Transaction activity over the last thirty days has been relatively slow for Altus. There were no new purchases, no sales, and no new properties put in contract for purchase or sale. All our currently active projects continue to move forward (click here for an article about Camp Hall) without changes in status other than being one month closer to construction completion. Our sister company, Altus Capital Group Inc, had an active quarter as private money loan volume continues to grow.

We have received a lot of questions about the current banking situation, specifically the implosion of Silicon Valley Bank (SVB). While we did move some money around between our various banks, we have had no direct impact of the bank failure. And in fact, we are already seeing a benefit of inflows into our Liquidity Fund as people search for somewhere secure to place funds. Many of the questions have been looking for explanation as to what happened. Since we don’t have much activity to report in this Mid-Month Update, we thought it could be helpful to stray from the normal script and provide CliffsNotes of what happened that led to the second largest bank failure in the US history.

Up until only a brief time ago, Silicon Valley Bank was considered one of the most solid banks in the country. Every Wall Street analyst had a buy recommendation on the stock but one, who had a hold recommendation and price target of $190. As the country’s 16^th largest bank by assets, it had only 17 branches, but those branches were enough to service a massive deposit base. In fact, over 90% of deposits at the bank were not FDIC insured. FDIC insurance is/was capped at $250,000, so for 90% of the deposits to be uninsured, it gives an idea of the size of the depository relationships and the sheer wealth of the depositors. By comparison, the Washington Mutual failure (the largest in US history) had only 24% uninsured deposits.

You may read articles that the failure was because of bad bets in the tech industry. While a large amount of deposits were indeed companies or individuals tied to the tech industry, it was not that relationship that caused the failure, at least not directly. SVB didn’t make risky bets on tech company stocks. They didn’t have a real estate portfolio that blew up (i.e. Washington Mutual). To the contrary, SVB had more than half of its assets in US treasuries, traditionally a huge show of financial stability.

Why is this time different? Why is it not a blow up in an underlying loan portfolio? It all goes back to the Federal Reserve. It has been argued, probably accurately, that the crypto and tech start up bubbles were caused by the largesse of the Federal Reserve, first through QE infinity (quantitative easing), and then later through their efforts to soften the COVID blow (dramatically supported by government fiscal stimulus). The trillions in liquidity added to the markets needed a home. With debt providing negative real returns (even before inflation kicked in) investors looked further afield in hopes of securing returns. That led to inflows into venture funds, which in turn led venture funds to invest more money into start-up companies like Uber, WeWork, and thousands of others. Most of those companies were not (and have never been) profitable; but were focused on growing market share until some future point where somehow the profitability switch could be turned on. So long as money continued to flow into the venture funds and then out of the venture funds into the companies through A, B, C, etc. rounds of funding, the non-profitability wasn’t an issue because cash was plentiful.

That cash, either held by the venture funds or by the companies that received funding, needed a place to go. Silicon Valley Bank was that place. But companies flush with cash don’t need loans. They have cash. So without great places to invest that cash SVB bought long-term, low yielding treasuries. Lots and lots (and lots) of these treasuries.

It can be hard to imagine now, but only eighteen months ago the three-year treasury was returning less than ½ of 1%. The ten-year treasury was around 1.4%. Even after a huge drop in yields the last couple days, the three- and ten-year treasury rates are still 4.3% and 3.7% respectively. Eighteen months ago regional bank loans were pricing between 3.75% (on the very low end) to 5.25%. More importantly, those loans had varying duration, ranging from fully adjustable (common in construction loans) to 7-year terms (unless hedged).

Without enough loans to fund, SVB bought treasuries at very, very low returns. Even with the extremely low interest rates paid on deposits, the margins earned by SVB were minimal at best. This was okay when deposits could be reinvested at huge scale into the treasuries. There is much less staff needed to buy treasuries than find, underwrite, fund, and manage a real estate loan portfolio. And the bank’s retail overhead was already much lower than its competitors because of the incredible deposit per branch ratio.

Fast forward a few months and interest rates have gone up dramatically. At the same time the Fed is performing quantitative tightening, sucking liquidity out of the markets. The reduced liquidity resulted in a reduction in flow of funds into venture funds, and in turn into the private tech companies. Those companies continued to burn through cash, drawing on their deposits held by SVB, but without the historical influx of new funds as companies received VC funding and needed a place to put the funds.

At the same time, savvy depositors started seeing other institutions paying dramatically higher interest rates on deposit. Because of the miniscule spreads between the interest rates paid on deposits and the income earned on the treasury portfolio, SVB had its hands tied and couldn’t raise their deposit interest rates to compete. If you have treasury responsibility for a company and have $100 Million on deposit, when another bank is offering 2% higher for those deposits, you very seriously have to consider moving your banking to pocket the extra $2 million per year. And so people and companies did, resulting in the trickle of normal business cash burn turning into a more steady creek of cash outflows.

Banks of this size are required to hold 10% of deposits (transaction accounts) in cash. As SVB’s cash balances continued to dwindle they needed cash to stay in compliance. Easy, right? Just sell some of the treasuries. This leads to two problems. For one, treasuries are captured on the balance sheet in two different areas. Normally they are labelled as long-term investments “held to maturity”. In that case treasuries can be booked at the face value of the treasury. However, when there is any intent to sell those treasuries in the short run the asset is moved into current assets and must booked at its current market value. The offsetting journal entry is a loss (or gain if interest rates have dropped). Banks, like SVB, which have to suddenly dip into their chest of treasuries face huge operating losses.

The second issue is those treasuries have to actually be sold. You or I can just tap a few buttons in our Charles Schwab app and sell a couple hundred bonds. The market is huge and liquid, and those bonds are easily absorbed into the transaction volume. But if you wanted to sell billions of dollars in bonds, it isn’t so easy. Your trader needs to find a buyer, so they would start by reaching out to known buyers in the market. This is a very public process, and it doesn’t take much time nor a lot of analysis to find out who is selling and why. The Wall Street trader then calls his venture capital buddy with the big news. The venture capital buddy immediately pulls money from the bank and calls all his/her portfolio companies and encourages them to do the same thing. The portfolio companies pull money from the bank and the controller of one of those companies calls a couple friends at companies where he/she used to work with the gossip. They in turn pull their funds. And the bank run is on.

On Saturday Janet Yellen was saying there would be no bailout. On Sunday a bailout plan was announced, at least for the depositors. But the uninsured deposits were over $150 Billion, while the market cap of SVB was $17 Billion at the beginning of February and $16.6 Billion at the beginning of March. There is considerably more value being bailed out than not being bailed out. This is obviously good for you if you are a depositor.

And yet, it doesn’t give me the warm and fuzzies about carrying substantial funds in a bank, whether personal or business funds. SVB was a strong bank with no indication of issues, and then BAM, it hit a wall. If it can happen to SVB, it can happen to any bank if the markets turn against it. And that is a scary proposition.

It is of course impossible to run a business without having funds in a bank, but it is well worth considering other options. Treasuries and securities are highly liquid and can be sold as needed, but also expose the business to changes in valuation. The shorter the duration of the bond, the less risk there is around changes to value.

Investment vehicles such as our AE HGF Liquidity Fund are also interesting possibilities. The fund pays an annualized preferred return monthly (going up to 4.93% on 4/1/23), and it is liquid in 30 days or less.  The Liquidity Fund is competitive with other riskier liquidity options available, and it has a substantial amount of collateral as security (all loans are less than 50% LTV). Even if there was a massive run on redemptions like with SVB, the fund has the backstop of liquidating positions in the loan portfolio to pay investors (there is also an additional share class buffering the preferred, and significant cash reserves on hand).

Another less liquid, but still short-term option is private money lending. Current private money lending rates are well above inflation, providing one of the few yield-based options with meaningful real returns. If you would like to learn more about private money lending, please join us Thursday at 4:00 PST/7:00 EST. Click here to register.

As always, opportunities are first offered to our active investor interest list. Please reach out to us if you have funds for lending and would like to be added to the list. If you are trying to figure out the capital stack for your own project, feel free to reach out and we are happy to brainstorm possibilities with you.

If you have interest in discussing equity or lending opportunities in greater detail, please reply to this email or call our office at (707) 932-5887.  We will gladly add you to our distribution list and/or schedule an appointment to discuss your investing needs.

Happy Investing,

The Altus Investment Team

This message is not an offer or solicitation of an offer to buy or sell any securities.  Offers are made only by prospectus or other offering materials.  The information contained herein has been obtained from a variety of sources which are believed to be reliable, but have not been independently verified, and may be subject to change without notice.  To obtain further information, you must complete our investor questionnaire and meet the suitability standards required by law.