Before Friday, Silicon Valley Bank (SVB) was a thriving U.S. bank where credit losses were fairly low while enjoying a tripling of deposits between 2019 and 2021.
But then – Boom.
So, What Happened to SVB?
In keeping with our commitment to straightforward opinion and unfiltered advice, here’s a plain language primer on how it all works. This should help you understand all the people posting about this online. (You know, the Twitter-posters who have shifted overnight from being online crypto, NFT, and SPAC experts to now global banking experts.)
First – banks accept deposits from clients.
This becomes a liability because they owe the money back on demand. These liabilities carry a cost – explicitly in the form of interest they have to pay to clients and implicitly through service costs like ATM machines, branches, call centers, paper statements, etc.
Banks (which are a for-profit entity) look to make money by LENDING those deposits in the form of mortgages, small business loans, etc and charge the BORROWER interest.
So, what happens if there are more deposits than borrowers? That becomes a negative return for the bank, right?
NOW – refer back to the fact that SVB TRIPLED their deposits between 2019 and 2022.
Woof…they need to lend those deposits out OR they need to do something else with the money to earn a return equal to or higher than the explicit and implicit costs of the deposits.
What does a bank do if they can’t lend the money out? They will BUY loans (ie: bonds) like U.S. Treasuries and Mortgage-Backed Securities (MBS).
Back to SVB.
As you likely now know, a ton (if not all) of their deposits were from VC-backed companies that needed a place to deposit the ridiculous amounts of money they raised to sell $800 coffee machines, a NEW startup by Adam Neumann (failed WeWork dude – see the Hulu documentary), and the Dyson Zone, a device that combines noise canceling headphones with a personal air filter.
Since deposits were flowing in faster than SVB could responsibly lend them back out, they bought bonds guaranteed by the US government: Treasuries and those MBS.
Smart, right? Yeah, kinda. You see they bought what are referred to as “long duration bonds” which matured at 10+ year mark.
Here’s the way to understand duration – when interest rates rise, bond prices fall. Channeling my inner CFA, a general (emphasis on GENERAL) rule of thumb is for every one year of duration, each 1% interest rate move impacts the price based on the number of years until it matures.
The rough math equation is:
- Bond Price = 1% interest rate change X years to maturit
- Price = 1% times 10 years. The price of a 10-year treasury loses 10% of its value when interest rates move up 1%.
- (Troll Alert: YES I know it’s a little more complicated than that but I’m not teaching a CFA course here, I’m explaining something)
Think of it like you are holding the eraser of a pencil between your thumb and forefinger and you wiggle it up and down. The tip of the pencil (the price of the 10-year bond) is moving way more than the green metal part connected to the eraser (the price of the 2-year bond). The price movement is amplified so longer dated bonds fluctuate WAY MORE in price than short-dated bonds.
Ok, back to SVB.
Remember, SVB bought safe (safe from default, not in price fluctuation) US Treasuries and MBS but they bought 10-year maturities…and when interest rates go UP, the market value of those safe securities goes DOWN…and in this case, their portfolio of the 10-year bonds went down way more (like 10x) than if they had owned 1-year bonds.
That’s bad enough but then there’s also this:
Banks also use leverage. Meaning THEY borrow to borrow and SVB was levered at least around 10x. Meaning they OWE $10+ for every $1 of shareholder equity.
Meaning if SVB was levered 10x and they experienced a 10% paper loss on bonds with the recent interest rate moves that’s 10×10 = 100% loss.
So SVB ended up in a situation where they were carrying a HUGE PAPER LOSS on their balance sheet. You’ll hear the term mark-to-market and in the banker world, it’s not a huge deal so long as those customers leave their deposit money in SVB.
Lots of “whoops” and “ouches” in here so far, right? Read on…
If a lot (or all) of the customers want their money back quickly, SVB needs to sell those bonds. This is where the term ‘run on the bank’ comes from.
If that bond selling has to be done when they are at a “mark to market loss” in value, it turns a paper loss into a real loss…fast.
And when, as in this case, those losses are big enough, it doesn’t have enough money on hand to meet those customers withdraws.
SVB has customers with really large deposits from money they raised to build and sell those $800 coffee machines and accounts with more than $250,000 aren’t fully insured by the FDIC. So, one whiff of trouble and they run.
Oh, and long gone are the days of standing in line at the bank. Bank customers can open their phones and move money drunk at 2am from the bar…which means the modern day run on the bank is more like watching Usain Bolt running the 100m wearing a jet pack carrying a satchel of cash.
DAVE’s OPINIONS ON SVB:
- This was poor risk management at SVB. They are accountable. Has anyone out there been taken by surprise at the Fed’s increases of interest rates? No. Yet people are blaming the Fed…but the Fed was not in charge of interest rate risk management at SVB. (More on this below)
- Is anyone surprised that, regardless of the SVB run, depositors are looking at money market mutual funds yielding 4.5%+ and moving their money out of regular cash accounts at their banks yielding 0.5%? If I owned a bank I would move the interest rate I’m paying on deposits up to 4% immediately…and then watch my profits (and stock price) plummet. Bad news for banks, their future earnings and the banking sector as a whole.
- SVB is one thing, regular banks are another. Banks everywhere saw their deposits swell to unprecedented rates because of the COVID stimulus. It can be argued that the rapid Fed interest rate increases caused profit and mark-to market paper loss pain in the regular banks, but a problem only happens when depositors lose faith in the bank and want their money. The Government stepping in to protect deposits will lower that fear going forward…which is a good thing.
- I bet this is the beginning of the end for Fed rate increases. It’s stupid for the Fed to keep raising rates only to see banks fail and bail out deposits. That’s like building a self-licking ice cream cone.
- This (so far) is not a bailout. While it seems that depositors are going to be ok, equity and bond holders of SVB are wiped out. Don’t get it twisted.
- Finally – this may not be the last bank to fail. I’ll spare everyone the “have 12-18 months of cash…” speech (but its more applicable now than ever) and simply state that everyone should be cautious about over-reacting.
- For clients – Schwab is financially strong. We have zero concerns about accounts and deposits. Call us if you have any concerns.
Keep looking forward,