What Happened To Silicon Valley Bank?

I would wager that very few Americans had heard of Silicon Valley Bank before last week.

That changed as the 16th largest bank in the United States was declared insolvent and taken over by the FDIC on Friday.

It became the second largest bank to ever fail in the United States (after Washington Mutual in 2008).

What happened?

The same thing that happens to all banks who fail in a fractional banking system.

What happened to SVB was no different than what happened to the Bailey Building and Loan in the movie "It's a Wonderful Life".

George Bailey (Jimmy Stewart) tries to calm anxious and angry depositors 
"It's A Wonderful Life" (1946)

Bank depositors lose confidence in the safety of their deposits in the bank and seek withdrawals. The bank only has a fraction of the deposits available in current liquidity to meet the withdrawal requests.

George Bailey was able to halt the run on his bank because he and his new bride Mary used their  honeymoon money to meet some of the demands and convince the remaining depositors to keep their deposits with the bank.

Mary Bailey (Donna Reed) offers the Bailey Honeymoon funds to stop the bank run
"It's A Wonderful Life" (1946)

Silicon Valley Bank attempted to raise additional equity to boost its balance sheet and depositor confidence but it failed.

The bank's failure was clearly a surprise to Forbes.

It had recently named Silicon Valley Bank one of America's Best Banks.

Here is SVB promoting that recognition in a tweet four days before it went under.

Banks have historically failed because they made too many bad loans. 

However, banks also put money into investment securities. The 2008 banking crisis was precipitated not only by bad mortgage loans but investments in mortgage backed securities that went bad.

A popular alternative is for banks to invest in treasury securities. It is supposedly a safe investment in which it can earn a spread between what the treasury bill or note yields and the interest the bank has to pay  its depositors.

That strategy works well when the yield on the treasury security is stable or falling while the bank is paying almost no interest to its depositors. It does not work well when treasury rates begin to rise.

As interest rates rise, the value of the underlying treasury security falls. It is like having a bad loan.

In addition, as treasury yields rise there is more and more incentive for a depositor to withdraw their funds from the bank (if it does not increase bank deposit rates) and put their money into treasuries.

Two years ago the yield on a 2-year Treasury was 0.14%. It was 5.05% right before SVB failed.

The yield almost immediately dropped to 4.60% on Friday as demand surged in a flight to safety as depositors in other banks undoubtedly moved money to Treasuries.

Simply stated, SVB failed because of the rapid increase in interest rates on treasury securities.

The higher yields created losses in its investment portfolio reducing its equity base.

The higher yields created an incentive for depositors to withdraw money to benefit from the higher rates as SVB did not adjust depositor rates accordingly.

SVB lost on both dimensions. It was caught in a squeeze.

Of course, SVB got into this position by having a disproportionate amount of its assets in investments rather than in loans.

57% of SVB's assets were investments. Only 35% were in loans. By comparison, San Francisco-based First Republic Bank, which is comparable in size to SVB, has 78% of its assets in loans and only 15% in investments. 

SVB also apparently did a poor job of anticipating these rate hikes and hedging that exposure.

The big question now is what will the fallout be from this?

The shareholders of SVB will most likely lose everything.

This is a stock that carried a market cap value of about $9 billion a month ago.

The depositors will most likely get access to all of their money depending on how the FDIC puts together a salvation plan for the bank. That goes without saying for deposits with less than $250,000 in bank deposits. 

However, 97% of SVB's deposits are above the FDIC's $250,000 insurance limit.

There are a lot of Silicon Valley tech names who use SVB as their primary bank.

Crypto company Circle has $3.3 billion on deposit with SVB.

Roku has almost $500 million.

Unless there is a quick resolution how do these companies meet payroll, pay vendors and continue as going concerns themselves?

There are a lot of concerning after-effects to any bank failure.

That is why it is easy to criticize actions by the FDIC, the Treasury Department or the Federal Reserve to bail out these banks. However, the reality is that it is the little guy that quickly gets hurt in the after-effects of these failures.

In this situation you also have to realize that it is tech companies in California that have the most to lose in the SVB failure. 

Is there a more influential group for the Democrats in power in Washington?

There is a lot of money and votes provided to Democrats from tech companies in California.

It is hard to see where they are not going to protect them in the end.

(Update-After I finished writing this blog post, as I predicted, the FDIC, Treasury Department and Federal Reserve, announced that it was going to insure that all depositors, both insured and uninsured, would be paid in full currently. It also extended the same protections to depositors of Signature Bank in New York which was taken over by state regulators over the weekend. 

Banks in California and New York are bailed out that cater to tech and crypto companies. However, if the same thing happened to a bank in Wyoming that had mostly farmers as depositors, would they receive the same treatment?

The question that also hangs over the market and the economy is whether other banks have the same type of exposure?

There is no question that there are a lot of banks that have the same problem.

For example, this graph shows the unrealized gains (losses) of banks holding investment securities at the end fo 2022.

As has often been said, "what goes up eventually comes down".

This is a graphic representation of that principle.

Credit: https://twitter.com/balajis/status/1634543503958212610

However, SVB seemed to have much more exposure in its investment portfolio than other banks.

For example, Bank of America has less than half of the exposure that SVB had to unrealized investment losses as a percent of equity.

SVB's losses were equal to its entire equity.

Credit: https://twitter.com/Mayhem4Markets/status/1634347023003529216

One thing is clear.

Banks in general are going to have to raise the interest rate on their deposits to compete with treasury rates or we will see more bank outflows. Money will always go where it is treated best.

Of course, this will reduce banks margins which is something the bankers do not want to do. That is especially true when they are looking at losses on their investment portfolio. However, they really don't have a choice.

Finally, what does all this mean for the Federal Reserve?

Do they continue raising interest rates now that something has broken due to its policy decisions?

The market is already betting that the Fed is going to back off.

Last week market futures were forecasting there was an 80% chance the Fed would raise rates another .50% at its March meeting. Those odds have now dropped to 40%.

You should now have a better idea of what happened to Silicon Valley Bank.

The big question now is what happens next?

We could be in for a very interesting week in the financial markets.

Fasten your seat belts if the contagion spreads.

What is most troubling is the same people who got us into this problem (ultra low interest rates, money printing and excess government spending which led to inflation which the same people said was transitory) are now telling us they have the solutions.

Fasten your seatbelts, indeed!