WTF issue 115 - SVB goes broke
Hey there and welcome to issue 115 of WTF is going on with the economy?!
Recently, we’ve been publishing on a biweekly basis as we’re in the final stages of getting launched right now.
However, late last week, there was a bank collapse that took the financial world for a wild ride through the weekend.
The event was big enough that we thought it was worth sharing as not only is it important to know about, but there are also some interesting lessons about bonds and banking we can take from it.
It’s worth noting that this is a fast-moving story. Some information will likely change as more details emerge.
What’s the story behind Silicon Valley Bank?
Silicon Valley Bank (SVB) was a small financial institution located in Santa Clara, California, right outside of San Francisco.
Established in 1983, the bank primarily served tech companies located in Silicon Valley (mystery solved) as well as some other local businesses in the area.
Over the years, SVB became the bank of choice for both venture capital funds (VCs) and the startups they invested in.
For the majority of its history, the bank did well while flying mostly under the radar, by providing:
- Bank accounts to startups and VCs
- Financing to these companies
- Private banking for founders and other executives
During the pandemic, the bank saw its deposits soar as startups boomed, fueled by cheap money (thanks to low interest rates) and an economic environment that favored digital services over in-person ones.
Up until last Wednesday, everything was fine at the bank.
By Friday morning, though, the US government had taken it over, signaling the end to what was the 16th-largest bank by deposits in America.
Why did it collapse?
Silicon Valley Bank’s demise comes down to a perfect storm of varying factors, including our old friend “human irrationality.” (More on this dude a bit later on).
A changing interest rate environment
Over the past year, the US central bank -- the Federal Reserve -- has hiked interest rates to try to control inflation. We’ve covered these movements before in previous issues, but in short, raising interest rates should:
- Make it less attractive to borrow money and invest
- Encourage people and companies to save it
In turn, economic activity cools which lowers prices and inflation in the process.
For startups and VCs, though, that meant an end to easy money. Over the past few months, the sector has been hit hard, with job lay-offs across the board and a massive slowdown in funding.
SVB felt the impacts particularly hard as:
- VCs stopped funding startups (which meant fewer deposits) and
- Startups began spending money instead of raising it, which drained bank reserves.
A mismatch of assets to liabilities due to market changes
Almost every bank practices a technique called “fractional banking.”
Fractional banking means that a bank will only have a fraction of its reserves versus the amount of loans it makes.
In other words, for every 1 dollar they have in deposit, they’ll lend 10 dollars to borrowers.
Fractional banking is a standard and regulated process.
Banks make money and help grow the economy by making loans. Regulators, for their part, manage the risk by determining the deposit ratio. (It’s also a tool that can control inflation. If the deposit ratio is low, then there will be less loans, and therefore, less economic activity).
To cover these risks, banks will ensure that they have enough assets to cover the liability that are bank deposits.
Banks generally use a mix of income-generating assets that cover these liabilities including:
- Loans they make to borrowers (repayment cash flows)
- Mortgage-backed securities which are mortgages bundled as investments
- Corporate and government bonds that pay income over a set time period.
As a rule, banks try to hold these assets for the duration of their life. In bonds, we call that “hold till maturity,” which means that the bank will:
- buy the bond when it’s issued and
- Receive all of the periodic interest payments until the borrower repays it all back, including interest (known as the coupon payment).
The trick for banks here is to make sure that the mix of their income-paying assets keep up with market interest rates. Doing so successfully can mean life or death for a bank, as SVB found out.
There were two problems for SVB that ultimately proved fatal.
Interest rates rose too fast versus their asset portfolio
As interest rates increased, the value of the bonds in their portfolio dropped compared to the market rate.
For example, SVB could have bought a US treasury (a bond issued by the government) 10-year bond in March of 2021 that paid 1.6% interest over its lifetime.
That meant that SVB would have guaranteed annual income of 1.6% until March of 2031.
However, today if the US government wants to borrow money for 10 years, they’ll need to pay 3.9% interest.
For anyone holding the 10 year bond from 2021, selling it now means taking a big loss since investors can get over double the amount of income (3.9%) by lending money to the government today.
You can see that in the chart below. The green line is the constant return from a 10-year bond bought in March 2021 with a 1.6% interest rate.
The red line is the changing market rate for the government to borrow money for 10 years, which the Federal Reserve largely determines through interest rate policy.
Anytime the red line goes above the green line, the 10-year bond from March 2021 is losing money on the market. If SVB wanted to hold till maturity, that wouldn’t be an issue. Unfortunately last week, it was.
As information trickled out, it became clear that SVB’s asset portfolio was mostly longer-term bonds they bought earlier in the pandemic and before interest rates rose. All of a sudden, when depositors came calling, the bank was staring at massive losses.
Customers wanted more cash than their assets could cover
Over the past couple of months, SVB’s customers were withdrawing money faster than their assets could provide the income to meet those liabilities.
The bank, in turn, had to sell some of its assets on the market to raise cash. Since these were worth less on the market than their face value (i.e. the interest rate the borrower pays back), SVB had to take a loss.
the amount they wrote off was just under 2 billion dollars. While not a large amount considering that SVB had over 200 billion USD in assets, it was enough to spook their clients.
A bank run by startups
As news spread among Silicon Valley on Wednesday that SVB had to sell some of its assets at a loss, startup founders and investors banking with the company began to withdraw their funds.
Panic quickly set in (we’re in the social media age and no one is as well connected as the Silicon Valley tech scene) and by Thursday, deposit holders were rushing to get their funds out.
During the day, there were requests for over 42 billion USD of withdrawals in what amounted to a classic bank run fueled by FOMO (the missing out part here being their money).
How Silicon Valley Bank collapsed
In addition to trying to sell its assets, SVB also attempted to raise funds by selling some of its shares. Unfortunately, any deal that might have had to do so fell through. Throughout the day, the bank’s management tried in vain to reassure markets and customers alike that they were financially sound.
They were having none of it. The withdrawal requests continued while the share price of the bank plummeted 63% from Wednesday until Friday.
By Friday morning, regulators had seen enough.
Shortly before markets opened, the US government took over SVB, sealing the firm’s spectacular and sudden demise.
What about SVB’s depositors?
Government workers toiled over the weekend to quickly unwind SVB’s balance sheet and find a new home for their clients.
In the United States, all bank deposits have a guarantee of 250,000 USD. (Banks pay into an insurance fund to collectively cover failures).
The problem with SVB, though, was that most of its clients were companies that held far more than that amount in the bank.
That caused considerable panic from many startups and VC funds alike (although it should be noted that they themselves initiated the run which led to the demise).
By late Sunday, however, the government announced that they had been able to unwind the bank, meaning that depositors could access their funds on Monday as normal.
What does it mean for the financial system as a whole?
Silicon Valley Bank’s collapse was the second largest in US history and the biggest since the 2008 financial crisis.
Given these uncertain times and still-recent scars of the great recession, this episode is rightfully making people nervous.
In context, though, we might have dodged a bullet. Here’s why.
Silicon Valley Bank failed because it was overexposed to one sector. SVB’s demise had a lot to do with the fact it catered almost exclusively to one sector: tech startups. This industry has been through the ringer lately and it was only a matter of when not if, the pain would ripple throughout the startup ecosystem.
Other startup and tech-focused banks also collapsed last week: Silvergate and Signature Bank. These companies faced exposure to the enigmatic crypto industry which has had its own issues as of late.
Further, SVB did relatively little lending for a bank. Other banks make their money by lending out funds across the economy to companies of all sizes and industries. Without a broad lending portfolio (or even a significant one at all), SVB was almost entirely reliant on the tech sector to stay afloat.
Diversification isn’t just for retail investors; it’s for everyone.
Banks are in a much better place than in 2008? Yes, but it’s not pretty.
Since the financial crisis of two decades ago, banks, governments and regulators have created a much safer and secure banking environment.
Controls on banks’ activities and capital are stricter than ever before.
The rules governing lending tightened and consumer protections increased.
Banks aren’t holding worthless toxic assets like they did in 2023.
The results speak for themselves; despite the turbulent economy of the past few years, SVB’s failure was the first failure since 2020. Even then, only 4 banks failed that year, which was just above the average of 5 a year since 2014.
Are we out of the woods? Not yet.
As of this writing (Monday afternoon in Europe), the markets in general and banks in particular are taking a pounding.
Regional banks' stocks are getting hit hard, with four mid-sized American banks seeing their shares halted from trading after taking steep losses.
There’s talk of the Federal Reserve adjusting its interest rate policy and even the US government stepping in to guarantee all deposits.
This week will be one for the books, and could even be the inflection point in the economy investors and analysts have been anticipating.
That said, this episode certainly acts as a wakeup call. For banks, it means stress-testing their reserves and ensuring they can operate effectively in volatile interest rate environments.
For startups, it’s a reminder to both diversify your deposit risks by working with multiple financial institutions and looking beyond cash to manage your runway.
Regulators will no doubt take this situation as a valuable lesson learned on how to manage a bank failure in today’s economic environment.
Whatever the case, we can all agree on one thing: the memes were fantastic.