Inconceivable! How Silicon Valley Bank Failed and How the Fed Was Complicit

Many of you have heard of the failures of three banks: Silvergate Bank, Silicon Valley Bank and Signature Bank. Besides all of them starting with the letters “Si” are there any common denominators in these failures? At least in the case of Silicon Valley Bank, there are some very obvious mistakes that were made that led to their demise. 

Back in 2020 and 2021 when the Federal Reserve had lowered rates to zero percent and Jerome Powell said that they, and I quote, “… weren’t thinking about thinking about raising rates,” Silicon Valley Bank (SVB) believed them. At the same time, in the height of COVID lockdowns and stimulus, SVB experienced an onslaught of deposits from tech companies that were attracting an overwhelming amount of investment. In the face of historically high inflation, the Fed began to raise rates precipitously, and the plot thickened. 

When you are a bank you do two primary things: you borrow money and then reinvest it in other things. The main two things that banks invest in are loans and bonds. Loans and bonds have all different terms, one year, five year, ten year, twenty or even thirty year maturities (and everything in between). They also have different interest rates depending on the risks associated with the endeavor. “Risk free” bonds, also known as Treasuries, are seen as the gold standard in terms of credit quality. There is virtually a zero percent chance that Treasury bonds and bills will not be paid back because the issuing entity (the Treasury of the United States) has the ability to raise unlimited debt- debt ceiling limits notwithstanding. Loans, on the other hand, are the most risky things that banks invest in from a credit standpoint. Loans are generally to individuals and businesses who don’t have access to a money printer and therefore have a much higher risk of defaulting on their loans. 

Based on what I’ve just outlined, you would think that SVB probably had a bunch of loans that went bad, right? Wrong. The mistake that SVB made was to invest their tsunami of deposits into ten-year agency guaranteed Mortgage Backed Securities and Treasuries. Unlike the 2008 Great Recession, which was based on the underlying credit quality of the investments that banks made, the current crisis is based on the length of the maturity (or duration) coupled with a very low rate. They had the problems of a mismatch in maturity of investments with deposits that could be withdrawn at will. Additionally, many of the depositors in SVB were technology companies that in many cases had multi-millions of dollars on deposit. For instance, Roku had around $480 million in their checking account. The Federal Deposit Insurance Corporation (FDIC) only insures the first $250,000 in deposits so there were many entities that had excess deposits that could be lost in the event of a bank failure. 

SVB had almost half of their asset balances invested in bonds with a greater than ten-year maturity at around a 1.6% rate. Most of this was invested at the very top of the bond market, meaning that the interest rates were very low. If things weren’t bad enough, Jerome Powell went back on his word that rates would remain low for a very long time and began the most aggressive interest rate increase since the 80s. When rates rise that quickly, banks are forced to compete for deposits by paying higher interest on their deposits. In the case of SVB, they weren’t able to pay because they had so much of their balance sheet invested at a 1.6% rate. Now the stage was the set, the pieces were all in place to have a 1920s-style bank run, and that is exactly what happened. 

Large depositors are the first to get antsy because they could lose anything over $250,000 and since Roku had almost 2000 times more than that in the bank, they wanted their money back. “No problem” you might think, “they have high quality bonds that they can sell to create the required liquidity to give them their money back.” The problem is that those ten year bonds paying 1.6% are now worth 80% of what they paid for them. They had around $95 billion of these bonds and they were worth about $77 billion now meaning they had lost about 20% of their value. So SVB took Roku’s $480 million, invested it in bonds that are now only worth about $390 million. Ouch! If SVB were to sell those bonds they would recognize a $90 million loss. There are a lot of complicated reasons for how this can happen, and it boggles the mind, but there they were. 

The large depositors started frantically withdrawing their money forcing SVB to sell their pristine credit quality bonds at a 20% loss. This created an $18 billion loss on their books. But don’t worry they had $16 billion in capital! Jokes aside, $2 billion is a lot of money to everyone except Congress. The regulators were involved at this point and there was nothing left to do but to declare SVB dead and check its pockets for loose change. Long term bonds at very low interest, plus flighty large depositors, plus a historic increase in interest rates all colluded to destroy Silicon Valley Bank. 

There are many questions left unanswered about this situation. Will the contagion spread? Does the fact that banks collectively have about $650 billion of these losses mean that there are more failures to come? Will the FDIC bail out other depositors who have more than $250,000 in their accounts at banks? Is the Federal Reserve an ultimate good or bad for the economy? Unfortunately, we do not have the answers yet. However, for most people who keep their bank deposits under the $250,000 limit, this situation is not a significant problem. For those who are fortunate enough to have more significant deposits, it might be a good idea to spread your deposits around and make sure you are under the limit. Please let us know if we can help you with managing the risk of your portfolio and aligning it with your retirement goals.