We all have preconceived notions of how things operate and that guides us to making quick decisions. Often the real world is more complex and it takes time to digest the information and change our notions. For example in the banking sector. we think of a local bank whose prime functions are to take in deposits and lend out in mortgages and personal loans. There are many other functions at a bank, but we often think that is the normal because in fact in 99% of the time, it is the normal.
In mid March, a bank specializing in the tech sector collapsed for a bad business model and over concentration of prime depositors. The bank is the Silicon Valley Bank (SVB) and the business model was to cater to Venture Capital firms who invested in startups and the tech infrastructure. The process of Venture Capital firms is to lend money to startups and when they show their products can be regional or national or international in scope to invest more money and then to bring the companies to the stock market where they can sell some of their shares at a high premium. If the company is successful and the stock rises, the venture capital firm sells off more shares, earns a bigger profit and can look for the next company. The model depends on a healthy new issue market for companies to go public. In the last 6 months, investors did not want potential, they wanted real sales which translated into profits.
While the IPO was vibrant, companies tended not to need a great deal of cash to run their business, money was coming at higher valuations of the company and when the IPO was issued the shares, companies could sell shares or equity into the market and have a very healthy balance sheet. When the change happened and their were fewer IPOs, companies needed to go the bank or SVP to receive their cash.
At the bank, SVP was swimming in cash and decided to buy bonds with long maturities. Most of the bonds were US government bonds and the US has not defaulted on any of its bonds. The bank believed they were safe and secure and life was ok. When the federal reserve decided to raise interest rates, although the bonds would pay at maturity the principal and interest, the value of the bond fell. If the bond rate on a 10 year bond is 2%, and interest rates past 2%, no investor is going to pay 100% to buy the bond, it is worth less or when interest rates go up, bond prices fall and the reverse is true, when interest rates fall, bond prices go up. Giving the change in the IPO market, the venture companies each with multiple companies banking at SVP needed cash to maintain operations as start up companies burn through lots of cash or the burn rate. The bank needed to sell bonds to meet the cash flow requirements of the companies and announced it sold $20 billion in bonds at a loss of $1.8 billion. The bank was going to sell equity to investors to meet a shortfall on their balance sheet. The venture capital companies decided to move their primary banking relationship to bigger banks and the run on SVB was on. What the facts are and what the public perceives can be two different things. Will the fed continue to raise rates or is that off the table for now?
Linking to dividend paying stocks, we all start with what we think we know, but is there a difference? What is the difference that makes the stock unique and good to own forever? Do you understand the business model and what can change in the business model? If the answer is yes, then you can understand how the company will react to changing conditions, if and when they happen. How specialized is the company’s you invest in? For example many companies are dependent on China for their supply system and went the ports backed up, what were the alternatives for companies?
There are more questions than answers, till the next time – to raising questions.