Yield Me Tender

Malt Liquidity 94

Damming the Floodgates

Lending requires striking a fine line between generating a yield on deposits and preserving liquidity to return them. Generally, the larger an institution is, the easier it is to avoid a bank run — that being said, those institutions are likely to be “too big to fail” and have minimum capital requirements to prevent worst-case scenarios. A tricky problem to solve is that deposits are not exactly optimally distributed — if a flood of money comes in during a low-rates environment, you have to find some yield on it, else you’re just going to lose money on operations. But rates rising was generally predictable, and as newer issues hit the market with higher yield, the value of the older, lower-yielding notes takes a hit. This seems to be the problem Silicon Valley Bank ran into:

SVB, the parent of Silicon Valley Bank, late Wednesday said it would book a $1.8 billion after-tax loss on sales of investments and seek to raise $2.25 billion by selling a mix of common and preferred stock. The bank’s assets and deposits almost doubled in 2021, large amounts of which SVB poured into U.S. Treasurys and other government-sponsored debt securities. Soon after, the Federal Reserve began its rate-hiking campaign.

The issue here isn’t that they mispriced the risk of default on their notes and won’t get paid — it’s that the mark-to-market on their holdings which they were forced to acquire in 2021 is severely in the red. These notes will all pay their coupon, but if they need access to that capital, they can’t hold the note to its term length — they must sell it off and use that capital to return deposits.

SVB’s debt securities declined substantially in value last year, but in ways that weren’t always reflected in SVB’s earnings and shareholder equity, as noted in a Wall Street Journal article. As of Dec. 31, SVB’s balance sheet showed securities labeled “available for sale” that had a fair market value of $26.1 billion, which was $2.5 billion below their $28.6 billion cost. Under the accounting rules, the available-for-sale label allowed SVB to exclude the paper losses on those holdings from its earnings and regulatory capital, although the losses did count in equity.

As a lender, the worst thing that can happen is all your depositors clamoring for their money back at once. The second worst thing is everyone thinking that you won’t be able to pay deposits and wondering whether they should get their money while it’s still there. It’s a self-fulfilling prophecy, of sorts — the floodgates open when everyone rushes to pull money out that they know is not fully liquid. As I’ve noted before regarding Credit Suisse,

Turmoil begets more turmoil. Losses and scandals (and the occasional mysterious death) require constant restructuring and replacement of executives, who will all have different ideas on how to “recover” from the business, but the reputation loss is the real death sentence….

Admitting that business lines aren’t going well just shows even more incompetence which leads to more caution from potential clients which leads to even more business lines being shut down — it’s the death spiral.

Seeing your lender sitting on a bunch of unrealized losses is like sitting next to that guy at the sports bar who placed way too much money on the game at -180 that’s looking like a +300 halfway through the third quarter. It’s not exactly certain that he’s about to go broke, but you start to consider whether you should close your tab halfway through the fourth to avoid the drama of witnessing someone stuck with a tab they can’t pay.

SVB’s year-end balance sheet also showed $91.3 billion of securities that it classified as “held to maturity.” The significance of that label is that it allows SVB under the accounting rules to exclude paper losses on those holdings from both its earnings and equity.

In a footnote to its latest financial statements, SVB said the fair market value of those held-to-maturity securities was $76.2 billion, or $15.1 billion below their balance-sheet value. The fair-value gap at year-end was almost as large as SVB’s $16.3 billion of total equity.

It’s always a little worrisome when a lender is essentially obligated to disclose that they are sitting on a bunch of bonds that have definitely traded down but that it’s not factored into earnings because of an accounting categorization. Forced liquidations beget more liquidations until everything is gone and you’re left holding a bag much smaller than the one you took in. Silicon Valley Bank, as the name implies, primarily services the financing of that region of the world’s interests:

The bank derives its income from a variety of business lines: fund and asset management; investing in companies alongside VC firms such as Andreessen Horowitz and Sequoia Capital; underwriting tech IPOs; and even providing billions of dollars of financing for vineyards and wineries — the pet projects of Silicon Valley entrepreneurs. But SVB’s core business is centred on banking deposits of cash raised by tech start-ups, and lending to the venture capital and private equity firms that back them. At the peak of the tech investing boom in 2021, customer deposits surged from $102bn to $189bn, leaving the bank awash in “excess liquidity”.

As anyone who has looked at the success rate of startups and equity movements prior to the free-money era knows, this is a pretty alarming trade. Venture-backed investments are notoriously volatile, as evidenced by the cratering of every speculative growth stock in 2022. And those were the ones that made it to the finish line! Taking all this capital from a high-burn sector and putting it in long term notes is a precarious short volatility position against the most volatile class of investments — what did they even expect to happen? This is borderline malfeasance levels of assuming liquidity. Believe me, I understand how frustrating it can be to have to find yields when you are flush with cash when there is no yield to be found. Furthermore, as a bank, what you can do with deposits is regulated to oblivion post Dodd-Frank. In a very bizarre way, through totally safe investments, SVB finds itself taking it on the chin because of liquidity mismatches and how they’re positioned against their deposits. I don’t think I’ve ever seen someone so leveraged on rates not rising through a completely mundane position before. It’s important to keep in mind how levered lending as an institution has to be to make profits to pay for all its operations and then some. Turns out Tyler Durden didn’t need to blow up anything — all he needed to do was hike rates more than expected.

Wrung Dry

I’ve talked before about the unsustainability of food delivery to deliver actual profits:

“In 60 years,” CFO Stuart Levy said on Thursday, “we’ve never made a dollar delivering a pizza. We make money on the product, but we don’t make money on the delivery.”

“So we’re just not sure how others do it,” he added.

I have always reviled the marketing of the gig economy as “entrepreneurship” when the reality is much closer to “preying on people desperate for income”. Remember that axiom about risk transfer externalities a few sentences ago? Well, the flood of cheap VC funding into “gig economy” companies transfers the risk of making ends meet from the business itself to the services it inserts itself into delivering and the people who facilitate the deliveries themselves. As Levy correctly notes, there aren’t sufficient margins in delivery - while food delivery startups such as Grubhub or Doordash command 10-11 figure valuations, they don’t actually make any reliable profit; rather, they are enabled by artificially subsidized cost of capital allowing them to show explosive revenue growth.

But I haven’t really talked about “build your own meal” delivery businesses before. Alas, it is time:

Based in Berlin, HelloFresh dominates the market for cook-at-home ingredient packages. In the U.S. it accounted for 78% of meal-kit sales last year, helped by various acquisitions, according to an analysis of consumer-purchase data by Bloomberg Second Measure. Home Chef, owned by supermarket chain Kroger, came next with 12%, followed by Blue Apron at 6%. Blue Apron’s stock has performed so badly that the New York Stock Exchange in December threatened to delist it.

HelloFresh is clearly big in the meal-kit business… They tend to be less expensive than eating out, but much more expensive than cooking from scratch: HelloFresh currently charges $60.95 to deliver a box of two meals for two people each…

The extraordinary sums HelloFresh spends on keeping customers support this thinking. The company’s marketing budget last year was 1.3 billion euros, equivalent to about $1.4 billion or 17% of its revenue. Yet it still lost customers, with 7.1 million active globally in the fourth quarter, down from 7.2 million for the same period of 2021. Growth mainly came from price increases. Marketing costs will rise again this year, the company said—a big factor in the weak profit guidance.

You don’t really need to do any complicated financial analysis when assessing the profit potential of “middleman” services — you just need to get a sense whether it’s even possible to make money. Food delivery is a great example: the average restaurant’s profit margin is about 3-5%, the cost of the delivery itself we can approximate at $5 (assuming $15 min wage + 3 deliveries per hour), and the average order total is roughly $30. Assuming liquidity and ignoring taxes, for a $35 order (including delivery cost), how much could a delivery service reasonably encroach on a restaurant that’s only making a couple bucks on the order (ignoring packaging costs) without charging an obscene amount on top of the order? Thus you get a delivery order costing double the food cost and still these operations aren’t profitable. Margins cannot be invented out of nowhere — price increases cannot magically ignore the demand curve.

Similarly, taking a look at grocery delivery, one would think that the margins would be better due to verticalization. However, companies like HelloFresh are actually middlemen that take the form of quasi-wholesalers — they are essentially trying to boost grocery margins by sectioning off produce into stylized, smaller portions. Doing a similar analysis as we did in the paragraph above, we can see that grocer margins are around 1-3%. On top of the delivery labor, there’s a further issue in that restaurants are generally in the same locality as the person ordering a meal, while grocery warehouses are not — the spoilage risk is significantly higher. As such, the packaging is much more expensive and the cost is internalized, as opposed to delivery apps outsourcing packaging costs to restaurants. The margins simply don’t make sense, and the claim that people are going to order more meal kit delivery than they did during the pandemic seems absurd. This is reflected by the marketing budget increasing despite the cost of capital ratcheting up — that isn’t advertising, that’s heavy subsidies to absorb users who balk at the objectively insane sticker price tag for a few mediocre groceries and a small amount of meat to keep the wheel spinning as long as possible. The fact that they’re losing customers despite all this spend screams “unsustainable business” to me. Just another example of the post-ZIRP regime cleansing out nonsense.