The How, Why and What Next of the Silicon Valley Bank Failure

Alright, let’s jump into the Silicon Valley Bank (SVB) collapse and the current banking panic mania sweeping across the (especially financial) news.  I thought the most helpful thing I could do was explain some of the basics and put it into a broader context.

So, let’s get to it…

Photo by Bradyn Trollip on Unsplash

The Basics of Banks and Bank Collapses.

First, what happened?

The SVB collapse was a surprisingly simple, straightforward, textbook bank collapse and seems to have been about as predictable as the sun rising in the morning.  That, of course, raises some other questions which I discuss at the end.

A bank’s basic business is to take deposits from people wanting to save money and lend it to people needing to borrow money.  And SVB was doing just that.

Banks pay depositors a low interest rate and charge borrowers a higher interest rate and thus makes money on the difference.  The problem is that there is a “maturity mismatch” already baked into the business model.

Depositors usually want short-term deposits so they can demand their money at any time, say, to pay their monthly bills.  Borrowers usually want longer-term loans that they can pay back over years.  If deposits were the same duration as loans, there’d be no problem: The bank would take the deposit for, say, one year and lend it to someone else for one year.  The borrower would pay the bank back the amount of the loan plus interest. The bank would then give the depositor back the full amount plus some interest. And viola, everyone’s happy.

When deposits are short term, however, the depositors come back for their money before borrowers have repaid.  The solutions to this are two: first, have lots of depositors and, second, don’t lend all the money out, keep some in-house in reserve and also invest some of it in stuff you can liquidate quickly if lots of depositors return all at once.

Notice that the first solution still relies on only a few depositors wanting their money at a time.  If the bank doesn’t have it for depositor A, it will have to take it from depositor B’s bank account.  And that means, that if enough people want their money at the same time, there will still be a problem.

That’s where solution two comes into play. Banks invest in other things like bonds and, especially, US Treasuries. As long as banks pay depositors less than they earn on investments, then banks still earn money. Maybe not as much as they would on other loans, but if they make some loans, some other investments and hold some money in reserve (which actually pays interest these days as well), then banks still earn money and if lots of people need their money back, the bank can use reserves and also quickly sell some bonds without problem.

Oh, and banking regulators require banks to only investment in “safe assets” which the regulators check periodically.  And what do regulators consider “safe”? US Treasuries. In the world of finance, US Treasuries are often used as “risk free assets”. The logic is: the US doesn’t default, therefore those government bonds are “riskless”.  (No comment, but yes, feel free to roll your eyes.)

What SVB Was Doing…

Now that we have the basics, let’s see what was specific to SVB.

First, they weren’t making car loans. They were investing in tech startups, hence the name Silicon Valley Bank.  A startup might need, say, $1 million to finance engineering development for the next 5 years to improve a product it’s sure people will one day buy.  The successful ones become the Googles, Amazons and Ubers of the world.

Second, they were indeed buying mostly long-term US Treasuries to get a reasonable and safe return.

…and Why it Was Dangerous

Startups are like athletes or rock stars. Yes, the most successful ones are wildly successful but they are few and far between. 

But, investing in startups is even worse than watching a high school basketball game and trying to pick the next Michael Jordan to invest in.

It’s worse because investors don’t even get to see startups “play” first. It’s more like high school kids lining up and telling you why they, really, will be the next Michael Jordan. Now, which one gets my million dollars?

In short, it’s dangerous.  But, when interest rates are super low – as they were since the 2008 financial crisis – any potential return is worth it. Borrowing money is cheap (interest rates were near zero) and alternative investments aren’t paying much (interest rates were low), so, take a long bet on a startup, invest in good advisors and consultants and just take the risk.

(Permission to roll your eyes again.)

When interest rates rose over this past year from near zero to 5-6%, the worst of those bets turned bad. Money suddenly wasn’t cheap and alternative investments were paying better.

When money isn’t free, you think twice before investing and that eliminates some of the riskiest investments.

In addition to loans to startups, they were also investing in US Treasuries and interest rates killed that too.

A quick aside on why interest rates and the price of bonds are negatively related.

Assuming it’s 100% guaranteed, how much would you pay to get $100 next week?  If you say “$90”, then you pay $90 today and get $100 next week. That’s a return of $10, or, in percentage terms, an 11% return on $90.

Now suppose you are only willing to pay $80 for the $100 next week. Then you’d pay $80 today and get $100 next week, earning a $20 or a 25% return on $80.

The $80 and $90 were the prices you paid for the bond paying $100 next week.  It should be easy to see that as the price rises, the return (in dollars or percentages) falls.  And as the price of the bond falls, the return rises.  For our purposes here, let’s call that return, “the interest rate”.

As the Fed raises “the interest rate” in the economy, it raises the return on bonds, pushing down their price.  Let’s see why that’s a problem.

When SVB invested in those long-duration Treasuries, they paid a lot because interest rates were low. And bank regulators, correctly said the US government isn’t likely to default, so these were considered very safe.  SVB must have felt clever and flush with a liquid investment it could sell anytime to get cash to pay depositors if needed.

But when the Fed raised rates, bond prices dropped. Now when they try to sell, they don’t get enough back to pay depositors. And if the original total amount they bought was how much they counted on to pay all my depositors, then they can never get enough cash to pay everyone. Unless, of course, interest rates fall and prices rise back to where they were. But that won’t happen anytime soon and depositors need their money today.

What Happened to SVB

SVB was hit with weakening returns from the startups and a sudden loss in value in its Treasury investments.  These problems came in large part because the Fed has been raising rates dramatically and that both makes the economy tougher for businesses – especially startups which, by definition, aren’t experienced businesses yet – and makes the price of Treasuries fall. That sets up a powder keg.

Then we add the match to the top: Most deposits were made by wealthy people trying to get good returns and invest in technology companies. That means they were large deposits and the Federal Deposit Insurance Company (FDIC) only insures the first $250,000 of a depositor’s money.  As Apricatas on Substack points out, “As of the start of the year, less than 6% of its total deposits were covered by FDIC insurance.” (link)

Pre-Covid, about 10% of SVB’s deposits were covered by the FDIC. But when Covid hit and then interest rates were dropped to zero, you may recall, investors went crazy throwing money at everything that was popular and trending on social media from nutty crypto startups to meme stocks and all sorts of things. Money flooded into SVB during that 2020-2022 period.

As interest rates rose throughout 2022, SVB began skating on increasingly thin ice. According to Apricatas, “The end result is that the bank was likely, mark to market, insolvent by the start of the year.” (link)

If its depositors had stayed calm, SVB might have found a large investor and been okay.  They were indeed looking for an investor. But when you go looking for a large investor, news spreads quickly and depositors got nervous and started withdrawing money.  SVB tried selling bonds, but at a loss.  That news spread too.  And, in today’s digital world, the whole thing spun out of control and the collapsed nearly overnight.

Why I’m Not Worried

SVB was the 16^th largest bank in the United States and the 2^nd largest US bank ever to fail.  The immediate concern is that this is another 2008 Great Financial Crisis.  It is not.

The biggest difference is that the 2008 crisis was a “mortgage” crisis and this made it hit nearly all financial institutions at once. 

Due to innovations in finance, large government backing of mortgage agencies, and a push by regulators for banks to hold “safe” assets, mortgages became securitized and those securities were rated AAA (the highest and least risky, after US Treasuries).  This meant that every financial institution wanted to hold these implicityly-government-backed, super safe assets.

The match that lit the 2008 powder keg was that the Fed lowered interest rates dramatically after 9/11.  It did not keep interest rates in line with the standard recommendation for rates after that (called a “Taylor Rule”) and the exceptionally low rates led to housing bubbles which people then jumped onto, flipping houses, driving up demand for mortgages and houses.

That explosive growth in mortgage backed securities blew up when the Fed started raising rates dramatically in 2005 and 2006. The house flipping mice quit running full speed in the mortgage market wheel and suddenly house and mortgage values collapsed. Every financial institution held mortgage backed securities and suddenly no one knew how much their portfolios (i.e., their assets) were worth and the whole financial system screeched to a halt. Leeman Brother’s collapse was the headline but the real bomb had already gone off and the house of cards had already begun collapsing. 

Because every financial institution held those mortgage-backed securities, when they all realized that many of these underlying mortgages were actually “toxic” but no one knew how many toxic ones were mixed into the securities they held, no one knew the value of anything and the world collapsed.

There is no sense in which SVB’s collapse is revealing new information about the banking system’s foundational assets.  That is, there isn’t a mortgage backed security out there and SVB’s collapse just made us all realize it’s worthless.

In that regard, I’m not worried and don’t see this as the cause, per se, of a new global banking panic.

Why I Am Worried

But, if you read that 2008 story again, you can see that the rest of the negative mix is there: All banks hold a certain asset that’s considered “safe” – meaning the risk of default is low – in part because regulators encourage them to hold “safe” assets and then guarantee that they are watching the system and each bank in the system to make sure it is systemically safe too. Then Fed policy runs interest rates into the ground, overstimulating investment into every possible area imaginable which leads to a lot of bad investments that only made sense in that red-hot-market environment.  And this eventually blows up.

So, the first worrying factor for me is sort of a “slow-burn” worry. It is this: WTF Regulators?! What are you doing?  You didn’t see this coming?  Can we trust you at all for anything?

I turn to a few quotes from Prof. John Cochrane who recently wrote quite well on this topic with regard to the SVB collapse (link):

“In sum, you have "duration mismatch" plus run-prone uninsured depositors. We teach this in the first week of an MBA or undergraduate banking class. This isn't crypto or derivatives or special purpose vehicles or anything fancy.”

“This is basic Finance 101 measure duration risk and hot money deposits.”

“Where were the regulators? The Dodd Frank act added hundreds of thousands of pages of regulations, and an army of hundreds of regulators. The Fed enacts "stress tests" in case regular regulation fails. How can this massive architecture fail to spot basic duration mismatch and a massive run-prone deposit base? It's not hard to fix, either. Banks can quickly enter swap contracts to cheaply alter their exposure to interest rate risk without selling the whole asset portfolio.”

So problem/worry number one is: I had little faith, but now I have ZERO faith in our banking regulators and the entire banking regulation framework.  This is a problem for everyone in the financial world. If the regulators said SVB was fine just a few days or weeks ago and now it’s closed, who else are they saying is fine, but isn’t?

The second worry for me – and most financial observers – is that the financial-side of the economy for the last 10 years was based on “free money” (i.e., very low interest rates) and nearly every financial institution in the world … again, in the world … holds US government bonds (i.e., “Treasuries”).

Now, we all know that bond prices and interest rates move in opposite directions. So, as the US and nearly all other major central banks raise interest rates, those bonds will fall in value and this will directly affect the value of the portfolios of all those financial institutions.

The worry is that this is just the beginning.  Actually, the worry is that Sri Lanka was the beginning last Spring for emerging market problems, the UK’s gilder crisis was the beginning for developed markets (where major financial institutions nearly collapsed due to poor portfolio management and over reliance on “safe” UK government bonds), and now SVB in the US confirms this is serious concern for everyone.

I will add one final note just to ensure none of us sleep well tonight: Talk of the US defaulting on its own debt – the “risk free” Treasuries – during this congressional budget battle sends shock waves through the foundations of the global financial system.  And those are ripples today but can be tsunamis tomorrow.

Some of these things will be inevitable. As interest rates normalize – zero and negative rates around the world was not normal – the bad investments will materialize. SVB is showing that. Startup struggles are showing that. Other banks and investments are showing that.  It will make it hard for businesses.  This is the unwinding of bad policy and it hurts.

But it’s like going through the pain of the hangover to get back to sobriety.  In the end it’s better than hitting whatever bottom we were headed for but were just too numb to realize.

I hope, therefore, that the US debt ceiling debate will get resolved without any serious threat of any default and that the economy slows and cools so the Fed and other banks can ease on interest rate increases.  The sooner we move to the healing phase, the better for everyone.

Then let’s try to avoid doing this to ourselves again!

Some non-technical and interesting articles.

You can read monetary and financial expert, Prof. John Cochrane, discussing the regulatory failure that was revealed by SVB on his blog:

https://johnhcochrane.blogspot.com/2023/03/silicon-valley-bank-blinders.html#more

You can read an excellent and in-depth article on all the details of the SVB collapse on Apricatas on Substack:

The Death of Silicon Valley Bank

All the financial papers have great articles on this too, each focusing on different aspects: Wall Street Journal, Financial Times, and Bloomberg.