Normally staid and boring bank stocks have been volatile investments in recent weeks, after the collapse of some high-profile banks -- including Silvergate Capital, Silicon Valley Bank (owned by SVB Financial), and Signature Bank. The contagion spread across the industry, as some banks, such as First Republic and Credit Suisse, also had deposit runs, while others saw their stock prices plummet from the panic.
So how did this happen? Last year, smaller and regional banks outperformed their larger counterparts, mainly because of a surge in interest income due to higher interest rate, without taking a hit like larger banks did from a slowdown in investment banking. But the banks that failed are not your typical regional banks: Signature and Silvergate catered to the cryptocurrency industry, while Silicon Valley Bank (SVB) was a leading bank for start-ups and venture capital investors. Although there are many issues that led to these failures, one of the big issues for SVB had to do with its long-term bonds. Let's take a look at why.
Deposits surged during tech boom
As mentioned, SVB is one of the leading banks in the country for entrepreneurs and venture capital investors. As such, it took in huge amounts of deposits in 2020 and 2021 during the technology boom, as its banking customers raised a lot of cash from venture capital investors and deposited it with SVB. Deposits went from about $61 billion at the start of 2020 to about $191 billion at their peak in early 2022.
That left SVB with lots of deposits, so the bank put a lot of that excess money in long-term bonds as a way to generate additional income. Long-term bonds, such as 10-year Treasury bonds, typically generate higher returns than shorter-term bonds.
Those long-term bonds, primarily safe U.S. Treasury bonds and government agency bonds, were bought when interest rates still were at historic lows. Most of the bonds were invested in held-to-maturity (HTM) bonds, about $91 billion, while about $21 billion was in available-for-sale (AFS) bonds, which could be sold before they matured. The percentage of HTM bonds was much higher at SVB -- and Signature bank, for that matter -- than any other bank.
This was exacerbated after the Federal Reserve began aggressively raising interest rates in 2022, for a couple of reasons, the most important of which is that bond prices fall as rates rise.
How long-term bonds hurt Silicon Valley Bank
When the Fed started raising rates to stave off inflation, the market for VC and private equity investments slowed significantly. In turn, tech stocks, which had been wildly overvalued, started crashing.
VC funding dried up along with it, so many of SVB's early stage and start-up clients started to pull their deposits, as they were cash-strapped and needed the capital. Many of their clients held large deposits over $250,000, which is the amount up to which the Federal Deposit Insurance Corp. insures. This meant that SVB had a high percentage of uninsured assets.
As the deposit outflows continued, SVB was forced to sell off some of its bonds to increase its liquidity -- but because most of the money was in HTM bonds, they were limited to selling the AFS bonds.
To make matters worse, as interest rates had increased rapidly, from basically zero to the current 4.75% to 5%, the $21 billion portfolio of bonds, most of which were purchased when rates were minimal, was underwater. So SVB announced on March 8 that it sold its $21 billion in AFS bonds, which resulted in an after-tax loss of about $1.8 billion.
When word quickly spread among its clients, they started pulling deposits, particularly those large clients with uninsured deposits. Soon there was a run on deposits, and the stock price tanked. Two days later, on March 10, the California Department of Financial Protection & Innovation shut the bank down and the FDIC took it over. On March 26, the FDIC sold all of its loans and deposits to First Citizens BancShares.
These bank failures rattled the entire banking industry. Federal banking regulators stepped in to create a Bank Term Funding Program to shore up banks facing liquidity pressures.
But ultimately, the conditions that brought down SVB were largely confined to that business model, and most banks, particularly the large and super-regional mid-sized banks, have much more diverse deposit bases and a lower percentage of their deposits in HTM bonds. Plus, larger banks have to adhere to strict liquidity regulations, while those under $250 billion in assets do not. As of Dec. 31, SVB had about $209 billion in assets, meaning it wasn't subject to the more rigorous standards.
