The SVB debacle showed us that the masses are gullible as F**K!

If you are tracking the Silicon Valley Bank saga, you would have heard multiple accounts of how the disaster came to be. You would also have recently heard how the US Feds acted swiftly as a savior!

Do not let the political spin doctoring and the media make us believe that we need to celebrate Feds like a hero! The Government created this mess.

In a nutshell

1. Declining deposits: (10% of startups on venture debt in SVBs loan portfolio, not able to get further investments)
2. Declining bond portfolio value: (43% or $91B of the asset portfolio in MBS with unrealized losses less than book equity)

(Check the Appendix at the end of the blog to learn more about how mortgage backed securities or MBS works)

Moral of the story?

Bad asset liability management + Fed rate hikes = $42b deposits to be redeemed in 10hrs and the 19th largest bank shut down in under 48hrs with a projected contagion risk of $450b in coming months.

Point #2 is totally SVBs fault. I don’t understand how regulators allow these losses to accrue at a portfolio ratio of 43%!!!! (Regulation for this already exists, more regulation is not the answer)

IMO, the above two points were caused primarily because of the hostile environment created in money markets due to broad brushstroke Fed Rate hikes to control runaway inflation on the goods side (we do not have service inflation).

Fed rate hikes are a contagion risk. A “Contagion Risk”.

I would also blame the VCs who did not keep their portfolios accountable to have enough cash to survive the 2023 and 2024 economic hostility.

Most of it all, the startup founders did not hold themselves accountable to figure out financial prudence and frugality.

Market Movement

If SVB stayed at par value, it was at serious risk of a credit downgrade due to unrealized losses, which would have led the bank to sell a large portion of its bond investments at a loss.

Instead, SVB announced a $2.25 billion equity deal with the help of its adviser, Goldman Sachs. This was indeed a decent move.

Despite this, SVB was downgraded by Moody’s by Wednesday anyway.

Initially, large mutual funds and hedge funds showed interest in taking sizable positions in the shares, but they became hesitant when they saw how quickly the bank was losing deposits, which worsened after venture capital firms advised portfolio companies to pull out money as a precaution.

So, in a way the VCs caused the bank run!

Fed Takes Action

And then Sunday night (March 12th, 2023) Fed announce the following:

https://home.treasury.gov/news/press-releases/jy1337

The linked article is such an ambiguous position by the Feds! They make it clear that there is no bailout (taxpayer's money shall not be used).

The gist of the article is as follows: Feds makes it clear that the book equity value will be driven to zero because of conservatorship and depositors will become creditors with a certificate.

They state that 100% money shall be available Monday (March 13th 2023) through a 1 year loan program enabled by $25n backstop through FDIC.

What is not clear is the time derivative for the assets, loan terms, renewals, which banks are participating as investors, startups on venture debts, and most importantly book equity.

I am surprised that people are celebrating this as great news.

Here is the modus operandi which is not in the statement:

“The additional funding will be made available through the creation of a new Bank Term Funding Program (BTFP), offering loans of up to one year in length to banks, savings associations, credit unions, and other eligible depository institutions pledging U.S. Treasuries, agency debt and mortgage-backed securities, and other qualifying assets as collateral. These assets will be valued at par. The BTFP will be an additional source of liquidity against high-quality securities, eliminating an institution’s need to quickly sell those securities in times of stress.”

Fed makes a Jackass of us all 👏

Here is why the masses are gullible as f**k.

1. Fed creates a contagion risk with aggressive rate hikes with no clarity.
2. Fed regulators allow bank opacity by clearing high-risk asset liability management principles allowing SVB to invest money in MBS. (which is security packaged by the US Treasury for the money markets!!!!). The $91B of “agency MBS” is, mortgage-backed securities issued by Fannie Mae and Freddie Mac (Which are US Treasury sponsored), which trade as a liquid rates product in the US.
3. Hostile interest creates losses to accrue on the books due to over exposure to MBS, devalues SVB creating a bank run and SVB gets frozen.
4. Fed steps in like a hero, drives book equity to zero, and offers “1 year loan” by collateralizing MBS (which is US Treasury’s sponsored asset) through a redirection channel they ambiguously call “Bank Term Funding Program”. No clarity on time derivative.

Alright, let me explain in plain speak, let’s dive into the crazy world of financial jargon and see if we can make some sense of what the US Govt is upto.

First, the Fed regulators approved a $91 billion investment into Mortgage Based Securities, which are sponsored by the US Treasury. So, basically, a whole bunch of money from SVB depositors is now covering the mortgages, and the US government got $91 billion. It’s like a big financial potluck, and the government got the biggest piece of the pie.

But then, things start to get a little crazy. The Federal Reserve decides to increase interest rates, which causes the value of the $91 billion MBS to plummet. The asset value starts accruing losses.

But wait! The Federal Reserve then decides to freeze SVB assets worth a whopping $200 billion. That’s like freezing the bank account of a small country. It’s a huge amount of money, and it’s just sitting there, frozen like a popsicle.

But never fear, because the Federal Reserve steps in like a hero with a “plan” to lend loans to depositors whose $91 billion they already have in a sister account in the US Treasury. And just to make things even more convoluted, they create an “indirection” to involve other banks as investors, with a $25 billion backstop. It’s like a financial game of hot potato, and the Federal Reserve is doing everything they can to keep the potato from getting too hot.

Overall, it’s a complicated situation that involves a lot of money and a lot of financial jargon. But, at the end of the day, it’s clear that the Feds are doing everything they can to keep the financial system running smoothly, even if that means coming up with convoluted plans involving sister accounts, indirections, and frozen assets.

This is so target rich with schemes that this should be a hilarious movie plot!

And the public is celebrating the news with joy 🤣 😢 🤦‍♂️

It’s not like there was no alternative.

• Either, Mark-To-Market with no additional discounts to top 4 banks retaining book equity and allowing the premium on time derivate along with easy top tech startup customer acquisition.
• Or, bailout with warrants to taxpayers allowing the premium to be harvested upon MBS maturity as well as asset book equity growth in money markets.

They were both quite optimal plays. Anyway, welcome to the new age of fiscal policies!

Appendix: What the hell is an MBS?

MBSs (Mortgage-Backed Securities) are financial instruments that are backed by a pool of underlying mortgages. When a borrower makes a mortgage payment, a portion of that payment goes towards the interest and a portion towards the principal. MBSs are created by securitizing these underlying mortgages, which allows investors to buy a slice of the income stream generated by the pool of mortgages.

MBSs with the same issue date, coupon, and original face value can have greatly different current faces because they pay down at different rates based on the characteristics of the underlying loans. This is because the underlying loans have different characteristics such as the creditworthiness of the borrowers, their ability to refinance easily, and their prepayment speeds.

For example, the pool of underlying mortgages may be made up of borrowers of high creditworthiness who can refinance easily if interest rates drop. In this case, the prepayment speed of the mortgages is likely to be high, which means that the MBSs will pay down faster than MBSs with underlying mortgages made up of borrowers of lower creditworthiness who may find it difficult to refinance.

Moreover, even if the borrowers are roughly equivalent in terms of credit rating, differences in the prepayment speed of underlying mortgages will impact the current face. For instance, if the pool of underlying mortgages consists of a mix of adjustable-rate and fixed-rate mortgages, the prepayment speed of adjustable-rate mortgages is likely to be higher, especially if interest rates drop, resulting in a faster payment of the MBSs backed by these mortgages compared to those backed by fixed-rate mortgages.

Therefore, investors need to be aware of the underlying characteristics of the mortgages in the pool when evaluating MBSs, as these can impact the cash flows and returns of the MBSs.