SVB Financial: Beware the ides of March

13 Mar 2023 , 09:43 AM

People, even with a passing interest in William Shakespeare, would be familiar with the “The Ides of March.” During the reign of Julius Caesar, his oracle warns him to beware the ides of March. Now, the ides of March roughly correspond with around 15th March. On that fateful afternoon, Caesar sardonically reminds the oracle that the ides of March had come, to which the oracle replies, “The ides of March have come your Majesty, but the ides of March have not gone.” The same evening, Caesar is assassinated by Brutus. Now, if that sounds familiar, there is a reason.

Michael Burry and the Big Short on SVB Financial

Michael Burry of Scion Capital is best remembered for his remarkably bold short positions on sub-prime mortgages in 2006 and 2007 when they were the hottest assets in the market. Eventually, in 2008 when sub-prime imploded, Burry was laughing all the way to the bank. For the Hollywood buffs, his eccentric character was immortalized by Christian Bale in the movie “The Big Short.” Michael Burry was back in the limelight when he tweeted about SVB Financial being the next Enron; the power company that went bankrupt in 2001 under a pile of worthless derivative positions and some opaque accounting. The reasons for the analogy are not clear but Michael Burry has since deleted the tweet. However, the underlying message of the tweet refuses to go away.

To an extent, Michael Burry highlighted what many had been fearing for a long time. The global venture funding business and the start-up business has been through a long winter. It was already being anticipated that a player like SVB Financial, which controls a big chunk of the venture banking business would be hit. After all, weakness in the core venture funding industry combined with rising interest rates was a recipe for trouble. What Burry meant in his tweet was that the case of SVB Financial may just be like the ides March coming. There could be many more such specialized regional banks that may be equally vulnerable to this combination of niche business models and rising interest rates. We will get to know that only in the coming weeks.

What exactly went wrong with SVB Financial?

On Friday, 10^th March 2023, the regulators shut down Silicon Valley Bank (SVB Financial) leading to almost a mini crisis in banking and financial stocks. The impact was felt even in India as the Bank Nifty took a hard knock. What exactly is the business model of SVB Financial and where did the model go wrong? The Federal Deposit Insurance Corporation (FDIC) has already taken control of SVB Financial after the stock price of the bank fell by 86% in just two days. But what is SVB Financial all about and where it went wrong?

SVB is a California based bank, and as the name suggests, it takes deposits from Silicon Valley tech startups and also provides them funding. In fact, SVB had provided funding to 44% of all venture capital-backed listed tech and healthcare start-ups. Obviously, its fortunes were closely tied to the fortunes of the venture capital industry and the start-up ecosystem. What was the undisputed strength of the bank for the last many years, came home to roost last week. Here is what happened at SVB Financial.

There were 2 reasons for the sudden implosion of SVB Financial. One was the slowdown in the start-up funding ecosystem and the second was the spike in interest rates by the Fed. Firstly, the start-ups were finding it increasingly difficult to get timely funding and that was delaying their ability to repay funds. That also impacted the venture financiers, who did not have the same access to liquidity as a few years back. This led to venture funds and start-ups withdrawing deposits worth $41 billion from the bank. This run was too much to handle. It was worsened by the spike in Fed rates. To meet the demand of withdrawals, SVB had to undertake a fire sale of its bond portfolio. Higher Fed rates meant that they had to book a loss of $1.8 billion. When SVB could not raise equity to cover the gap, it imploded.

Is the contagion likely to spread across banking?

As of now, there no real evidence of the contagion spreading across the entire financial sector. The 2008 crisis was of a different level. Every bank either had exposure to toxic assets or had funded toxic assets and were sitting on piles of dud assets. In comparison, SVB Financial may be more of a localized problem. Yes, it will have implications for the start-up ecosystem globally, but it is nowhere close to the global financial crisis in gravity. Hence, the systemic risk to the banking and financial system may be limited to knee-jerk reactions from the financial stocks in next few days.

However, the problem for niche banks and financiers could be more serious. For instance, Silvergate Capital became another high-profile bankruptcy after it faced problems with rising rates and its core franchise of crypto businesses. In the US, the big banking stocks like JP Morgan, BOFA, Wells Fargo and Morgan Stanley lost $55 billion in value, but they also recovered in most cases. However, smaller regional banks and niche banks may have a bigger problem coming out this crisis. Only when the dust settles would we know the actual impact of the SVB implosion on the start-up ecosystem in the US and across the globe.

Next few weeks could be critical for the financial system

While it may be easy to dismiss this as a crisis that has beset the smaller niche banks, the actual picture may be a little more complicated. It is OK for one bank to go bust, but if a series of smaller banks bust, then the impact would start showing. Even if the big banks are not vulnerable, the provisions for losses would surely leave a hole in their balance sheet. The fall in financial stocks on Friday, was the third biggest fall since the global financial crisis. The other two big falls were in 2011 and 2020. Clarity will emerge in next few weeks.

One question is whether SVB Financial would be bailed out. There are several reasons why a bailout is possible. Firstly, the US government would not want to create problems for the start-up ecosystem in the US, something that has been the highlight of the US growth story. Secondly, the hawkish stance of the Fed to counter inflation was the reason for the crisis. The Fed would not want SVB Financial to become a poster boy of their anti-inflation battle. However, all is not above board since the top management had sold stock ahead of the news and big silicon valley depositors had removed deposits of $41 billion. Either they were clairvoyant or better informed, though the latter looks more likely. The US may look at a bailout like the one it had syndicated for LTCM; back in 1998.

Cannot miss the message for India

Indian markets also suffered the banking carnage in the aftermath of the SVB Financial crisis. RBI has also adopted a hawkish monetary stance and this outcome would force the RBI and the government to rethink the model of extreme hawkishness at this point. Indian companies are already facing the brunt of higher cost of funds. Indian start-up system is also under strain since November 2021 and funding sources are drying up leading to a spate of lay-offs. For India, the SVB Financial could be more than a passing interest. It would have implications for the way India approaches rates and how it deals with start-ups.