This post originally appeared on March 10, 2023
The financial world has spent the last few days captivated by the slow-motion implosion of Silicon Valley Bancorp (ticker: $SIVB). A couple of years ago, some well-meaning colleagues suggested SIVB as a potential long idea for DKI. The thesis was that while you had to pay a high but not unreasonable price for the bank, an investor would get a portfolio of venture capital assets at a discount.
Silicon Valley was the bank of choice for many venture capital startups. As part of helping to finance many of these companies, SIVB had compiled a portfolio of illiquid interests in tech companies at high valuations. My colleagues thought these assets were hidden value. I thought the multiple the market was charging for the stock indicated the assets were anything but hidden, and that these illiquid assets might not be marked to market. That’s a fancy way of saying these assets were held on the balance sheet at a valuation that was not reflective of what they’d receive in a sale.
Higher Interest Rates and Long Duration Assets:
Venture capital and other high-growth technology companies are long-duration assets. That means that the value is based on high earnings or cash flow that will come many years in the future. These assets are more sensitive to changes in interest rates than shorter-duration ones.
A simplified example will help explain. Imagine I tell you that I’m going to give you a million dollars next week. Chances are you wouldn’t even bother to check what the interest rate (or discount rate) is for the week. Now, let’s say I agree to give you the same million dollars, but in ten years. All of a sudden, the present value of that future promise is highly dependent on the interest rate. Another Federal Reserve rate hike would mean the current value of that promise would be lower.
Low Rates Blew Up an Asset Bubble:
In addition to low interest rates raising the current value of these long-duration technology companies, people desperate for any yield also contributed to higher asset prices. More than a decade of interest rates at or around zero pushed yield-starved investors into more risky investments. The same people who are locking in just under 5% for two-year treasuries were willing to invest in risky illiquid options when rates were much lower. The Federal Reserve warped people’s investment preferences by making the simple act of saving to be a negative return activity.
The Rest of the Book Wasn’t Marked Properly Either:
Venture capital firms raised a lot of money in recent years and deposited much of it in low-yielding accounts at SIVB. In response, the bank bought large amounts of treasury securities. Those assets fell in value as the Federal Reserve raised interest rates during the past year.
The bank would have been able to weather that except with the funding window no longer wide open as it was during the Covid years, many of Silicon Valley Bancorp’s customers began reducing balances. Others simply took their money to places where they could earn a higher return. Those actions meant SIVB had to sell treasuries at a discount to fund lower deposit balances and withdrawals.
It’s legal for a bank to not recognize lower value on assets its not going to sell before maturity. However, when they have to sell those assets before maturity, there’s no way to avoid recognizing the loss of value. This action scares other depositors who all want to get assets out in an old-fashioned bank run and ensures that more assets get sold. That action forces the bank to recognize more losses and the whole cycle repeats again.
Are We Going to See Contagion?:
As I was writing this piece, the regulators have shut down SIVB. The stock prices of other banks and financial institutions are falling in sympathy. The big question right now is will the failure of Silicon Valley Bancorp take down other banks.
The answer is probably not. From a fundamental point of view, SIVB was a small institution with huge exposure to one very long-duration industry. Those specific characteristics are not shared by most other banks, and the banking sector in general, is in better shape than it was post 2008 crisis.
The reason we’re not using more definitive language here is because perception can create a negative reality in the world of leveraged deposits. If the regulators don’t succeed in keeping the public calm and reassured that their deposits are secure, we could see bank runs that would challenge the entire sector. This is unlikely, but explains why we’re not 100% certain that contagion won’t happen.
Our final thought on the matter is regarding DKI stock pick, Enova International (ticker: $ENVA). The stock is down with the rest of the finance sector. However, Enova makes non-prime loans to small businesses and individuals. Company assets have a very high yield, and the Enova customer isn’t very interest-rate sensitive. The noise surrounding SIVB shouldn’t affect a specialty lender like ENVA.
If you have questions about this subject or report, I’m reachable at IR@DeepKnowledgeInvesting.com.
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