Contagion from Silicon Valley Bank Causes Rout in Regional Bank ETFs

Silicon Valley Bank: What exactly happened?

According to the Financial Times, the root cause of the crisis was SIVB's $91 billion bond portfolio, which incurred heavy unrealized losses as interest rates rose throughout 2022. 

The majority of SIVB's capital is comprised of cash deposits from its customers, most of whom are US-based tech start-ups. SIVB invested this capital in longer-duration mortgage-backed securities. However, this was done at a time when bond yields were low, thus locking in a low, but steady return. 

The problem is that as a bank, SIVB is also required to make interest payments to customers who hold deposits with them. When rates rise, SIVB must pay higher and higher levels of interest on these deposits, while their portfolio of bonds continues to earn much lower rates.

This created a problem for SIVB, specifically when it came to its net interest income. But that’s not all. Thanks to rising bond yields, bond prices have fallen sharply over the last year, with longer-duration assets like SIVB's holdings suffering particularly hard. 

Currently, SIVB's $91 billion bond portfolio has suffered a $15 billion haircut and is sitting at a market value of $76 billion. To avoid locking in a loss, the bank has elected to hold these bonds until maturity, where their original face value will be paid out.

However, the fact still stands that SIVB is staring down a $15 billion unrealized loss. Once it disclosed this, all hell broke loose. Short sellers began targeting the stock, while customer hysteria sparked a run on the bank. This Twitter thread from a former employee sums up the situation well. 

What this means for regional bank ETFs

The situation with SIVB has spilled into its industry thanks to the interconnected nature of today's markets. With 2008 firmly in the rear-view mirror, many investors have forgotten about the potential for contagion, especially when it comes to concentrated industry bets. 

Over the last week, the SPDR S&P Regional Banking ETF (KRE) has fallen by -17%, despite SIVB comprising just 1.01% of its portfolio as of Mar. 9, 2023. The broader SPDR S&P Bank ETF (KBE) lost -15% while only having a 0.73% exposure to SIVB.

It's clear from the performance of these industry-specific ETFs that contagion is very much alive and present, especially for industries like banking where counter-party exposure can be widespread. Even the much broader SPDR Financial Select Sector SPDR Fund (XLF) suffered a -8% loss over the week. 

Investors looking to make these industry-specific bets must also become familiar with the concept of idiosyncratic risks – those that have outsized effects on single companies, industries, or sectors. This contrasts with systematic risk, which affects the entire market.

As with most investment risks, the correct way to mitigate this is diversification. By adding additional industries, sectors, or assets with lower correlations, investors can offset the effects of potentially devastating tail risks like what happened with SIVB.

Even investors who are not specifically targeting bank stocks must reconsider their risk exposure. For example, the dividend ETFs held by many income investors tend to have concentrated exposure to high-yielding financial sector stocks such as regional banks. 

For instance, consider the much higher losses suffered over the last week by the SPDR Portfolio S&P 500 High Dividend ETF (SPYD) versus the benchmark SPDR S&P 500 ETF Trust (SPY). The former has a much higher 19.39% weighting to the financial sector, which many dividend investors may have overlooked. 

At the very least, the ongoing SIVB crisis serves as a somber reminder to ETF investors to always examine the underlying holdings carefully in their funds of choice, especially when it comes to narrow ETFs targeting specific sectors or industries. 

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.