The daily news cycle is of very little importance when it comes to long-term investing, but the failure of Silicon Valley Bank is the type of news item that catches the attention of even the most disciplined investor.
Listen now and learn:
- What happened with Silicon Valley Bank
- The broader health of the banking industry
- Implications for future investors
Listen Now
Show Notes
I recorded this episode on March 27, which was my first day back from an extended spring break vacation with my family.
The market news cycle never really stops when you’re away, but I’ve long known that the daily news cycle is of very little importance when it comes to long-term investing.
Even so, I knew the failure of Silicon Valley Bank is the type of headline that catches the attention of even the most disciplined investor. So in this episode, I wanted to offer a recap of what happened and explore some potential implications for investors.
The Failure of Silicon Valley Bank
The failure of Silicon Valley Bank starts with the unprecedented monetary and fiscal policy response to the pandemic that led to a surge in money supply and liquidity.
Deposits at U.S. banks rose by $5.4 trillion from 2020 through the end of Q1 2022. But loan demand throughout the pandemic was relatively weak, so only around 15% of that volume was channeled towards loans, while the rest was invested in securities portfolios or kept in cash.
Now, here is where I get to use some terminology for the first time since taking my CFA exams: when banks purchase securities, they must choose upfront to designate the assets as “held-to-maturity” or “available-for-sale.”
Assets designated as “held-to-maturity” are not marked-to-market – this is really important. Think about your own bond portfolio. A recurring theme in this year’s episodes of The Long Term Investor is that all investors lost money on bonds in response to a dramatic increase in interest rates.
See More: What You Need to Know About Bonds
But banks that owned bonds designated as “held-to-maturity” haven’t needed to recognize those losses, but instead, those bonds remain on balance sheets at their amortized cost.
If a bank were to sell an asset from their portfolio designated as “held-to-maturity,” the entire portfolio of those designated assets would need to be marked-to-market. The other nuance to these accounting rules for “held-to-maturity” assets is that they don’t allow banks to hedge the risk of those assets.
Assets designated as “available-for-sale,” on the other hand, are marked-to-market. Classifying assets this way creates an element of volatility in a bank’s capital base, but banks enjoy the flexibility to adjust as market conditions change.
At the end of 2020, about three-quarters of U.S. banks’ securities portfolios were held as “available-for-sale,” but rising interest rate expectations and declining bond prices caused U.S. banks to reclassify more of their portfolios to “held-to-maturity.”
By the end of 2022, U.S. banks held only about half of their securities as “available-for-sale.” Naturally, different banks used different strategies to transition their investments, but with the benefit of hindsight, it’s easy to see that Silicon Valley Bank got it completely wrong.
The Unique Business Model of Silicon Valley Bank
The bread-and-butter customer base for Silicon Valley Bank are tech startups and venture capital firms. That boom in money supply and liquidity during the pandemic that I mentioned was particularly beneficial to this customer base.
Venture capital firms were investing hundreds of billions of dollars into profitless tech startups that had to keep those investments in cash in order to fund operations.
The economics behind making these types of investments are relatively straightforward. Not only do low interest rates encourage capital to flow to higher-risk investments to earn a return, but when interest rates are zero, future cash flows are more valuable than cash flows today.
Silicon Valley Bank’s deposits more than tripled over a two-year period ending in March 2022, compared to the entire U.S. banking industry, which saw 37% growth in deposits over that same period.
Also of note is that more than 95% of Silicon Valley Bank’s deposit base was not FDIC-insured, ranking them 99 out of the 100 largest banks in the country. (Side note: uninsured depositors are typically the kind of investors who withdraw their assets when there are signs of turbulence.)
Because interest rates were so low in early 2021, Silicon Valley Bank invested the bulk of its deposit growth in long-duration securities to earn more yield and designated those holdings as “held-to-maturity” portfolio to avoid marked-to-market losses flowing through the bank’s income statement.
Again, more banks were designating assets as held-to-maturity, but Silicon Valley Bank was particularly aggressive about it. In fact, more than 55% of Silicon Valley Bank’s assets were invested in long-term government bonds, the highest percentage out of the country’s 100 largest banks.
As rates started to rise, Silicon Valley Bank’s held-to-maturity portfolio got hit hard – unrealized losses went from zero in June 2021 to $16 billion in September 2022 – a whopping drawdown that, if marked-to-market, would completely wipe out the $11.8 billion of tangible common equity that supported the bank’s balance sheet.
So Silicon Valley Bank was technically insolvent at the end of September 2022, but those losses didn’t have to be recorded on the bank’s books because (again) they were from assets designated as “held-to-maturity.”
It was a bad situation, but one the bank openly discussed on earnings calls as something they would work through over time. Basically, the bank’s executives were making a bet that deposits wouldn’t run off. As we know now, it turns out that was a bad bet.
And while a bank run looks different than it did 100 years ago, this was a good old-fashioned run on the bank.
It started with the reversal of easy money factors. As monetary policy tightened, venture capital investments into companies that banked with Silicon Valley began to dry up. And not only were new deposits down, these companies also began burning through their cash on hand to fund operations.
But the bank run really started in earnest when venture capital firms began instructing portfolio companies to move their funds elsewhere. The run intensified on social media as a couple of key stakeholders effectively shouted “fire” and began circulating screenshots of the bank’s website struggling to meet withdrawal requests.
To meet liquidity, Silicon Valley Bank sold $21 billion of “available-for-sale” securities at a $1.8 billion loss after tax and made a surprise announcement on March 8th that it would need to raise more than $2 billion from its equity holders.
To round out the whole “what happened while I was on vacation” timeline, there were a few other headlines of note:
Signature Bank went down on March 9 and Silicon Valley Bank followed on March 10.
The following week, the Federal Reserve set up lending facilities to enhance liquidity, and then joined a global coordination effort among major central banks to enhance liquidity and ease strains in the global funding markets.
By March 16, First Republic Bank received $30 billion in deposits from 11 large U.S. banks to shore up its balance sheet.
On March 18, the Mid-Size Bank Coalition of America wrote a public letter to regulators requesting to extend FDIC insurance to all deposits for the next two years with the belief that such a guarantee would prevent a greater run on the banks.
On March 19, UBS Group stepped in with support from the Swiss National Bank to buy Credit Suisse for pennies on the dollar. Now Credit Suisse’s demise wasn’t really related to the same issues as Silicon Valley Bank….in reality, Credit Suisse has been plagued with all sorts of scandals, losses, and questionable business strategies.
But I’m mentioning it because the questions I received from this headline suggest that people are worried about a repeat of the Great Financial Crisis.
So let me be clear: this is not 2007-2008.
A Repeat of 2007-2008 is Unlikely
First of all, unlike 2007-2008, the bank failures to date are the result of problems unique to those banks – specifically largely unhedged interest rate risk and outsized exposure to venture capital, startups, and crypto.
Secondly, the Great Financial Crisis was a solvency issue whereas today is about liquidity. Today’s largest banks are well-capitalized, and our country’s capital-markets-based financial system is not intricately linked with its regional banks. The largest banks also undergo regular stress tests.
(Interestingly, bank deregulation in 2018 rolled back some Dodd-Frank regulations including increasing the size of banks subject to stress tests from $50 billion to $250 billion. That meant Silicon Valley Bank was not subject to the stress tests that include events such as a sharp spike in interest rates….but I digress.)
Third, regulators were slow to act during the Great Financial Crisis, but that has not been the case today. Not only do they have the tools, but they’re also using them. While U.S. banks are sitting on $600 billion of unrealized losses on their “held-to-maturity” portfolios, those losses are due to the increase in interest rates, not a significant deterioration in credit quality. And in the event of a need to raise cash, the Fed’s facilities are at the ready, minimizing the need to realize any of those “held-to-maturity” losses.
In short, this doesn’t mean that we don’t see trouble at other small banks, lenders, brokers, or other credit intermediaries, but this doesn’t appear to
Implications For Investors
Just two weeks ago in Episode 91: When Will the Bear Market End?, I talked about the importance of setting expectations.
While I don’t personally think these bank failures will directly impact the economy or markets, I do think there are some indirect implications worth noting.
For starters, the Federal Reserve seemed to be preparing markets for larger rate hikes than what they ultimately announced last week. There is a saying in economics that to quell inflation, central bankers must tighten monetary policy until something breaks.
Throughout 2022, the Federal Reserve raised interest rates at the fastest clip since the 1980s to combat high inflation. While markets declined in response, the broader financial system remained intact. Now that something has broken, it appears we are entering a new phase of the monetary policy cycle.
I’ve seen very compelling arguments for how we should both expect inflation to fall faster than expected and remain higher for longer. I’ve seen strong arguments arguing that interest rate cuts will come sooner at which point asset prices should rally.
You will hear intelligent arguments made for all sorts of different outcomes, but choosing the correct short-term market forecasts is not the key to investment success. Unless you need to spend the entire value of your portfolio in the next year or two, what happens next doesn’t really matter.
As I made abundantly clear two weeks ago, it’s periods like these that require you to embrace fear and uncertainty in exchange for the returns you need to compound your wealth over time and meet your goals.
One final thing that must be mentioned for your cash parked at the bank.
Predicting a bank run is essentially impossible. That’s why it’s important to mind the $250,000 FDIC limits. There’s no guarantee that the government will backstop deposits of any bank that fails. It seems that the political clout of Silicon Valley Bank’s customers might have played a role in the decision to make all of the uninsured depositors whole.
But there are good cash options for people with more than the FDIC limit. At Plancorp, we use Federally Insured Cash Accounts with up to $25 million of FDIC insurance per tax ID. Another alternative is purchasing short-term Treasury bills. As of this recording, the 3-month and 6-month T-Bills are yielding just under 4.6%.
Resources:
Submit Your Question For the Podcast
Do you have a financial or investing question you want answered? Submit your question through the “Ask Me Anything” form at the bottom of my podcast page.
If you enjoy the show, you can subscribe wherever you listen to podcasts, and please leave me a review. I read every single one and appreciate you taking the time to let me know what you think.
About the Podcast
Long-term investing made simple. Most people enter the markets without understanding how to grow their wealth over the long term or clearly hit their financial goals. The Long Term Investor shows you how to proactively minimize taxes, hedge against rising inflation, and ride the waves of volatility with confidence.
Hosted by the advisor, Chief Investment Officer of Plancorp, and author of “Making Money Simple,” Peter Lazaroff shares practical advice on how to make smart investment decisions your future self with thank you for. A go-to source for top media outlets like CNBC, the Wall Street Journal, and CNN Money, Peter unpacks the clear, strategic, and calculated approach he uses to decisively manage over 5.5 billion in investments for clients at Plancorp.
Support the Show
Thank you for being a listener to The Long Term Investor Podcast. If you’d like to help spread the word and help other listeners find the show, please click here to leave a review.
Free Financial Assessment
Do you want to make smart decisions with your money? Discover your biggest opportunities in just a few questions with my Financial Wellness Assessment.
