VCs Go “Meme”
Our take on the unsolved issues from the SVB debacle
VCs Go “Meme”
Over the last four business days investors have had a crash course on the impact of “unintended consequences”, a euphemism often used by one set of smart people to roast another set of smart people. By now, for most readers it has become quite clear that a decade of unnecessarily “easy money” in the form of artificially low short-term rates and central bank quantitative easing (QE) keeping the long end of rates lower than they would most likely be otherwise, fueled massive amounts of smart money seeking excess returns in venture capital, flooding start-up balance sheet with cash, that in turned “had” to be parked in the VCs’ own favorite bank, Silicon Valley Bank (SVB). As the Federal Reserve (the other set of “smart people”) started raising rates in earnest, drying up new funding for VCs’ portfolio companies, startups started drawing down on their cash balances, forcing SVB to sell portfolio assets to meet deposit drawdowns. But, with long term rates now much higher, SVB’s “safe” assets, such as US Treasurys and mortgage-backed securities had to be sold at materially lower prices than those paid to acquire them, leading to a capital hole for the bank. An unsuccessful equity funding round for SVB unleashed the rumor mill and the bank run was on.
For those still scratching their heads on how a such a scenario can be so drastic to the viability of a bank, we remind investors of the adage: “The only thing different between a bank and a hedge fund is a bank has more leverage”. With banks operating with roughly 10% equity and 90% debt, imagine a scenario where the “ultra safe” 30 year US Treasury has gone from a 1.7% yield at the beginning of 2022 to as high as 4.3% in late 2022, and currently sits at 3.7%. A bond with say 25 year duration (coupons make duration less than maturity), in a scenario of where rates increase by 1%, would lead to a 25% decline in the bond’s value. So much for “ultra safe”.
The US Treasury’s and Fed’s action to take over SVB, guarantee all deposits above FDIC limits, and extending this guarantee to all banks, has had an immediate positive impact for bank stock prices, and has certainly removed main street’s concern for whether there’s any place left in the world to park money. The upshot of this bailout is the immediate recalibration of market expectations of future rate rises. What had been an expected 50 bps rate rise in the next Fed meeting, is now openly speculated as a potential “pause” or even a rate cut. From a Fed that was so behind the eight ball calling inflation “transitory” for too long, we have no opinion on whether they will blink all the way to a rate cut.
As the dust settles, we believe the most lasting impact to be on the eye of the storm, the venture world and its portfolio companies, many of which, we understand, had undrawn credit lines at SVB, which they counted on as part of their continued funding in an otherwise tight capital world. For the rest of us, we believe a big unanswered question for the banking system is how can banks manage the mismatch of long term assets (loans, mortgages, Treasuries, etc.) with short term liabilities (deposits for most main street banks). In a world of online banking and mobile banking, the ability of depositors to transfer money with a few key strokes is potentially a weapon of mass destruction.
What the VC world did late last week as it responded to the failed capital raise by SVB is no different than the retail “Redditors” that pushed meme stocks to the stratosphere during the pandemic lockdowns. Even “smart” money can fall for herd mentality. VCs essentially went “all meme” on each other scrambling to take money out of SVB before each other. In the financial crisis of 2008, things were much different for banks. Bank runs, like the one that took down Wachovia Bank, were done in the wholesale funding market between banks. Retail deposits were too “sticky” to put immediate liquidity pressure on banks. Furthermore, with the exception of mortgage portfolios imploding, “ultra-safe” Treasuries provided a valuable counterbalance to a degree. Today, barely a decade later, technology has completely upended the idea that a retail bank run is a slow burn. We could be entering a new “too big to fail” banking era, where the government implicitly, or explicitly, encourages “big banks”, and in turn seeks to regulate them even more. After all, regulators are very good at always fixing last year’s problems.