Hey everyone,
First of all, I apologize for the delay in posting. It’s been a few weeks since I last posted and the truth is, I got a little pot committed to finishing the federal government budget posts and ran out of time to write them. They take a good amount of time to research. I do want to finish them, but I might take a break from them for a bit and make some general comments. Below is a piece I wrote (along with another writer) about SVB. This is meant for a financial advisor’s client base, so it is a little overly simplified for what I normally write for this audience, but you still might enjoy it.
Anyway’s, I will get back to posting regularly on Wednesdays and Fridays. I will complete the series on the federal government, but I might have to wait until I have a bit more time with work. So on Wednesdays expect a market or business update, and Fridays a book review. In other exciting news, soon enough my company will be launching our services and I will be happy to share our beta products with you all. If anyone is interested in providing some feedback on our demo site, send me an email. Devin Lasarre who writes the Invariant Substack offered me some spectacular advice, if you don’t follow his wonderful Substack I suggest you do.
Glad to be back everyone, enjoy the piece on SVB.
This week we have been fielding questions surrounding the fall of Silicon Valley Bank (SVB) – which began on Friday, March 10th and progressed over this past weekend. To fully understand what transpired, it’s important to understand a few things: First, we need to understand how the banking system operates in general. Second, we need to know how rising interest rates impact bond holdings. Lastly, we need to understand Silicon Valley Bank’s clientele and what brought about the bank’s downfall. Below is an attempt to concisely explain what transpired and the potential implications for the greater financial system.
The Banking System & Interest Rates
Most people are aware that when you deposit funds at your local bank branch, the bank then turns around and loans a large percentage of those funds out to individuals and small businesses to generate earnings for the bank. At no time does the bank ever have 100% of deposits sitting in their vault simply waiting for you to tap your cash. In fact, they usually keep closer to 10% on hand for that purpose – per regulations from the Federal Reserve. Of those reserves kept on hand - some are completely liquid to help cover day to day withdrawals from depositors, while some is invested conservatively in holdings such as Treasuries issued by the United States Government. That’s what brings us to point two, which is the need to understand the inverse relationship that exists between bonds and interest rates.
Rising Interest Rates & Their Impact on Bond Holdings
Over the past year everybody was painfully reminded that when interest rates go up, bond prices fall. This is in large part why portfolio returns were so dismal in 2022 – equities and fixed income were hit hard in the same year. As the Fed raised rates to combat inflation – the face value of existing bonds held by investors fell. Why? If you are buying a bond, why would you buy a federal government bond that yields you 3% when, because rates have gone up, someone else will sell me the same government bond yielding 5%? You would never accept the lower yielding note, instead, you would require the lower yielding note be sold to you at a discount to make both notes equally attractive to you. As in investor – if you can hold the bond to maturity – it will mature at the originally determined face value and the fact that the yield fluctuated with interest rates over time doesn’t matter at the end of the term. But if you cannot hold the bond to maturity, and some event requires you to sell the bond early, you might be forced to realize the loss. This brings us to SVB.
SVB Specifically
Silicon Valley Bank (SVB), was located in California and provided banking services to startup tech and life-science companies, as well as venture capital firms. Over the past year SVB grew rapidly in the number of deposits at the bank, with majority of these depositors keeping well over $250,000 (current FDIC limits) in their accounts. SVB then invested a large percentage of these deposits in long-term
treasuries. As interest rates have risen rapidly over the past year, the value of those long-term treasuries has fallen, resulting in losses on the books of SVB’s financial statements. Simultaneously, as funding has dried up over the past year for tech start-ups, SVB’s customers were also pulling their money at higher rates than prior years – forcing the bank to sell some of these bonds at a discount vs. being able to hold them to maturity. When the bank’s financial statements came out last week, depositors became fearful that the bank would collapse and they rushed to pull their funds, resulting in an old fashioned “run on the bank”. Even though SVB had invested in “safe” government treasuries, they mismanaged the liquidity of those funds in a rising rate environment and misjudged the impact rising interest rates would have on their ability to meet higher than expected withdrawals.
Is this like the 2008 Financial Crisis?
A lot of people have been asking aloud if this is 2008 all over again, and we’re happy to say that we don’t think it is. There is an important difference between 2008 and what we’re seeing today. In 2008, the problem was the banking sector had lots of Mortgage-Backed Securities (MBS) that everyone thought were safe, but then proved to be unsafe. Once people realized the MBS’s were higher risk, nobody knew what a MBS was worth. This unknown value prevented the banks from being able to sell the MBS for needed cash, and with fears of a banking collapse, the federal government stepped in and injected liquidity into the banking system.
Today, in the case of SVB, we know what the treasuries are worth. The issue is that rising rates caused the face-value of many interest-bearing assets to drop, including treasuries. When the values dropped, and depositors wanted their money – there just weren’t enough assets to cover the deposits.
Is there Cause for Concern?
Yes…., you should always be thoughtful when things like this occur, but it is too early to tell if this is the story of a system wide financial problem, or the story of a few banks being mismanaged. On the one hand, most banks and financial institutions hold long-term bonds, and the face value of those bonds have all dropped together in unison. On the other hand, SVB is less strictly regulated than larger banks, and has a significantly different customer base than most banks. It is simply too soon to tell if this will become a larger issue or not. As of right now regulators are displaying high levels of confidence that this is a contained incident, and the Federal Reserve has stepped in to cover all deposits at SVB fully – even those over the $250,000 FDIC limits.