SVB: Understanding and Managing Interest Rate Risks
CBOT: 10-Year Treasury Futures (
ZN1!)
Last Wednesday, Silicon Valley Bank (SVB) NASDAQ:SIVB announced that it incurred $1.8 billion loss in the sales of its bond portfolio and sought to issue new shares. Within 48 hours, a bank-run induced by panic customers brought down the legendary bank.
On Friday, US banking regulators seized control of SVB. By Sunday, the Treasury Department, the Federal Reserve, and Federal Depository Insurance Corporation (FDIC) jointly announced a rescue plan that would make whole all depositors. However, SVB shareholders are not protected.
Why has happened to the well-respected and once well-capitalized bank?
Opportunity and Risk Go Side-by-Side
Traditional banks seldom extend credit to startups, which are mostly under-collateralized, with little or no profit and big uncertainties about their future survival.
SVB developed a niche competitive edge to provide banking services to companies funded by venture capitals. In the past 40 years, it nurtured many high-profiled tech startups through their entire life cycle, from early-stage to IPO and to Big-Tech giants.
If Sequoia Capital invested in your firm and you apply for a loan from a commercial bank, you can expect the loan officer to ask: “Sequoia Who?” But if you go to SVB, they would say: “$10 million will be in your account tomorrow.”
VCs are exceptionally good at spotting future technological trends, and they follow a rigorous due diligence process to pick investing targets. By working with VCs and startups closely, SVB created an ecosystem that foster technological innovations, and grew to become the 16th largest US bank by deposit.
However, SVB’s concentration in the high-tech sector also make it vulnerable to a boom-and-bust cycle. Last year, bear market hit the industry hard. Publicly traded firms couldn’t raise money with falling share prices. Private companies found the path to IPO got blocked. As startup clients withdrew deposits to keep their companies afloat, SVB is short on capital. It was forced to sell most available-for-sale bonds at a huge loss.
Bad news travelled fast in close-knit tech investing community. VCs urged their portfolio companies to get the hack out of SVB. All told, customers withdrew a staggering $42 billion of deposits on Thursday. By the close of business day, SVB had a negative cash balance of $958 million, according to the filing, and this triggered the government takeover.
A Commercial Bank with a Failing Grade
In fiscal year 2022, SVB earned $4.5 billion in Net Interest Income (NII) and $1.7 billion in non-interest income. When you take away the bells and whistles, SVB is by large a commercial bank. About 73% of its revenue comes from taking in deposits at a low interest rate and making loans at a higher interest rate.
Based on its 2022 10K filing, SVB managed $209.2 billion in total interest-bearing asset and earned $5.7 billion. This represented an effective yield of 2.73%. During the same period, SVB paid out $1.2 billion in funding cost, which equated to 0.57%.
• Therefore, in 2022, its NII = 2.73% - 0.57% = 2.16%
• In comparison, its NII for year 2021 was 2.02% (=2.09% - 0.07%).
• On the surface, SVB was doing well, with NII spread increasing by 14 basis points year-over-year.
What has gone wrong then? Dive deeper into SVB’s balance sheet, we see the long-dated Treasury bonds and illiquid mortgage-backed securities it held got hammered by the rising interest rates. Simply put, SVB got its interest payment back, but the value of its investment principal eroded in a huge way in a rate-hiking environment. All in all, managing interest rate risk is at the core of banking business.
A Naked Bond Portfolio
In its 10K, SVB puts its investment portfolio in Available-For-Sales (AFS), Held-To-Maturity (HTM) and Non-marketable securities categories.
AFS balance was $26.1 billion as of December 31st, including:
• U.S. Treasury securities $ 16,135m (61.9%)
• Agency-issued MBS $6,603m (25.3%)
• Agency-issued CMBS $1,464m (5.6%)
• Foreign government debt securities $1,088m (4.2%)
• Agency-issued CMO—fixed rate 678m (2.6%)
• U.S. agency debentures 101m (0.4%)
• Total AFS securities $26,069m (100%)
Last week, SVB sold $21 billion in the AFS portfolio and incurred a loss of $1.8 billion, or -8.6%. AFS assets are marked to market every quarter. My understanding is that the loss figure was based on selling price vs. year-end fair market value.
Total loss calculated from purchasing price could be much bigger, as these bonds may have been marked down multiple times during previous quarters. Evidence: Since March 2022, CBOT 10-Year Treasury Futures (ZN) price went down from 124 to 109 (-12%) and 30-Year Treasury Bond (ZB) fell from 152 to 118 (-22%).
CBOT Treasury futures market, with its sheer size and liquidity, makes it the marketplace of choice to manage interest risk in times of uncertainties. Each ZN contract has a notional value of $100,000.
• On Monday March 13th, daily trading volume is 3,760,911 lots, which translates into total notional of $376 billion. Open interest (OI) stands at 4,311,338, or $431 billion in notional.
• Volume and OI for ZB are 719,518 and 1,209,881, respectively. Notional value for each is $72 billion and $121 billion, respectively.
What’s Next
On Friday, Signature Bank customers spooked by the SVB collapse withdrew $10 billion. That quickly led to the bank failure. Regulators announced Sunday that Signature was being taken over to protect its depositors and the stability of the U.S. financial system.
Despite government intervention over the weekend, fear ran contagious through the financial industry this Monday. San Francisco’s First Republic Bank, which had $212 billion in assets at the end of 2022, saw its stock price plunge as much as 70% when the market opened Monday morning.
By market close, US stock market stabilized. Investors wonder if a banking crisis could be the final punch to end the year-long Fed rate hikes.
Lessons Learnt
As investors, we usually allocate our financial assets across various instruments, such as stocks, bonds, and derivatives. The 60 (stock) / 40 (bond) portfolio is the most popular advice from Wall Street.
People generally pay more attention to what stocks to buy and hold, but we may not think twice about managing interest risk in a rising rate environment. The SVB fallout shows that even the safest, risk-free Treasury bonds, if not actively managed, could fall prey to interest rate changes and liquidity risk, resulting in loss of market value.
For me, this is a wake-up call and a good time to review my bond holdings. Some may be hidden in a 401K retirement plan. Hedging interest rate risk with CBOT Treasury futures and Micro Yield futures could go a long way to stay solvent.
A View on Interest Rate Trajectory
Today, the Bureau of Labor Statistics reports that the consumer price index rose 0.4% in February and 6% from a year ago, in line with market expectations. This is the most recent data the Fed will consider before it makes interest decision on March 22nd.
Inflation is cooling, but still too high. A bank run shows how damaging rising interest rate is to the economy. Whether the Fed will continue its rate hikes, pause them, or end them altogether, I think all options are open.
In my view, interest rate is in an uncharted territory once again. With investors in panic mode, they will likely overreact to the Fed decision. This may be a good time to place an order of out-of-the-money options on CBOT 10-Year Treasury Futures (ZN).
On March 14th, the June ZN contract is quoted at 113’220. Quoting convention in Treasury market is 100 and 1/64th. The quote reads as (113 + 22.0/64), or $113.34375 on $100 par value.
If the Fed slows or pause the hike, Treasury price will likely go up. Call options would be appropriate in this case.
• The 115-strike call is quoted 0’20 (=20/64). This is converted into $312.5 premium on the $100,000 contract notional for each contract.
If the Fed stays its course on fighting inflation, Treasury price could fall. And put options would be a way to express your view.
• The 112-strike put is quoted 0’14, or $218.75 premium per contract.
Happy Trading.
Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.
CME Real-time Market Data help identify trading set-ups and express my market views. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/cme/
ZN1!)Last Wednesday, Silicon Valley Bank (SVB) NASDAQ:SIVB announced that it incurred $1.8 billion loss in the sales of its bond portfolio and sought to issue new shares. Within 48 hours, a bank-run induced by panic customers brought down the legendary bank.
On Friday, US banking regulators seized control of SVB. By Sunday, the Treasury Department, the Federal Reserve, and Federal Depository Insurance Corporation (FDIC) jointly announced a rescue plan that would make whole all depositors. However, SVB shareholders are not protected.
Why has happened to the well-respected and once well-capitalized bank?
Opportunity and Risk Go Side-by-Side
Traditional banks seldom extend credit to startups, which are mostly under-collateralized, with little or no profit and big uncertainties about their future survival.
SVB developed a niche competitive edge to provide banking services to companies funded by venture capitals. In the past 40 years, it nurtured many high-profiled tech startups through their entire life cycle, from early-stage to IPO and to Big-Tech giants.
If Sequoia Capital invested in your firm and you apply for a loan from a commercial bank, you can expect the loan officer to ask: “Sequoia Who?” But if you go to SVB, they would say: “$10 million will be in your account tomorrow.”
VCs are exceptionally good at spotting future technological trends, and they follow a rigorous due diligence process to pick investing targets. By working with VCs and startups closely, SVB created an ecosystem that foster technological innovations, and grew to become the 16th largest US bank by deposit.
However, SVB’s concentration in the high-tech sector also make it vulnerable to a boom-and-bust cycle. Last year, bear market hit the industry hard. Publicly traded firms couldn’t raise money with falling share prices. Private companies found the path to IPO got blocked. As startup clients withdrew deposits to keep their companies afloat, SVB is short on capital. It was forced to sell most available-for-sale bonds at a huge loss.
Bad news travelled fast in close-knit tech investing community. VCs urged their portfolio companies to get the hack out of SVB. All told, customers withdrew a staggering $42 billion of deposits on Thursday. By the close of business day, SVB had a negative cash balance of $958 million, according to the filing, and this triggered the government takeover.
A Commercial Bank with a Failing Grade
In fiscal year 2022, SVB earned $4.5 billion in Net Interest Income (NII) and $1.7 billion in non-interest income. When you take away the bells and whistles, SVB is by large a commercial bank. About 73% of its revenue comes from taking in deposits at a low interest rate and making loans at a higher interest rate.
Based on its 2022 10K filing, SVB managed $209.2 billion in total interest-bearing asset and earned $5.7 billion. This represented an effective yield of 2.73%. During the same period, SVB paid out $1.2 billion in funding cost, which equated to 0.57%.
• Therefore, in 2022, its NII = 2.73% - 0.57% = 2.16%
• In comparison, its NII for year 2021 was 2.02% (=2.09% - 0.07%).
• On the surface, SVB was doing well, with NII spread increasing by 14 basis points year-over-year.
What has gone wrong then? Dive deeper into SVB’s balance sheet, we see the long-dated Treasury bonds and illiquid mortgage-backed securities it held got hammered by the rising interest rates. Simply put, SVB got its interest payment back, but the value of its investment principal eroded in a huge way in a rate-hiking environment. All in all, managing interest rate risk is at the core of banking business.
A Naked Bond Portfolio
In its 10K, SVB puts its investment portfolio in Available-For-Sales (AFS), Held-To-Maturity (HTM) and Non-marketable securities categories.
AFS balance was $26.1 billion as of December 31st, including:
• U.S. Treasury securities $ 16,135m (61.9%)
• Agency-issued MBS $6,603m (25.3%)
• Agency-issued CMBS $1,464m (5.6%)
• Foreign government debt securities $1,088m (4.2%)
• Agency-issued CMO—fixed rate 678m (2.6%)
• U.S. agency debentures 101m (0.4%)
• Total AFS securities $26,069m (100%)
Last week, SVB sold $21 billion in the AFS portfolio and incurred a loss of $1.8 billion, or -8.6%. AFS assets are marked to market every quarter. My understanding is that the loss figure was based on selling price vs. year-end fair market value.
Total loss calculated from purchasing price could be much bigger, as these bonds may have been marked down multiple times during previous quarters. Evidence: Since March 2022, CBOT 10-Year Treasury Futures (ZN) price went down from 124 to 109 (-12%) and 30-Year Treasury Bond (ZB) fell from 152 to 118 (-22%).
CBOT Treasury futures market, with its sheer size and liquidity, makes it the marketplace of choice to manage interest risk in times of uncertainties. Each ZN contract has a notional value of $100,000.
• On Monday March 13th, daily trading volume is 3,760,911 lots, which translates into total notional of $376 billion. Open interest (OI) stands at 4,311,338, or $431 billion in notional.
• Volume and OI for ZB are 719,518 and 1,209,881, respectively. Notional value for each is $72 billion and $121 billion, respectively.
What’s Next
On Friday, Signature Bank customers spooked by the SVB collapse withdrew $10 billion. That quickly led to the bank failure. Regulators announced Sunday that Signature was being taken over to protect its depositors and the stability of the U.S. financial system.
Despite government intervention over the weekend, fear ran contagious through the financial industry this Monday. San Francisco’s First Republic Bank, which had $212 billion in assets at the end of 2022, saw its stock price plunge as much as 70% when the market opened Monday morning.
By market close, US stock market stabilized. Investors wonder if a banking crisis could be the final punch to end the year-long Fed rate hikes.
Lessons Learnt
As investors, we usually allocate our financial assets across various instruments, such as stocks, bonds, and derivatives. The 60 (stock) / 40 (bond) portfolio is the most popular advice from Wall Street.
People generally pay more attention to what stocks to buy and hold, but we may not think twice about managing interest risk in a rising rate environment. The SVB fallout shows that even the safest, risk-free Treasury bonds, if not actively managed, could fall prey to interest rate changes and liquidity risk, resulting in loss of market value.
For me, this is a wake-up call and a good time to review my bond holdings. Some may be hidden in a 401K retirement plan. Hedging interest rate risk with CBOT Treasury futures and Micro Yield futures could go a long way to stay solvent.
A View on Interest Rate Trajectory
Today, the Bureau of Labor Statistics reports that the consumer price index rose 0.4% in February and 6% from a year ago, in line with market expectations. This is the most recent data the Fed will consider before it makes interest decision on March 22nd.
Inflation is cooling, but still too high. A bank run shows how damaging rising interest rate is to the economy. Whether the Fed will continue its rate hikes, pause them, or end them altogether, I think all options are open.
In my view, interest rate is in an uncharted territory once again. With investors in panic mode, they will likely overreact to the Fed decision. This may be a good time to place an order of out-of-the-money options on CBOT 10-Year Treasury Futures (ZN).
On March 14th, the June ZN contract is quoted at 113’220. Quoting convention in Treasury market is 100 and 1/64th. The quote reads as (113 + 22.0/64), or $113.34375 on $100 par value.
If the Fed slows or pause the hike, Treasury price will likely go up. Call options would be appropriate in this case.
• The 115-strike call is quoted 0’20 (=20/64). This is converted into $312.5 premium on the $100,000 contract notional for each contract.
If the Fed stays its course on fighting inflation, Treasury price could fall. And put options would be a way to express your view.
• The 112-strike put is quoted 0’14, or $218.75 premium per contract.
Happy Trading.
Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.
CME Real-time Market Data help identify trading set-ups and express my market views. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/cme/
Jim W. Huang, CFA
jimwenhuang@gmail.com
jimwenhuang@gmail.com
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