Fatal, But Not Serious


As a friend of mine likes to joke about challenging situations, “It may be fatal, but it’s not serious.”

That statement accurately describes the current crisis of confidence. It may be fatal to Silicon Valley Bank (SIVB), but it does not pose a serious threat to the stock market or to the broader U.S. financial system.

We are not facing a repeat of 2008 for two important reasons.

First, the factors that doomed SIVB are not systemic; they are idiosyncratic.

Second, the assets supporting bank balance sheets bear no resemblance to the mortgage-backed refuse that littered balance sheets in 2007-2008.

A Bad Case of the “Stupid”

What we are facing today is just a bad case of “stupid.” That’s the idiosyncratic part of SIVB’s failure. Its overseers did stupid things that directly caused its demise.

That statement may sound harsh… and if it were purely a post-mortem, it might be. But allow me to share a few of my past observations about SIVB…

The bank pursues an inherently high-risk, “VC-like” business model. SIVB’s heavy reliance on nontraditional and non-recurring revenue sources poses recurring earnings risk and creates “poor visibility”…

The bank is so unconventional that, on the one hand, it can describe itself as a provider “of innovative banking products and services to fast-growth and middle-market companies… [which has] developed creative solutions for some of the most successful technology startups and life science companies in the world.”

But, on the other hand, one could describe it as kind of a venture-capital fund in bank’s clothing. In short, it is as New Economy and unorthodox as the Valley that spawned it…

SIVB generates a significant portion of its earnings from nontraditional activities like gains from the sale of equity warrants tied to credit agreements…

The equity warrants are attached to a loan or credit line and help sweeten the return to the bank.

SIVB’s loans to emerging growth and the startup companies often include equity warrants… [Because of the VC market slowdown], we would assume – although we cannot say for certain – that the value of SIVB’s warrant portfolio is worth much less than it used to be. And if warrants are no longer contributing to the return on SIVB’s loans, the interest return alone must carry the day…

Consequently, we theorize that SIVB is stuck holding a book of loans in which credit was underpriced because now-worthless equity warrants were included in the original calculations.

After presenting this skeptical analysis of SIVB, I recommended shorting the stock. It tumbled more than 50% during the following seven months.

The year that I published these skeptical remarks was 2002, more than two decades ago! In other words, my post-mortem is actually a premortem. Silicon Valley has been a gunslinging risk-taker for a very long time.

Despite its near-death experience after the dot-com bust and again after the 2008 crisis, it persisted in its unorthodox strategy. During boom times in Silicon Valley, that unorthodoxy has served it well… And has served company management particularly well.

During the last 10 years, for example, former CEO Greg Becker made 28 open-market sales of SIVB stock, for total proceeds in excess of $60 million. But he did not purchase even one single share in the open market during that timeframe.

He simply cashed out stock options as they vested and sold the stock. That behavior is neither illegal nor uncommon. But it does help to promote the kind of short-termism that ultimately doomed SIVB.

You see, the bank didn’t fail because of some sort of hyper-sophistication gone wrong, or some technological “black swan;” it failed because the bank’s management committed one of banking’s mortal sins – in fact, it is banking’s only mortal sin: “borrowing short and lending long.”

SIVB, under CEO Becker’s watch, financed itself almost entirely with customer deposits and then used that money to make long-term investments – VERY long-term investments.

The bank used part of those funds to lend to start-up companies – the kind that rarely produce profits… or even revenues.

That’s risky.

But rather than mitigate that risk by balancing it with relatively safe, short-term investments, SIVB plowed 40% of its assets into long-term bonds.

Based on 2022 year-end numbers, SIVB held about $24 billion in bond maturities ranging from six to 15 years and another $50 billion in bonds maturing after 16 years!

That’s super risky… and super stupid.

But don’t take my word for it, “ask” SIVB’s balance sheet. At year end, its bond portfolio was showing a mark-to-market loss of more than $15 billion, which all but erased the bank’s entire shareholder equity of $16 billion.

In other words, SIVB was essentially a “zero” as 2022 ended. But it had sufficient liquidity to ride out the storm… unless depositors asked for their money.

And they did. At the end of last week, depositors yanked more than $50 billion out of SIVB’s vaults. That’s why most deposits are called “demand deposits,” because customers can demand the money whenever they want.

SIVB’s Myopic Missteps

So let’s break this down into very simple terms.

SIVB financed itself with billions of dollars that depositors could demand back at any time. Then used those funds to make loans to profitless startups and/or buy long-term bonds.

That’s just plain stupid.

It is so stupid that neither you nor I would attempt it. We would be too fearful to attempt it.

Imagine I loaned you $100,000 and told you, “Use the money for absolutely anything. But just remember that I can ask for it back any time I want, with no notice whatsoever.”

Would you then turn around and give your brother-in-law a 15-year loan that pays a higher rate of interest?

Would you use all the money to buy a “portfolio” of collectible vintage Barbie dolls?

No, you wouldn’t. Because if I asked you to return my money, you would not be able to do so.

Your brother-in-law might agree to pay you 50 cents on the dollar to re-pay his loan early, and you might be able to get 80 cents on the dollar for your Barbie collection.

But because both of those transactions would take place before you had intended to make them, you would probably receive fire-sale prices and not be able to repay my entire $100,000.

You would be insolvent.

That’s what SIVB did. It used short-term money to make long-term investments. And when those long-term investments lost value, the bank had no equity left over to pay depositors.

Now to be fair, all banks use short-term money to make long-term investments. That’s the nature of the beast.

But all banks do not use only short-term money to make only long-term investments. That swashbuckling banking strategy was unique to SIVB.

Why Risk It?

So the obvious question that follows from the SIVB saga is “Why?”

Why would management pursue such a risky and reckless strategy?

The answer is two-fold.

First, this obviously risky strategy was not obviously risky to management. This bank had succeeded so spectacularly in recent years that management probably assumed it would continue to do so… no matter what.

Success can be as blinding as a solar eclipse. Otherwise intelligent folks will do unintelligent things, simply because they don’t really know what risk looks like.

Why would they? They’ve never seen failure.

Second, managements that receive bountiful stock-option compensation tend to focus excessively on short-term results. That’s because short-term results are the ones that boost their stock price and ramp up the value of their options.

In the case of SIVB, for example, the temptation to buy long-term bonds would have been considerable. By doing so, the bank generated a net interest margin that was significantly higher than what a prudent asset allocation would have produced.

That plump margin produced plump earnings that rocketed the stock price 160% from later 2020 to late 2021 – or more than double the gains of the KBW Bank Index.

But the rising interest rate trend of the last few months drove a stake through the heart of SIVB’s “brilliant” margin-fattening strategy… and the rest is history.

The Bottom Line

Bottom line: SIVB does not pose a systemic risk at this point. It is simply the latest example of corporate hubris that will become the newest case study in business school curriculum.

As Michael Burry of “Big Short” celebrity observed yesterday, “2000, 2008, 2023, it is always the same; people full of hubris and greed take stupid risks and fail.”

Burry then concluded, “This crisis could resolve very quickly. I’m not seeing true danger here.”

I completely agree. This situation may be fatal, but not serious. Investors with an investment horizon beyond one year should be using the current weakness to invest in some their favorite names from their shopping list.

I would also point out that today’s inflation reading of 6% continues the downtrend that began last fall. That’s fantastic news for stocks, and yet one more reason to step into the market and make a few buys.

Eric Fry is an award-winning stock picker with numerous “10-bagger” calls — in good markets AND bad. How? By finding potent global megatrends… before they take off. In fact, Eric has recommended 41 different 1,000%+ stock market winners in his career. Plus, he beat 650 of the world’s most famous investors (including Bill Ackman and David Einhorn) in a contest. And today he’s revealing his next potential 1,000% winner for free, here.

Article printed from InvestorPlace Media, https://investorplace.com/smartmoney/2023/03/fatal-but-not-serious/.

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