For years, Silvergate Capital Corporation and SVB Financial Group were the favorite financial stocks of Wall Street’s momentum crowd chasing their stocks that flew to the moon.
No longer. Last week, the two stocks hit rock bottom as both financial institutions faced a liquidity crunch that left them in the hands of regulators. On Friday, Silvergate shares were trading at $2.50 per share, down from their all-time high of $212 set in November 2021, while SVB shares did not open for trading (they closed at $717 in October 2021 traded).
Is this an isolated case or the beginning of another financial crisis? David Trainer, CEO of New Constructs, a Nashville-based investment research firm, believes the former is more likely than the latter.
It’s about the strategy of the two banks to lend money to subprime business customers.
“SVB Financial Group’s struggles show the dangers of doing business with bad companies,” he told the International Business Times. “Many tech startups are zombie companies with no business models and no credit. The SVB is now learning that firsthand.”
While the two financial institutions got away with this strategy during the bull market, they felt pain during the bear market.
“The SVB’s problems show that companies, including banks, need to be much more critical of who they do business with,” added Trainer. “Since the bear market began in January 2022, the market has been penalizing companies without business models, and SVB’s problems are the latest frontier in the market’s calculation. In addition, the market is fed up with companies doing business with unprofitable companies or unprofitable themselves.”
Still, he sees no risk of contagion to the rest of the banking sector after the SVB’s struggles.
“The big banks’ deposit base is much more diversified than at SVB and the big banks are in good financial shape,” he added.
Brian Dally, co-founder and CEO of Groundfloor, a marketplace for retail investors, sees a bigger problem spreading across the financial sector due to rising interest rates.
“The Fed is causing a liquidity crisis. It will show itself in many expected and unexpected ways,” he told IBT. “The SVB shows us that a liquidity crisis can be a tough spot for ‘middlemen’ – that is banks, REITs and fund managers. In the case of the SVB we see ‘maturity risk’ because they have invested so heavily in government bonds, their investments have lost value as interest rates have risen. That’s fine if you can hold the investment to maturity, but you couldn’t and didn’t have to sell it.”
Banking veteran Panos Angelopoulos provides more insight into how maturity risk, or fixed rate risk – to use a more appropriate term – works and how it can become a serious problem for the banking industry.
Under widespread capital regulations, banks must decide whether to classify fixed income securities such as government and corporate bonds as “investment securities” or “commercial securities”.
Investment portfolio securities are held to maturity; As such, they don’t need to be adjusted for capital gains and losses when interest rates change — something that can affect the bank’s balance sheet.
In contrast, trading portfolio securities are subject to mark-to-market rules and therefore may result in capital gains and losses as interest rates change.
Banks have an incentive to classify fixed income securities as investments in a rising interest rate environment. Therefore, they do not need to raise capital in order to meet the capital requirements, as the market value of these securities decreases as interest rates rise.
But that may change if they face massive deposit withdrawals and need to sell investment securities to raise cash.
“In this case, the entire investment portfolio must be reclassified as a commercial portfolio,” explains Anelopoulos. “Hence, it could have a devastating impact on capital requirements.”
Could there be a banking crisis? Angelopoulos believes so when the problem is widespread and existing shareholders and markets are unwilling to bail out banks.