Podcast: The Silicon Valley Bank collapse

Brian Levitt:

Welcome to the Greater Possibilities Podcast, where we put concerns into context and opportunities into focus. I'm your host, Brian Levitt. Jodi Phillips is off this week. I think today we will be leaning into that line about putting concerns into context.

Justin Livengood is coming up. He will be helping us put recent concerns into context. Justin is the Senior Portfolio Manager of the Invesco Midcap Growth Strategy and a Senior Research Analyst in Healthcare, Financials, and Real Estate sector on the Invesco Discovery Growth Strategies.

So real quick, anyone who has not been paying attention over the last couple of days, we did have the second-largest bank failure in US history — that would be Silicon Valley Bank. And I know that sounds particularly disconcerting to a number of people. Now this was a bank that was heavily focused on banking for tech startups. And those tech startups had their deposits at the bank, but they were largely funded by venture capitalists. And when that money dries up and the tech startups need access to their deposits, money starts to leave the bank.

Over 90% of those deposits for some reason or another — which Justin may help us understand — were not insured. And the banks were sitting on what seemed to be high quality assets, but many of those high quality assets were US treasuries or mortgage-backed securities, which had become worth less as interest rates had gone up.

Selling those assets to meet deposits would've resulted in sizable losses for the banks and ended up in a bank failure and concerns that would then lead to crisis throughout the regional or smaller bank parts industries as concerns that deposits would then move and more banks would fall under similar pressure. So, of course, we got a policy response by the Fed, the FDIC, and the treasury.

The bank did fail. It's not a bailout. Don't listen to what you hear on Twitter. The bank did fail. The depositors were protected, and regional banks get access to a line of credit from the Fed.

So that's the backstory. Let's bring in Justin. Justin, thank you for joining.

Justin Livengood:

Thanks for having me.

Brian Levitt:

You and I have known each other for a long time. Have we done this enough? I mean, are we through cycling through crises or is this just the rest of our career?

Justin Livengood:

I can't believe if I think back a week ago that I'd be sitting here today talking about the failure of actually two banks, not just Silicon Valley, but Signature was a $100 billion bank that went under on Sunday night.

Brian Levitt:

And Silvergate…the crypto one.

Justin Livengood:

And before that Silvergate…exactly! So this is definitely more of a shock than perhaps even some of the crises we've dealt with in the past.

Brian Levitt:

And Justin is such a good resource for me and somebody I always talk to when things like this happen. And we have just been through way too many of these. I mean from having conversations about a Global Financial Crisis and a pandemic and on and on, it gets a little tiresome. But here we are again.

Let's start from where we were before all of this happened. You always hear that when the Federal Reserve tightens interest rates significantly, something ends up breaking. Had you been concerned that something could break? And were you particularly concerned about anything in the banking sector?

Justin Livengood:

I wasn't concerned about a break, at least in this degree. And the reason is the credit picture in the banking industry was, and still is, quite clean. The bank CEOs were actually pretty surprised, and I'm talking about large and small banks, that they haven't been seeing more non-performing assets and loans starting to slip past due, which you might expect at this point of an economic cycle. That's typically where a bank crisis starts — on the credit side. And that's what happened in 2007-2008 etc. That wasn't happening here. In fact, Silicon Valley Bank was not on, nor Signature, any watch lists of any regulators.

Brian Levitt:

Yeah, some of the analysts had them as outperform.

Justin Livengood:

Oh, absolutely. Now what I was concerned about, particularly as a growth investor, the banking industry was struggling with the yield curve and the downward slope of the yield curve, which was pressuring net interest margins and their ability to grow profitably their loan book and their earnings. And so, through the back half of last year, and certainly here at the start of 2023, earnings estimates for the group have been coming down. The stocks had not been performing well and valuations had been compressing, but it was again entirely related to yield curve dynamics and just the bank's inability to grow more. It had nothing to do with credit, had nothing to do with people expecting some sort of an exogenous shock like this to suddenly put a run on the banks in front of everyone. So while the group was struggling, this was not on people's radars.

Brian Levitt:

Can I hear you say again that it's not 2008?

Justin Livengood:

Yeah, it's not 2008. This is not a systemic credit issue where there are going to be other problems on the left side of banks’ balance sheets, this is all on the right side. This is all funding, liquidity, deposits, and confidence. This is not, oh boy, everybody's sitting on a bunch of bad bonds. As you said a moment ago, the Silicon Valley balance sheet, the securities portfolio, was a bunch of treasuries and AA-rated mortgage-backed securities…Fannie, Freddie stuff.

Brian Levitt:

These are not subprime loans that are packaged up and put on the balance sheet.

Justin Livengood:

And what happened, and we don't need to dwell on this too long because I think it's increasingly well known, but Silicon Valley grew…they doubled their deposits in 2020-2021 over that two-year period by a magnitude of almost a $100 billion dollars. And they just couldn't lend that deposit inflow out quick enough, which is understandable. And so, when banks find themselves in that situation, they put that deposit overflow into securities.

The mistake, in hindsight, that Silicon Valley made was they went out the curve as they were investing those excess deposits in 2020 and 2021 by buying things with 4, 5, 6-year duration — but again, they were high quality instruments. And when the Fed started to tighten, they were slow to either adjust the duration of that portfolio by hedges or however you want to risk manage it. And so they ended up with a pretty big unrealized loss in that portfolio.

They opted last week to try to sell some of those securities in a transaction that, in isolation, kind of made sense in terms of taking a loss, backfilling it with some capital, they had already kind of booked the loss on their balance sheet. So from again, blinders on sort of perspective, what they were trying to do here in the last couple weeks wasn't nuts. The problem was it was misinterpreted by their deposit base. And this gets to where now you really had the crux of this crisis.

That deposit base of Silicon Valley was way too concentrated. Because it wasn't just that they had all these small tech and healthcare companies that were their depositors, it was really that they had a hundred key relationships with the venture capital and private equity firms that owned all these companies. And when a couple of those VC and PE firms last week sensed, or got wind, that there might be something wrong at Silicon Valley, they sent an email to their entire portfolio of 50 companies, I'm making that up, and said, ‘Hey everybody, get out, get out.’

And that is a very small clubby world. And as soon as a couple of them did it, everybody did it. And the stat that now is becoming, I think, well known but is worth repeating, on Thursday in a six hour span, $42 billion of deposits were withdrawn or attempted to be withdrawn from Silicon Valley Bank because of this stampede created by a very small number of depositors of VCs. Compare that to 2008 when Washington Mutual went under and had to be taken over the Fed and JP Morgan in the two weeks leading up to their collapse, they had $17 billion of cumulative outflow. So two weeks to take out $17 billion at WAMU versus six hours.

Brian Levitt:

Everything's so much faster these days.

Justin Livengood:

So much faster.

Brian Levitt:

You put something out on Twitter, get out and…

Justin Livengood:

Exactly. So, Silicon Valley was essentially done on Thursday night, which is why Friday morning California time, the regulators had to take the bank over. They couldn't even wait until the weekend.

Brian Levitt:

Help me understand this number…something like 93% or 97% — depending on where you read it — of the deposits were not insured. Was that a mistake of the CFOs at these tech startup companies? Do these tech startup companies have CFOs?

Justin Livengood:

They should, most do. It's a fair question. I think part of the problem is Silicon Valley Bank was around for 35 years. They have long-standing relationships and well-earned good relationships with all these constituents in this ecosystem — the venture capital firms, the management teams of these companies, they'd earned their trust.

90% of the innovation economy out there was in some way banking with Silicon Valley. It's just what you did. And so that mentality exacerbated this and created, I think, a higher amount of uninsured deposits than you might see in sort of a normally diversified set of clients. And for over three decades that wasn't a problem. So again, it's amazing that when all of a sudden there was someone yelling ‘Smoke’… the proverbial smoke in a dark movie theater…it caused, otherwise you would think sophisticated financial people, VCs, private equity folks to panic, and no one hesitated to just pull everything.

Brian Levitt:

And Silicon Valley on HBO was one of my favorite shows, and I remember…

Justin Livengood:

Great show.

Brian Levitt:

Right? Richard had a deal with so many different issues. I don't think he ever actually had a deal with his deposits being uninsured.

Justin Livengood:

That's true.

Brian Levitt:

Is this typical of other banks, the deposit issue?

Justin Livengood:

Being uninsured?

Brian Levitt:

Yeah.

Justin Livengood:

I mean it's typical in that certainly for commercial banks, yes, the majority of their clients are keeping more than $250,000 with them in various deposit accounts. Again, I think what might have been atypical here is these clients weren't diverse. They didn't have six operating accounts. Because if I'm a CFO of a startup tech company, I've got a lot more to do than worry about properly diversifying my cash when I'm just burning it anyways trying to come up with the next product we're working on.

So they weren't spending their time, as other companies might or sophisticated or larger companies, building out a whole portfolio of relationships and properly moving accounts. Silicon Valley can do most of the things that these startups needed, and so they were all comfortable working with them as their primary if not exclusive bank.

Brian Levitt:

So speaking of being comfortable, was the policy response enough? Are you comfortable with what the Fed, the FDIC, and the Treasury have done?

Justin Livengood:

I think so, and it's still evolving as we talk on Tuesday morning here, but I'm glad that yesterday, Monday, went relatively well in terms of no additional failures. I do think that the regulators over the weekend had to insure all the deposits or provide a discount window and a backstop for the uninsured deposits, as much as that created a now well-discussed moral hazard that we can in a moment chat about.

But I do think it was necessary and I think it will get us through the shock part of this crisis. I think people will, over the next few weeks. finish moving deposits around to get comfortable that they aren't going to be vulnerable to a situation like this with everyone's legacy banking relationships. And so I think we've weathered the worst of that storm.

Now there are definitely some additional issues that need to be dealt with in the industry, and I'm sure going to talk about those. But I do think upfront this was a relatively effective coordinated response and I'm glad the regulators sort of pushed back on the political rhetoric over the weekend that suggested maybe we let Silicon Valley fail. I think that would've been, especially with Signature right behind it, if you would let both these banks fail, that's $300 billion of failed assets…commercial assets…with a lot of important corporate and commercial relationships, that would've been a tough blow.

Brian Levitt:

Now you and I are both sitting here in downtown New York City. I did walk by Zuccotti Park this morning. I did not see people occupying Wall Street…at least not just yet. This idea of a bailout or this idea of taxpayer money being spent on this, is that largely a misnomer? Is the FDIC overfunded so that they can provide support on the deposits?

Justin Livengood:

Well, they're properly funded…I don't know if they're overfunded after this, but what they have said is they are going to assess all the other FDIC banks a fee — an assessment fee to essentially pay for this retroactively. So, at some point in the next few months, every bank CEO in America I guess, is going to get a bill in the mail that says, ‘Hey, you owe X to pay for Silicon Valley and Signature’s mistakes.’

And they're not going to have to pay the full amount because again the FDIC does have a decent amount in the trust fund right now and they're selling down assets. I mean they're actually going back to what we talked about a minute ago…there's a lot of good collateral at both banks, but particularly at Silicon Valley Bank, that the regulators can now sell and use.

Brian Levitt:

Sell the assets, right?

Justin Livengood:

…to help manage this so this isn't going to end up being a $100 billion hit to the industry. But to the extent there is a little additional needed to kind of true up the trust fund after that, they're going to charge the member banks. And that's just going to be one of many incremental new things the banks that survive this are going to have to be grappling with.

Brian Levitt:

It feels like a small price to pay to avoid a run on the banks. So let's talk about the issues that the banks are now facing as an investor and somebody who works in the financial sector. Are you optimistic about the banks or you still have concerns?

Justin Livengood:

So, I still have concerns and I can discuss a few different issues here. The first is you still have an inverted yield curve, albeit less inverted than a week ago, but still an inverted yield curve and a lot of pressure on just their core fundamentals — putting aside all the liquidity stuff that just happened. Now the next issue is every bank CEO in America right now has no idea what his or her deposit base is going to look like tonight or tomorrow night…things are still moving around. It will be incredible to listen to these Q1 earnings calls next month and see where the quarter balance sheets ended up and what that's going to mean just in terms of near-term earnings and growth outlooks. I mean banks are going to have to potentially shrink and reset expectations to the extent they've seen outflows…maybe they've seen inflows of deposits. This could go both directions.

Brian Levitt:

Some of the larger money centered banks.

Justin Livengood:

But ironically, the larger banks that are probably taking deposit inflows are going to have to put up more capital. They almost don't want it. Yeah, if you noticed, Chase and B of A aren't paying you a lot for your checking account.

Brian Levitt:

Right, right. I notice it every month. I'll notice it on my tax returns also. I put down my 12 cents.

Justin Livengood:

And that's not changing because they don't really want our deposits given how, again, the way the regulators treat excess deposits like that. So my point is there's still a lot of stuff moving around that is going to require these banks to step back, be cautious, be conservative, just in terms of near-term operating funnels. Intermediate term, the issue here I think particularly for the regionals and that group of banks just below the top 10 SIFI banks, is that there is going to be a whole swath of new regulations and capital requirements. I'm already hearing things. After the Global Financial Crisis, the Fed, and the regulators put in a whole set of rules for those top 10 banks, but they cut it off at banks with $250 billion of assets.

Brian Levitt:

How did that go?

Justin Livengood:

It sort of worked. But these banks, which ironically got just up close to that…

Brian Levitt:

They were very close.

Justin Livengood:

…$100 billion and $200 billion respectively in assets. So they're going to lower that threshold, and so are they going to lower it to 50? or who knows? But I guarantee that the next 75 to 200 banks on that list of assets are preparing for a whole bunch of incremental disclosures, new audits that are going to have to go through with the regulators, increased capital charges, carrying more capital for all the different activities they're doing. This is going to be incremental operating — I remember vividly going back after the French crisis meeting with lots of banks, including banks First Republic and Silicon Valley, who I knew well back in 2010, '11, and '12, and how much they were complaining about all the hiring they were having to do right after the financial to manage all these new rules and regulations that they were being asked to comply with.

In fact, the joke for a while was the best job you could try to get coming out of school was to be someone that had any interest in or expertise in bank regulation because there was a feeding frenzy for these people.

Brian Levitt:

Absolutely. I think Eisenhower probably should have warned us about the regulatory industrial complex.

Justin Livengood:

That's right. So, I don't think it will be quite that severe, but there's going to be an element of that for these regional banks now as we move into the back half of this year and next year.

Brian Levitt:

Which I have to assume means slower nominal growth for the economy as well. This whole idea that we're moving to a new level of nominal growth in this inflationary world, does this take away some of that?

Justin Livengood:

It might in two ways. First, just in general, as banks overall are pausing a little bit to make sure they understand ‘what's my deposit base look like?’ And then ‘what are the rules of the game going forward, regulatory-wise?’ They're going to be less inclined to make a new loan, maybe less inclined to onboard certain types of clients.

But then very specifically, the second thing I'd mentioned is in the technology, healthcare verticals that are directly affected by the Silicon Valley failure, there's going to be a period of friction here where you've got to go find a new bank. You've got to move, and it's not just, ‘oh, I've got to move my deposits over.’ It’s ‘I've got to move my payroll system. I had a line of credit that I was using with vendors, and I had 16 vendors hooked in and now I got to move that.’

Well, guess what? The banks that you want to move to either aren't going to be able to do everything because they're now afraid to bring on all those relationships as quickly as they otherwise might, or they're only going to do two things. Okay, Brian, you can bring me your deposits, but I'm not going to do all the other stuff that Silicon Valley was doing. I can't or I don't want to. So now I'm going to have to go find three new relationships and that may take me four months. And in the meantime, I can't do all the growth investing that I wanted to do as a …

Brian Levitt:

That's a shame. I mean, that just means a less innovative economy in the near term.

Justin Livengood:

Exactly. And it'll sort itself out, so I don't want to suggest this is a long-term issue. But it's definitely a short-term disruptive issue, particularly on the smaller end of the innovation economy. And I think the broader growth outlook could be a little bit impaired by this.

Brian Levitt:

And if the broader growth outlook is impaired, then that should potentially support the type of strategies that you invest in or the type of strategies that you manage. Because if you're back to a slow growth world, we probably need to pay up for growth wherever we can find it again.

Justin Livengood:

That's right. I think companies that are secular growers, that have products and ideas that are not as sensitive to the economy, and are well managed and well capitalized, are going to have increased advantages and get better valuations. And that is exactly the universe that we try to focus on in our different portfolios. The economy wasn't ripping, and all of a sudden this is going to tip it down. The economy was already, I'd argue, moving into a slow growth environment, and this is perhaps just going to nudge it a little bit more down that trajectory.

Brian Levitt:

Recession.

Justin Livengood:

I don't know.

Brian Levitt:

Semantics, probably.

Justin Livengood:

I agree. Exactly. I think it's less important whether we actually go negative for a couple quarters on nominal GDP or not. I do think the inflation topic is important because I think the Fed and monetary policy matters more than anything.

Brian Levitt:

As always.

Justin Livengood:

Ironically, the events with the banks here probably caused the Fed to be a little more dovish than they might have wanted to.

Brian Levitt:

Silver linings…perhaps.

Justin Livengood:

Perhaps, but we just saw a few minutes ago a CPI number that was for the month of February in line with expectations at least, but still 6% overall, 5.5% ex-food. That is not the 3%-ish number that I think the Fed ideally would like to get to. Forget two. I think three is what they're really... I don't think you're seeing 3% this year.

I mean, the pace of improvement in inflation is slowing. It's going to keep declining, but it is not going to collapse, I think, just based on the latest trends. So that's perhaps the biggest impediment is that the Fed is going to have to keep rates elevated at whatever the ultimate terminal rate is — probably well into next year — and that's going to continue to be a drag on the economy.

Now you layer on top of that what's just happened to the bank system where the banks are going to be a little more reluctant to lend and be as aggressive as they might have otherwise been. Particularly in certain parts of the economy that were serviced by banks like Silicon Valley. And yeah, it's a recipe for a slow growth environment.

Brian Levitt:

I can't let us end on a negative though. I've got a growth manager here, his last name is Livengood. Give me some optimism.

Justin Livengood:

Well, first of all, I do think, again, we're through the shock part of this banking crisis, so on the topic of this podcast at least, I do think we've seen the light at the end of the tunnel. Again, there's going to be a lot of subsequent stuff to deal with for the banks, but I think it's all manageable and I think our regulators and our banking system came through this relatively well. And again, this is not a credit related issue, which suggests this isn't going to be as pervasive as the financial crisis of '08-'09, so hopefully that's some good news.

Brian Levitt:

I'll take it, we'll take it.

Justin Livengood:

Even though I just said the Fed is the most important thing for the economy, they are essentially done or near done raising rates. And so there is some optimism in my mind that we've reestablished a proper equilibrium in monetary policy and that's going to let people adjust to a more normal yield curve —whether that's in the housing industry or industrial parts of the economy.

And as that reset happens, I think that's healthy and that's good, and that's going to be a stronger base for the economy and for the stock market to operate from in the next two to three years. I'm not saying that's going to cause anything perhaps in 2023 that's particularly exciting, but we needed to get away from some of the things that had happened the prior three years between COVID, the war — this has been an incredible stretch of volatility and just really unusual circumstances. We needed to get back to a more normal operating environment, and we're getting there.

Brian Levitt:

Well, let's look forward to that more normal operating environment. Justin Livengood, Portfolio Manager of the Invesco Midcap Growth Strategy, as well as a Manager on the Discovery Growth Strategies. Thank you so much for being here. This has been incredibly informative, and we look forward to having you again soon.

Justin Livengood:

Thanks, Brian.

Important information

You've been listening to Invesco's Greater Possibilities Podcast.

The opinions expressed are those of the speakers, are based on current market conditions as of March 14, 2023, and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.

Should this contain any forward looking statements, understand they are not guarantees of future results. They involve risks, uncertainties, and assumptions. There can be no assurance that actual results will not differ materially from expectations.

All investing involves risk, including the risk of loss.

Past performance is not a guarantee of future results.

Data on the size of bank failures sourced from the Federal Deposit Insurance Corporation, or FDIC, as of March 13, 2023.

Data on the amount of uninsured deposits at banks sourced from the FDIC as of March 10, 2023.

Information on the growth of deposits and makeup of assets on Silicon Valley Bank’s balance sheet sourced from the FDIC, as of March 13, 2023.

Information on the speed and amount of withdrawals at Silicon Valley Bank compared to 2008 events sourced from the FDIC, as of March 13, 2023.

Data on the Consumer Price index, or CPI, sourced from the US Bureau of Labor Statistics as of February 28, 2023. The CPI measures changes in consumer prices.

The profitability of businesses in the financial services sector depends on the availability and cost of money and may fluctuate significantly in response to changes in government regulation, interest rates and general economic conditions. These businesses often operate with substantial financial leverage.

Growth stocks tend to be more sensitive to changes in their earnings and can be more volatile.

Mortgage- and asset-backed securities are subject to prepayment or call risk, which is the risk that the borrower’s payments may be received earlier or later than expected due to changes in prepayment rates on underlying loans. Securities may be prepaid at a price less than the original purchase value.

A systemically important financial institution, or SIFI, is a financial institution that US federal regulators say would pose a serious risk to the economy if it collapsed.

The yield curve plots interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates to project future interest rate changes and economic activity. An inverted yield curve is one in which shorter-term bonds have a higher yield than longer-term bonds of the same credit quality. In a normal yield curve, longer-term bonds have a higher yield.

A credit rating is an assessment provided by a nationally recognized statistical rating organization (NRSRO) of the creditworthiness of an issuer with respect to debt obligations, including specific securities, money market instruments or other debts. Ratings are measured on a scale that generally ranges from AAA (highest) to D (lowest); ratings are subject to change without notice. NR indicates the debtor was not rated, and should not be interpreted as indicating low quality. For more information on rating methodologies, please visit the NRSRO website for Standard and Poor's, Moody's or Fitch Ratings.

The Greater Possibilities podcast is brought to you by Invesco Distributors Inc.

NA2792015