Storms make the oak grow deeper roots

“Storms make the oak grow deeper roots”

–George Herbert

We’ve decided to deviate from the typical format of our quarterly letter to explain the circumstances that brought down Silicon Valley Bank on March 10th. The speed at which the crisis emerged injected substantial fear into financial stocks causing many to question whether we were about to experience a recurrence of the financial crisis of 2008.

Silicon Valley Bank (SVB) provided banking services to nearly half of the country’s venture capital-back technology companies. Deposits tripled since 2019 as money flowed into venture backed businesses and SVB management purchased government backed bonds with the funds so that it could earn a profit between what it paid depositors and the interest yield it received on the bonds. Management’s critical error was purchasing bonds maturing years in the future in order to earn a higher yield, while depositors could withdraw their money at any time. This is known as “Duration Risk”. Compounding the issue, as interest rates rose the value of the bonds declined.

We think management took duration risk because it assumed new deposits would flow indefinitely into the venture capital funded businesses. The opposite happened and many of the venture backed businesses needed access to their deposits to pay bills and began to withdraw deposits. This put SVB in a bind; in order to raise cash to pay depositors it needed to sell bonds that were trading at a loss. SVB hired Goldman Sachs to assist the bank with raising more capital. When SVB venture capital fund clients discovered the bank was in a liquidity crunch, panic erupted throughout the venture capital community and a run on the bank occurred.

A key difference between the financial crisis of 2008 and now is that banks are not suffering from a credit crisis caused by failing loans. Instead, some banks took duration risk where assets and liabilities were not appropriately matched. The Fed has stepped in to assuage bank customer fears by providing banks easier access to short term loans to improve bank liquidity.

Importantly, we believe that the March bank scare will result in a tightening of credit availability, helping to slow the economy and alleviate inflationary pressures. Ironically, if the Fed can avoid additional interest rates increases it would help repair the duration risk taken by some banks. Thank you for entrusting Ayrshire Capital Management LLC with managing your money. We look forward to speaking with you soon.

Sincerely,

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