Original article: "Decoding Silvergate and the Silicon Valley Bank Crisis: A Big Gamble in the US Dollar Rate Hike Cycle"
Author: 0xmin
Small and medium-sized banks in the United States have collapsed one after another!
On March 8, Silvergate Bank, a bank known for its cryptocurrency-friendliness, announced liquidation and returned all deposits to customers.
On March 10, Silicon Valley Bank, which specializes in providing financial services to Silicon Valley technology companies, sold $21 billion in marketable securities and suffered a loss of $1.8 billion. It was suspected of having liquidity problems. Its stock price plummeted by more than 60% on Thursday, and its market value evaporated by $9.4 billion in one day.
This also scared a number of Silicon Valley bigwigs.
Founders Fund, the venture capital fund of "Silicon Valley Godfather" Peter Thiel, directly advised invested companies to withdraw funds from Silicon Valley Bank. Y Combinator CEO Garry Tan also issued a warning, suggesting that invested companies consider limiting their exposure to lenders, preferably not more than $250,000...
What’s even more frightening is that Silicon Valley Bank may be the first domino to cause a crisis, which will not only affect other US banks, but may also deal a blow to Silicon Valley’s technology start-ups.
What exactly happened?
Today we will tell a story about how a bank went bankrupt.
Interpreting the Bank's Business Model
First, we need to understand the banking business model.
Simply put, a commercial bank is a company that manages currency. The bank's business model is essentially no different from other businesses - buy low and sell high, except that the commodity is turned into money.
Banks get money from depositors or the capital market, then lend it to borrowers and make a profit from the interest rate difference.
For example, if a bank borrows money from depositors at an annual interest rate of 2% and then lends it to borrowers at an annual interest rate of 6%, the bank earns a 4% interest margin, which is net interest income. In addition, the bank can also earn profits from basic fee-based business and other services, which is non-interest income. Net interest income and non-interest income together constitute the bank's net income.
Therefore, if banks want to make more profits, just like selling goods, the best state is to have no inventory, that is, to lend out all the deposits absorbed at a low cost at a high price. After all, deposits have costs and interest needs to be paid to depositors.
This also constitutes both ends of the bank's balance sheet.
Owners' equity + liabilities: Owners' equity is equity. The deposits that customers put in the bank are essentially borrowed by the bank from customers, which is a liability. For banks, the more liabilities, that is, the more deposits, the better, and the lower the cost, the better. Crypto-friendly banks like Silvergate mainly attract deposits from large companies in the crypto world by providing unique services such as the SEN network.
Assets: Corresponding to deposits, the loans issued by banks to customers are the bank's claims and are assets, including various mortgage loans, credit loans for ordinary consumers, and various bonds, such as government bonds, municipal bonds, mortgage-backed securities (MBS) or high-rated corporate bonds.
So, how did a bank with such a simple business model go bankrupt?
When a bank encounters a crisis, it means that there are problems with its balance sheet, which usually occur in two situations: bad debts and maturity mismatch.
Bad debts of banks: Under normal circumstances, banks need to recover loans to generate profits. If the loans issued or the bonds purchased are a pile of junk and default one after another, the bank will face actual losses. Lehman Brothers went bankrupt during the subprime mortgage crisis because it held a large number of non-performing loans. The asset losses on its balance sheet were far greater than the bank's equity, which means that the assets were not enough to cover the liabilities. Maturity mismatch: The maturity of the asset side does not match the maturity of the liability side, which is mainly manifested in "short deposits and long loans", that is, the source of funds is short-term and the use of funds is long-term.
For example, you have to pay rent on the 1st of this month, but your only cash flow income is the salary paid on the 10th of this month. Your cash inflow and outflow do not match, and there is a maturity mismatch, which is a liquidity crisis. What should you do at this time? Either you sell your assets, such as stocks, funds, cryptocurrencies, etc., for cash, or borrow some money from friends to deal with the current crisis.
Back to Silvergate and Silicon Valley Bank, maturity mismatch was the reason they fell into crisis.
Not only these two banks, but also various crypto unicorns that have fallen into crisis before, such as Celsius, Biyin, AEX, etc., all went bankrupt due to liquidity crises caused by maturity mismatch.
Ultimately, this is all related to the Federal Reserve's interest rate hikes, and they are all corpses under the US dollar cycle.
How did Silvergate go bankrupt?
Founded in 1986, Silvergate Capital Corp (ticker: SI) is a community retail bank based in California, USA, which remained dormant for decades until Alan Lane decided to enter the crypto industry in 2013.
Silvergate Bank's main label is that it is a bank that is very friendly to cryptocurrencies. It not only accepts deposits from crypto trading platforms and traders, but also establishes its own crypto settlement payment network SEN (Silvergate Exchange Network) for cryptocurrency settlement, helping exchanges and customers to better deposit and withdraw funds, becoming an important bridge connecting fiat currency and cryptocurrency. For example, FTX has been using SEN for fiat currency deposits and withdrawals.
As of December 2022, Silvergate has a total of 1,620 clients, including 104 exchanges.
When the crypto bull market arrived, a large amount of funds flowed in, and customer deposits from the crypto industry increased dramatically. Especially due to the existence of SEN, a large amount of funds from exchanges had to be deposited in Silvergate.
From the third quarter of 2020 to the fourth quarter of 2021, Silvergate deposits soared directly from US$2.3 billion to US$14.3 billion, an increase of nearly 7 times.
The cryptocurrency-friendliness and crypto bull market have caused Silvergate's liability side, that is, deposits, to expand rapidly, but this has forced the company to "buy assets". The loan issuance cycle is too long, and this is not Silvergate's advantage. So it chose to purchase billions of dollars of long-term municipal bonds and mortgage-backed securities (MBS) during 2021.
As of September 30, 2022, the company's balance sheet showed about $11.4 billion in bonds, and only about $1.4 billion in loans. Therefore, Silvergate is essentially an "investment company" that arbitrages between the crypto world and the traditional financial market: relying on banking licenses and SEN to absorb deposits from crypto institutions at low or even zero interest, and then buy bonds to earn the difference in the middle.
Cheap deposits coexist with high-quality assets, and everything looks good until 2022, when two black swans arrive.
In 2022, the Federal Reserve entered a frenzy of rate hikes, with interest rates rising rapidly, causing bond prices to fall.
There is an equation for financial products: today's price * interest rate = future cash flow. The characteristic of bonds is that the amount of principal and interest repayment at maturity has been set, and future cash flow will not change, so the higher the interest rate, the lower the price today.
As of the end of the third quarter of 2022, Silvergate had unrealized losses of more than $1 billion on the book value of securities held.
In addition, during the crypto bull market, the wealthy Silvergate acquired Diem, the unfinished stablecoin project of Facebook, in early 2022, with a total of nearly $200 million in stock and cash. In January 2023, Silvergate disclosed that it had recorded an impairment charge of $196 million in the fourth quarter of 2022, reducing the value of the intellectual property and technology acquired from Diem Group at the beginning of last year, which was equivalent to the loss of all the $200 million.
In short, Silvergate bought too many high-priced assets at the peak of the bubble. However, in this case, as long as there were no problems with the balance sheet, it could have landed safely. But at this moment, Silvergate's super large client FTX collapsed.
In November 2022, FTX declared bankruptcy, and in panic, Silvergate depositors began to withdraw their money frantically.
In the fourth quarter of 2022, Silvergate's deposits fell 68% and withdrawals exceeded $8 billion, a situation we often call a bank run.
When the liquidity crisis came, Silvergate had no choice but to borrow money or sell assets to cope with depositors' redemptions.
First, Silvergate was forced to sell previously purchased high-priced securities in the fourth quarter of 2022 and January of this year to obtain liquidity, resulting in securities losses of approximately US$900 million, equivalent to 70% of its equity capital.
Silvergate also obtained some of its cash by borrowing $4.3 billion from the Federal Home Loan Bank of San Francisco, a government-chartered institution that provides short-term secured loans to banks in need of cash.
Everyone knows what happened later. On March 9, Silvergate Bank could no longer hold on and announced liquidation, saying that it would gradually wind down operations in an orderly manner and carry out voluntary liquidation in accordance with applicable regulatory procedures, and would repay all deposits in full.
Silicon Valley Bank Crisis
If you understand the Silvergate Bank crisis, then the Silicon Valley Bank (SVB) liquidity crisis is almost the same, except that SVB is larger and more influential.
Silicon Valley Bank has always been one of the most popular financial institutions among Silicon Valley's technology and life science start-ups. Once Silicon Valley Bank goes bankrupt, it will inevitably affect all kinds of start-ups, bringing about a double crisis of technology and finance.
The trigger of the incident was that SVB sold $21 billion in bonds in a "fire sale" manner, resulting in an actual loss of $1.8 billion. SVB then stated that it would raise $2.3 billion by selling stocks to make up for the losses related to the bond sales.
This scared all the Silicon Valley venture capital firms.
Founders Fund, the venture capital fund of "Silicon Valley Godfather" Peter Thiel, directly advised invested companies to withdraw funds from Silicon Valley Bank; Union Square Ventures told portfolio companies to "only keep a minimum amount of funds in the SVB cash account";
Y Combinator CEO Garry Tan warned his portfolio startups that Silicon Valley Bank’s solvency risk is real and suggested they should consider limiting their exposure to the lender to no more than $250,000;
Tribe Capital is advising many of its portfolio companies to withdraw some of their funds if they can’t fully withdraw cash from Silicon Valley Bank.
As a result, a bank run came and Silicon Valley Bank fell into a deeper liquidity crisis.
Let's analyze its assets and liabilities.
On the liability side, due to the low interest rates in the entire money market, SVB attracted a large amount of deposits with a deposit rate of 0.25%. Coupled with the good technology venture capital and IPO markets in the past few years, SVB's balance sheet has also grown rapidly, jumping from US$61.76 billion in 2019 to US$189.2 billion at the end of 2021.
However, the technology venture capital market has become sluggish, especially the IPO market has been very quiet in the past year, SVB's deposits have continued to decline, and for savers, directly purchasing U.S. bonds is a more cost-effective option.
On the asset side, like Silvergate Bank, when there is a large amount of deposits and it is impossible to release funds through traditional lending methods, SVB also chooses to purchase bonds such as MBS. The key to the problem is that it does not buy a little, but almost "all in".
When interest rates are low, big banks in the U.S. still put more deposits in government debt, accepting lower yields during times of economic uncertainty. Silicon Valley Bank thought interest rates would remain low for a long time, so it put most of its deposits in MBS for higher yields.
As of the end of 2022, SVB had $120 billion in investment securities, including a $91 billion portfolio of mortgage-backed securities, far outstripping its $74 billion in total loans.
According to SVB's public information, the company's $21 billion bond portfolio has a yield of 1.79% and a duration of 3.6 years. For comparison, on March 10, the 3-year U.S. Treasury bond yield was 4.4%.
As interest rates soar, falling bond prices will cause losses for SVB.
Silicon Valley Bank has a $91 billion bond portfolio held to maturity that today has a market value of just $76 billion, representing an unrealized loss of $15 billion.
SVB CEO Greg Becker said in an interview with the media: We expected interest rates to rise, but we didn't expect it to be as much as it is now.
In general, the difficulties faced by Silvergate and SVB are mainly due to their misjudgment of the pace of the Fed's interest rate hikes, which led to wrong investment decisions. Going all-in on bonds may feel good for a while, but the US dollar interest rate hike is difficult to end.
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