How To Find The Next Silicon Valley Bank

Amidst the collapse of Silicon Valley Bank, Silvergate, and Signature Bank I think it's important to take a look at what caused the downturn for these banks along with the government's reaction to see if similar institutions will run into these issues.

Trade Thesis

My belief is that there are many other institutions which face similar issues to that of Silicon Valley Bank and the goal of this article is how to identify which banks might be the next to fall.

I'll go over which risks the market hasn't yet priced in and what trade structures could be used to take advantage of them.

What Caused The Collapse of Silicon Valley Bank?

The first order of action is to review what caused the collapse of Silicon Valley Bank. Silicon Valley Bank primarily banks tech companies and it was the bank for half of Silicon Valley start-ups.

Quick synopsis as to why Silicon Valley Bank collapsed: in 2020 and 2021 the deposits into the bank increased as tech and VC was in a large boom and more capital came into the bank. When this capital came into the bank's portfolio managers had to find a way to allocate the capital. Since at the time rates were zero on t-bills they had to take on duration risk to get a higher yield. This led them to invest in MBS and long-dated treasuries. To our knowledge, they didn't use a large enough quantity of interest rate swaps to hedge duration risk. Since rates have gone up over the last two years the bonds went down in value, and at the same time tech and VC firms needed more capital so Silicon Valley Bank was forced to sell for a loss. Eventually, they didn't have enough assets to liquidate so they had to go to the market for an equity raise. This caused the stock price to crash which caused a bank run. Not having enough liquid assets to handle the withdrawals they went into the government's receivership. Of course, this is a simplified overview but it gives us a gist of the issue, which is that the bank invested its current liabilities into long-duration assets to generate yield and those duration assets now have a lower mark-to-market value than their current liabilities. There are other banks in a similar situation so this certainly won't be an isolated incident for much longer.

The Treasury's Reaction

The most important part of the whole story is the Treasury and Federal Reserve's reaction to this failure.

First off, any deposits up to $250k were automatically covered by FDIC insurance. Normally anyone with deposits above $250k would get a claim on assets of the bank and as those assets were liquidated they would get paid.

In this instance, the Treasury deemed Silicon Valley Bank as "systemically important", in other words too big to fail. Because of this, they didn't go through the normal procedure for depositors with more than $250k instead they immediately bailed them out for the full amount owed.

This sets a terrible precedent as from now on all banks will be deemed "systemically important" since the government isn't in the position to pick winners and losers, and because Silicon Valley Bank wasn't really "systemically important" outside of the tech and VC space this effectively means that all deposits are guaranteed by the FDIC regardless of the dollar amount. Of course, this leads to moral hazard as large depositors who should know better won't care where their capital is going as it is always guaranteed.

The Federal Reserve's Reaction

I believe the biggest moral hazard came from the Fed. The Fed created the new Bank Term Funding Program which provides U.S. depository institutions with a line of credit to draw against their assets. The purpose of this line of credit is to prevent bank runs as the line would provide banks with enough capital for those who are withdrawing.

The biggest issue with this line of credit is that it uses par value rather than mark-to-market value to lend against. The reasoning for this is that the banks intended to hold their long-duration assets till maturity so the par value is used rather than the current market value.

This allows banks to draw down on this line to pay their depositors on withdrawals. The issue with this program is the assumption that banks will hold on to their bonds till maturity. Banks could be in a position where they have to sell bonds early due to defaults on their mortgages; if forced liquidation value for homes is low while mortgages are foreclosed on then they have realized a large loss which they can't cover.

Hence in the short-term, this facility from the Fed provides more solvency to banks but it could create larger issues in the long run in regard to large unrealized losses which the bank could be forced to realise.

The Biggest Risk

A large risk that I don't believe the market has yet priced in is rates that banks pay on deposits will have to go up significantly to the point where they will become unprofitable. For example, if a bank used to pay 0% on deposits and made a 2.5% yield on their MBS the spread would be their margin; now if that bank pays 5% on their deposits then they would be 2.5% underwater.

Below is the current amount that banks are paying on deposits.

Credit Union and Bank Rates 2022 Q4

Comparison of Average Savings, Deposits and Loan Rates at Credit Unions and Banks For December 30, 2022

Source: NUCA

As can be seen, it's well below what is being paid on t-bills. This is because, over the last 3 years, banks have been flushed with deposits and weren't making enough loans to keep up with the number of deposits coming in; to disincentivise more deposits they pay a significantly lower yield than a t-bill.

This poses a major risk though. As rates continue to go higher depositors will increasingly look into alternatives like t-bills. Also, if the economy weakens and there is a larger need to withdraw capital then banks won't be flushed with cash as they are currently, and they will need to raise rates to encourage depositors to deposit more capital.

Once rates go high enough banks will become unprofitable. Also since the yield curve is inverted banks can no longer issue long-duration debt at a higher rate than what the short end of the curve is, nor is there a demand for this debt from consumers or businesses. This puts most banks in a position where they will become unprofitable and stay that way for years to come. Once a bank becomes unprofitable they must draw down on this line from the Fed faster or sell their assets, both of which will negatively impact them. I believe that this risk has not been seriously considered by most market participants.

But wait there's more.

This credit facility from the Fed is also full recourse.

Recourse: Advances made under the Program are made with recourse beyond the pledged collateral to the eligible borrower

This means that in the event of default, the Fed would not just take away collateral but also go after banks for any more capital owed on the facility they can't get from just liquidating the assets. This could wipe out equity and bondholders completely.

This program also ends on March 11, 2024; although I do believe that if need be, the Fed would likely extend it rather than take the risk of more bank runs.

Balance Sheet Ratios

So far I've talked about large risks I see in the banking system, but the key thing to keep in mind is that there's a large divergence between the highest quality banks, which are often going for a discount valuation and are strong buys, and those at significant risk of having to dilute lots of equity, liquidate assets or face bankruptcy.

Balance sheet ratios provide us with a way in which we can separate the banks that are at the highest risk and those that aren't.

1. AOCI/(TEC-AOCI)

AOCI is the gains/losses that are unrealized on the bank's assets. TEC stands for total equity capital. In layman's terms, this ratio tells us the unrealized losses the bank has relative to their equity.

Below is a chart with an overview of 20 banks which have the worst AOCI/(TEC-AOCI) ratio.

Source: Market Watch

Fellow Contributor WYCO Researcher has an interesting article going over market cap to AOCI ratios which is another related indicator of distress on a bank's balance sheet.

2. Cash(and equivalents)/Total Deposits

For this ratio, I couldn't find a particular list of banks and their ratios, so it would have to be looked at on a case-by-case basis.

This ratio looks at the amount of cash a bank has relative to the total deposits; this provides a view as to what percentage of deposits could be withdrawn without the bank having to sell assets.

For example, if a bank has $1 trillion in deposits and $100 billion in cash or cash equivalents then the ratio would be 10% indicating that depositors could withdraw 10% of deposits without causing the bank to have to sell off assets or draw down on a credit line from the Fed.

We can use this to compare two well-known banks, JPMorgan Chase (JPM) and PNC (PNC).

JP Morgan Chase has $540 billion in cash and cash equivalents while it has $2.3 trillion in deposits. This is a ratio of 23.47%, meaning that 23.47% of deposits can be withdrawn and JPM wouldn't have to sell any assets.

PNC has $6.446 billion in cash and cash equivalents while it has $436.3 billion in deposits. That means that only 1.48% of deposits are held in cash. While PNC could draw down on their credit line from the Fed to pay out depositors on their withdrawals, they might be in a position where they are forced to liquidate their MBS portfolio due to foreclosures rising, which puts a far larger solvency risk for PNC than what most market participants believe there is.

So while PNC and JPM are valued similarly by the market from a valuation perspective, with both at 9x earnings, PNC has a lot more solvency risk than JPM. Comparing banks in this manner provides interesting long-short pairs trades, where higher quality banks like JPM can be bought while an equal dollar amount of a lower quality bank like PNC can be shorted; since both banks go at the same earnings yield there is no carrying cost to this trade other than the short carry fees, but if solvency risk were to increase PNC would likely go down more than JPM causing this trade to be profitable. This essentially provides a free put option on PNC.

How To Trade This

Now that I've gone over what caused the collapse of Silicon Valley Bank, how the treasury and Fed are kicking the can down the road, and what to look for in other banks that are at risk, it's important to discuss what trades can actually be put on to take advantage of this.

While one could just short or a proxy like buy puts on banks they think are at risk or buy an inverse financials ETF, I think the most asymmetric trades will be pairs trades as I highlighted above.

Pair trades can be put on in many different ways, such as long the debt and short the stock, or stock-to-stock pairs trades as the one with PNC and JPM highlighted above. My preference is for stock-to-stock long-short pairs trades; these trades allow for a large upside in case of a large divergence with little to no carrying cost, essentially a free long put. The only risk in these trades is the idiosyncratic risk of the individual companies. I would look to have many different pairs trades like this; similar to a large fishing net, some fish will get through but some won't, so by having many different trades we can diversify both our risk and have a higher probability of taking advantage of a future bank failure as some of the trades will work out but others won't.

A few months back I had a pair that played out well which was long Ally (ALLY) and short Credit Suisse (CS) and I would recommend a read-up on the article to get an overview of what these kinds of relative value trades are structured as and how the divergences play out.

Key Characteristics of The Next Silicon Valley Bank

The following points are key characteristics that can be seen in the highest-risk banks:

-Small percentage of deposits in cash and cash equivalents

-Large losses on hold to maturity assets

-Unprofitable or has extremely slim net margins that could cause unprofitability if rates were to go higher on deposits

-Trading at a high P/B multiple

-Holds most of its loan portfolio in debt that has a high risk of default

The above requirements are what I would look for when searching for potential shorts in this environment. Since there are a large number of bank stocks out there when I filter through which ones, I want to look at I look at these key characteristics first. Then I can put in the time to do individual bottom-up analyses on each of the stocks that meet the requirements.

The Bottom Line

The bottom line for this article is pretty simple. I want this article to be a "how-to template" for finding future risks in the banking system similar to that of Silicon Valley Bank and using actionable trade ideas such as relative value pairs trades to take advantage of these risks playing out.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.