the over-leveraged consumer. I and the rest of the team have been monitoring for further signs of weakness.
Financial Sector Earnings
Within the overall S&P 500 earnings, it is estimated that Technology contributes the most at about 25%, while the second largest is Financials at 19%. The S&P 500’s decline in the SPX has in part been driven by reductions in earnings for the Technology sector. The SIVB fallout could lead to a reduction in earnings estimates across the financial sector. These downgrades can be driven by a number of factors such as lending margins being squeezed as cost of bank deposits are still catching up with rate rises that have already happened, higher regulatory costs and higher loan loss provisions, just to name a few. This could be another headwind for S&P 500 earnings in the future.
Banks are a transmission mechanism for the economy. To the extent that is hindered, there will be a negative trickle down effect for the economy that are yet to be seen. Somewhat ironically, the SIVB collapse may help Fed Chairman Powell’s goal to reduce supercore inflation driven by the sticky services component through aggressive interest rate hikes. Albeit clearly not the way he intended.
Technically, the Financials ETF has broken down.
What will the Fed do in the next meeting?
Given the recent CPI data, the Fed has every justification to continue to raise interest rates, which we discussed here. However, will the SIVB failure give them a reason to pause? The futures market has the odds at a resounding no.
And the reason is that under the headline CPI number, we are seeing the 2nd month in a row of 3 MoM annualized acceleration. If you combine the prior 3 months and annualized them, the number comes out to 4.08%, compared to last month’s reading at 3.4%. Furthermore, energy, goods, core, shelter and services all showed similar accelerations.
How to invest in technology in current environment?
In the public markets, the technology sector was already facing headwinds as higher rates impacted valuation. Meanwhile those with consumer exposed businesses have also had earnings impacted. The SIVB fallout adds additional headwinds. SVB’s demise has revealed the extent of the damage rising interest rates might cause on companies and banks that had grown accustomed to years of cheap money. Startups are especially vulnerable to any systemic drop in confidence, given their reliance on investors’ faith in their long-term potential when profitability might be years away.
Private markets will face a tougher funding environment. There is a talk of ‘day-of-reckoning’ for the private equity/venture capital-funded universe and may force PE funds to mark down private books sooner than they’d like to.
Softbank is a good public and sentiment proxy for the private markets. Before the meltdown, Masayoshi Son’s investment powerhouse — which has poured more than $140 billion into names from WeWork to ByteDance Ltd. and DoorDash Inc. — had already been reeling from the post-pandemic economic downturn.
SoftBank, similarly central to the global VC arena, has lost around 7% or $5 billion of its value since news of SVB’s difficulties emerged. Its credit default swaps are surging for the second straight day, and speculation is growing on what asset sales might be ahead should SoftBank need to help out portfolio companies.
SoftBank sees little impact from SVB’s failure on its portfolio companies, a SoftBank spokesperson said, adding that the company expects no impact on its own finances. Most Vision Fund portfolio companies are cash-rich, the company said during its earnings call last month. However, if we look at the chart, the market disagrees, as it is ~63% off its 2021 high, and only ~32% from testing its COVID low.
Attributes of stocks that we are looking for
This past week, I/O Fund analysts held a webinar that discussed “How to Build a Defensible Tech Portfolio.” Although macro continues to throw curveballs, we believe a defensible portfolio can help alleviate any concerns.
Defensible means the portfolio should be overweight the bottom line. For tech investors, stocks that do not materially cash burn are ideal right now. Per Silicon Valley Bank’s CEO Gregory Becker: “While VC (venture capital) deployment has tracked our expectations, client cash burn has remained elevated and increased further in February, resulting in lower deposits than forecasted.”
Per the same Reuters report, Silicon Valley Bank is selling assets to position for higher interest rates and faster cash burn: “We are taking these actions because we expect continued higher interest rates, pressured public and private markets, and elevated cash burn levels from our clients.”
Elevated cash burn is something the public markets will be very sensitive toward into the foreseeable future. We have found that expanding operating margins and GAAP profitability was rewarded last year, and we believe this is the best way to position for an unpredictable 2023. At the very least, while the FED raises rates, cash burn will continue and we believe it will surprise investors at times just how cash strapped the tech sector truly is. This is why we have built a defensible tech portfolio, as outlined in this webinar here.