The collapse of Silicon Valley Bank (SVB) has caused ripple effects around the globe, with many investors surprised and confused about how this could have happened and leaving Australian investors wondering, could this happen here? It has also reinforced a bigger concern that we have been warning of for the past year – the increasing risk of more and more ‘zombie’ companies as interest rates rise and the era of cheap money ends.

At Stock Doctor, we are here to support investors through all cycles and to answer your questions about this latest market development.

Why did Silicon Valley Bank collapse?

As the market cycle turned, tech companies no longer had access to cheap money and were forced to draw down on cash reserves. The problem for SVB was that they had to meet an increasing volume of redemptions, and the only way to do this was to realise a loss on their investments.

Let’s start at the beginning. SVB, a relatively large ‘niche’ bank with a $US45 billion market capitalisation at its peak, offered banking services to technology companies across the development spectrum, their venture capital partners and high-net-worth individuals predominately connected. It extended globally, including several listed Australian technology companies such as Life360, Sezzle, Dubber, Whispir, SiteMinder, and Xero.

At the end of 2021, supported by years of loose fiscal and monetary policy, many speculative tech start-ups and venture capital funds were flush with cash as an investment in the tech start-up space reached its peak.

Many of these firms were attracted by the SVB proposition, putting their money with “the bank that understood them”. At this point in the cycle, SVB had an abundance of clients, flush with cash from their ever-increasing rounds of capital raisings.

Traditionally a bank will attract deposits from a base of its clients (savers) and lend this cash to another segment of its customers (borrowers) whilst making a margin for its shareholders. But in the SVB example, most of their clients didn’t require loans because they were able to raise a huge amount of equity capital. Instead of lending its ever-increasing deposit base, the bank needed to ‘invest’ it in a portfolio of ‘safe assets’ such as government treasuries, high-rated corporate bonds & mortgage-backed securities in long-duration, low-yield investments. What surprised many is that the company didn’t appear to hedge any of its duration risk¹. Without hedging, the bank was betting that interest rates would stay low forever. Every credible financial organisation would have partially hedged against duration risk, but SVB were “all in.”

As any serious investor knows, as interest rates rise, the value of fixed-interest instruments falls. And the quick and swift rise in US and global interest rates the situation at SVB.

Why did the SVB collapse happen so quickly?

One of the headlines circulating was that this was such a rapid collapse that investors and deposit holders were caught by surprise and had no time to withdraw their savings. That is not actually the case. It played out over many months; we would say it was years in the making. In many ways, it was hiding in plain sight for all to see.

As rates rose, SVB used a Trump-era deregulation reform loophole, allowing them to reclassify part of their to “held to maturity”. It meant that SVB wouldn’t have to mark down the value of its portfolio to its liquid price (mark to market). This bought the bank time, allowing it not to realise the losses it was sitting on. They could continue to hope that the Federal Reserve would change direction – or that inflation would magically disappear.

But inflation stayed persistent, and the Federal Reserve kept tightening.

So, although SVB didn’t recognise losses on its portfolio, a liquidity event would quickly turn into insolvency. It is a model example of why staying focused on your investment process is important and not investing in a business with deteriorating fundamentals. Some very astute short sellers were (loudly) pointing out the risks of SVB and other banks to the market.

As a last-ditch effort, the bank tried to raise capital – which spooked their clients and Silicon Valley – rumours spread like wildfire. The bank was inundated with withdrawal requests they couldn’t honour. The game was over – the Federal Deposit Insurance Corporation took over within a few days.

What has happened since the Silicon Valley Bank collapse?

Concerned about contagion risk – i.e. the SVB collapse impacting the banking and financial sector more broadly – the Federal Reserve, the Federal Deposit Insurance Corporation, and the US Treasury have come to the rescue to guarantee 100% of all deposits. Tech companies will get their money back. It is a get-out-of-jail-free card. However, shareholders and bondholders will be lucky to get anything back from the collapse.

Are Australian banks vulnerable or at risk?

It is a question we’ve been hearing – could this happen in Australia? The short answer is an emphatic NO.

The Australian banking system is highly concentrated and is not exposed to particular geographics or industries like SVB was. It is also highly regulated. Regardless of their size, our banks are subjected to tighter regulatory requirements – disturbingly, SVB was not subjected to international capital requirement standards due to the lobbying power of community banks in the US.

Will the SVB collapse impact interest rate expectations in Australia?

A short-term positive for mortgage holders is that the collapse of SVB could force the RBA and US Federal Reserve to pause their planned interest rate rises if the actions by US regulators fail to limit financial contagion. The market now expects that the RBA will keep interest rates on hold at 3.6% at its April meeting.

Did Lincoln Indicators or Stock Doctor have any exposure to this risk?

No. Our Lincoln US Growth Funds are not exposed to SVB or US banks. And while SVB does business with some local Australian technology companies, these are all categorised in Stock Doctor as Financially Unhealthy and, therefore, do not meet our investment strategy.

Despite this, we have seen the contagion spread across some of the financials within our Star Stock universe. These stocks tend to be interest rate sensitive, such as Computershare, Challenger, AUB Group, Suncorp, Netwealth, HUB24, and the banks.

Our view is that the fundamentals have not changed across these stocks, and as always, we firmly believe such volatility may present opportunities for investors.

What are the key takeaways and learnings from the collapse of SVB?

This event is a timely reminder to remain well-diversified and not too concentrated towards a particular sector or theme. To remain focused on the underlying fundamentals and not get distracted by fads or trends that don’t align with your investment objectives.

More broadly, it could be seen (from the recent reporting season), that earning expectations are seen as too optimistic. Leaving the potential risk of further earning downgrades on the horizon. Generally, it could be considered prudent to leave some cash on the sidelines in volatile markets, enabling the opportunity to take advantage of further volatility (if or when it emerges).

1. Duration risk is the risk that changes in interest rates will either increase or decrease the market value of a fixed-income investment. Because payments are typically fixed, if the interest rate changes, then the market value of the investment will change.

Unlock your share market investment potential with a Stock Doctor membership.

Take up 14-day free trial today