About a month ago, we made a video about Silvergate Capital which was the largest bank servicing the crypto industry. After the collapse of FTX and Alameda research, there was a run on Silvergate's deposits and we explained how this could lead to bankruptcy for Silvergate. Sure enough, since we released that video, Silvergate's share price has continued to free fall and on March 8th, they announced that they intend to completely liquidate their positions. We all know about the Tech Bear.

Market Of the past year, money losing tech companies like those in the Arc Innovation ETF have seen their values plummet as the FED has raised interest rates while money losing tech stocks have been big losers from the Fed's hiking cycle. Banks theoretically should benefit as higher interest rates allow them to earn high yields on their loans. When Silvergate collapsed, most analysts viewed this as an anomaly and not related to the health of the broader Financial system. Unlike traditional, Banks, Silvergate dealt exclusively with the crypto industry, with FTX being one of their biggest customers.

But recent events suggest that the Silvergate collapse may not be as isolated as it first appeared with over 200 billion dollars of assets. Silicon Valley Bank or Svb is far larger and more mainstream than Silvergate. Svb takes deposits and gives out loans just like any other bank. What differentiates them is that they focus primarily on the technology industry.

Having funded early stage startups including Airbnb Uber Square and others, Svb was a major beneficiary of the Tech Bull run over the past 10 years, with its share price having risen almost 20-fold between 2009 and its peak in 2021. However, things have recently taken a turn for the worse. on Wednesday March 8 Svb announced I'd be raising 1.75 billion dollars of new stock in an effort to shore up its balance sheet. This news caused the bank's share price to lose more than 60 percent of its value the next day, and another 60 in the aftermarket.

Large, Unexpected: Equity raises are almost always a bad sign, especially for banks, as it usually means they're desperate for cash. The prospective investors weren't dumb, they knew the bank was in a dire situation, so nobody is Will going to build an owl. Unable to find any willing investors, Svb collapsed, becoming the second largest bank failure in U.S history, second only to Lehman Brothers. But how do we even get to this point? Svb has posted positive net income every year since 2009, and in the most recent quarter they made over 300 million dollars of profit.

How could they go from profitable to desperately needing cash within just a few months time? It's a similar story with Silvergay. The bank was printing consistent profits for years, but then all of a sudden they report a one billion dollar loss in the fourth quarter of 2022.. How is it possible that the financial fortunes of banks can change so quickly? As we dug into the numbers, we found that the collapse of Silvergate and Svb are shockingly similar. Join us as we uncover the unnerving similarities between the collapse of Silvergate and Svb, revealing the harsh reality that much of our financial system is built on pillars of sand.

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Founded in California in the 1980s, Svb is a commercial bank which focuses primarily on the startup and Venture Capital Industries At the time, there was a significant Gap In the market because most traditional Banks avoided Tech startups viewing them as too risky. Most banks prefer to lend money into home buyers or well-established companies that have very high probabilities of repaying their loans When you're only making a few percentage points of interest, even a small number of defaults can be catastrophic. That's why Banks tend to be so conservative in their lending practices. Tech Startups are on the opposite end of the spectrum according to a study conducted by Harvard Business School 75 percent of venture capital-backed startups fail.

On the flip side, if the tech startup is successful, it has the potential to be a thousand bagger. As a venture capitalist, you just need one or two of your startups to be successful to pay for all of your failures. The problem is, if a bank lends money to a startup, they don't participate in the Upside: If a bank lent money to Google in the early days at a five percent yield, they would only make a five percent return on the invest net, even if Google's share price increased fifty thousand percent. That's why it's so difficult for startups to get bank loans.

Svb developed an Innovative approach to solve this problem. They were willing to lend money to Tech startups, but in return they demanded to receive warrants, which are essentially call options that will allow Svb to participate in the upside if the startup's equity value appreciates. For example, they provided a 250 million dollar credit line to Uber while it's still private and received a huge number of Uber warrants in return. When The company IPO The warrants cashed out to the tune of hundreds of millions of dollars Silicon Valley Bank's unique focus on early stage Tech Startups has enabled them to establish deep relationships with these companies.

As these startups grow and become more successful, they continue to use SBB as their primary Bank Providing the bank with a low-cost source of deposits. This Advantage allows SBB to operate with a leaner cost structure than traditional Banks which are burdened with the cost of maintaining a large network of retail branches and being so plugged into the startup space. Svb Also became the go-to bank for Venture Capital funds who deposited their cash with the bank. The low interest rate environment of the 2010s created a gold rush for the Venture Capital industry.

Investors were pumping hundreds of billions of dollars into VC funds and much of this money found its way onto Svb's balance sheet. and despite the fact that many of Svb's borrowers were losing money, they were able to fund their losses from continued BC Investments so defaults remained low. The excesses of the Venture Capital industry was a massive Boon for Svb, with its net income skyrocketing to a peak of almost 1.8 billion dollars in 2021, this caused Svb's share price to Skyrocket becoming one of the best performing Bank stocks in the market as the bubble inflated in 2020 and 2021. But as we will see, this success was built on pillars of sand foreign.

Going into 2023, Svb's balance sheet looked to be in pretty good shape. As of December 31st, 2022, they had 212 billion dollars of assets and 195 billion dollars of liabilities. Equity is equal to assets minus liabilities so that gives the bank and Equity balance of 16 billion dollars. So the bank was solvent with a 16 billion dollar cushion or at least that's how it looked on the surface, of the 212 billion dollars of assets, 73 billion dollars of it were loans, 26 billion dollars were available for sale Securities 91 billion dollars were held to maturity Securities and the remaining 21 billion dollars were other as you can see available for sale Securities and helps maturity Securities make up the majority of Svb's balance sheet.

So what are these? Securities From 2019 to 2022, Svb's assets tripled from 71 billion dollars to 212 billion dollars. This was the result of VC funds raising huge amounts of money and depositing them at the bank. This massive influx of money was far in excess of what they could use in their regular lending operations, but they still wanted to generate some returns on it. They thought that the safest thing to do with this cache was to buy U.S government bonds Would the US government? Never having defaulted on its debt, this seemed like a pretty safe option.

Wanting to maximize their interest income, Svb purchased long duration government bonds with an average duration of 5.7 years. The problem was they bought in at almost exactly the wrong time. They acquired more of their bond portfolio in 2020 and 2021 when the Fed was pursuing its quantitative easing policy. They thus bought the bonds at very low yields.

Since then, the yields have increased dramatically as the FED has raised rates. Bond prices are inversely related to yield. Thus, as the yields have increased, Svb has incurred 15 billion dollars of unrealized losses on their bond portfolio. Turning back to Svb's financial statements, the bank made 1.8 billion dollars of net profit in 2021 and 1.5 billion dollars of profit in 2022..

How is it possible that they were able to maintain profitability despite suffering 15 billion dollars of losses on their bond portfolio? It all has to do with accounting technicalities. If you're a bank and you hold debt security such as government bonds, you can either classify them as available for sale Securities or health maturity. Securities Available for sale means that you intend to sell the bond before it matures. These Securities are recognized on the balance sheet at fair value.

This means that they are Market to Market on a quarterly basis. Any unrecognized gains or losses are reported on the bank's financial statements held to maturity. Securities are bonds that you intend to hold until they mature instead of being recognized at fair value, they are recognized at their amortized cost. This means the price you paid to buy it minus any coupon payments you've already received the exact same Bond can have different accounting treatment based on how you classify it.

So why is this difference exist? The idea is if you own a five-year U.S treasury bond with a face value of 100 in five years time, the US government will pay you 100 if your intention is to hold the bond until maturity. The day-to-day price fluctuations are meaningless now that we know what healthy material Securities are. Let's go back to Sbb's balance sheet. As of December 31st, 2022, Svb had 91 billion dollars of health and maturity Bonds on their balance sheet.

Remember this: 91 billion dollars is calculated based on amortized cost, not fair value. Because of the rise in interest rates, the market value of these bonds has decreased to 76 billion dollars. This is a 15 billion unrealized loss. Svb's reported Book value was 16 billion dollars going into 2023, which represented eight percent of their liabilities.

However, after subtracting the unrealized losses, their real book value is only one billion dollars, roughly 0.5 percent of their liabilities. Thus, Svb was already on the brink of insolvency. Please remember that many of Svb's clients are money losing. Tech Startups: They continually need to withdraw money from their bank accounts just to keep the lights on.

In the past, they were able to replenish their bank accounts by receiving fresh funding from their Venture Capital backers. But now that interest rates are increasing, that sweet VC money is drying up. This lets a significant deposit outflows from Svb. If enough depositors withdraw their money, Svb would be forced to start selling its ultimaturity assets and recognize massive losses.

This would cause the facade of their Book value to come. Crashing Down In A Desperate attempt to save the situation on March 8th, they announced the plan to shore up their balance sheet with a 1.75 billion dollar share issuance. However, by this point it was too late. The unexpected share sale served as a signal to the market that Svb was facing serious issues.

Their depositors panicked and started withdrawing funds hand over fist. Compounding the already serious liquidity issues, Svb failed to find any willing buyers for its proposed share sale as nobody wants to invest in a failing Bank. They basically found themselves in a bank run situation where everyone was trying to pull their money out. at the same time.

After the share issuance failed, Svb tried to sell themselves to another bank, but this too failed. Two days later, the FDIC took control of Svb. It will immediately start the process of liquidating the bank's assets. The FDIC ensures deposits up to 250 000.

But given the fact that most of Svb's clients are companies who have millions or even tens of millions of dollars in their accounts, this insurance doesn't do much good. With that being said, even after the unrealized loss, Svb's book value was slightly positive as of December 31st. The situation has likely deteriorated since then, so depositors may have to take a small haircut, but this will probably be less than 10 percent given that Svb is only slightly insolvent, Its collapse is unlikely to cause a 2009 level financial crisis, but this will be of little consolation to the bank's 6500 employees who will soon find themselves unemployed. Thank you! The SBB collapse was very similar in nature to the collapse of Silvergate.

If you want to learn about Silvergate in more detail, check out this video we made about it a month ago: Link in the description below. Basically, Silvergate was a bank that took deposits almost exclusively from the crypto exchanges, with FTX being one of their biggest customers. After FTX went bankrupt, end users started withdrawing money from crypto exchanges, who in turn withdrew money from Silvergate. Just like Svb, Silvergate owned a huge amount of long-term treasury bonds, which had decreased in value significantly, leaving the bank almost insolvent.

Up until right before they collapsed. Both Silvergate and Svb appeared to be profitable and in Good Financial Health But this was purely because they both had significant amounts of health and maturity bonds to their balance sheet valued at amortized cost. This hid the fact that their financial situation had been deteriorating for the past two years as interest rates Rose If you're ever considering investing in Bank stocks, it's important to remember that just looking at A bank's net income and Book value is not enough. You have to look at exactly what the bank's assets and liabilities are and come to your own judgment of what they're worth.

Because as we saw with these two recent examples, the true Financial Health of a bank can differ materially from what their Gap Book value might lead you to believe. Finally, while the Silvergate and Svb collapses are certainly shocking, there is currently no reason to believe that this will cause a 2008 level financial disaster. The 2008 crisis was precipitated by a sharp decrease in real estate prices and a wave of mortgage defaults. Almost all banks had exposure to mortgages, so this turned out to be catastrophic for the entire industry.

The collapse of Svb was caused by a dry up of cash in the Venture Capital industry most large Banks today have minimal exposure to money losing startups and are thus unlikely to suffer the same pay. Alright guys, that wraps it up for this video. What do you think about the collapse of Silicon Valley Bank Should Banks be allowed to Value their bond Holdings that amortized cost. Let us know in the comments section below.

As always, thank you so much for watching and we'll see you in the next one. Wall Street Millennial Signing out.