Silicon Valley Bank Failed - What You Should Know

Silicon Valley Bank and its parent company SVB Financial Group failed as a bank last Friday. Given that this is a concerning event, we wanted to give an update on the backdrop and why it happened.

How It Happened: 

There were a number of influences that together spelled the downfall of the bank.

From 2020 through 2021, Silicon Valley Bank took in incredibly high deposits through PPP loans and through clients that were taking their companies public through a Special Purpose Acquisition Vehicle (SPAC). The bank took those deposits and decided to invest in long-term bonds, such as mortgages and treasuries, while interest rates were low.

2022 was a very different year. Not only did Silicon Valley Bank’s unique customer base of private companies start to need cash and, as a result, pull their deposits, but interest rates also increased. This impacted the mark-to-market value of their longer-term bonds.  

In an effort to appropriately deal with the impact of mark-to-market losses, the bank used a valid accounting change to consider those bonds “held to maturity.” (Any bonds that are held to maturity do not need to be updated with the market value but can be held on the books at cost.)

Unfortunately, you cannot hedge interest rate risk for bonds that are in the “held to maturity” category, meaning the bank could not appropriately hedge interest rate risk for these longer-term bonds (of which they had many).

The combination of reducing deposits, too few assets that were marked at the market (or consistent with the current market value), and growing withdrawals forced the bank to sell their held-to-maturity bonds. When they did so, they were forced to realize the losses, and those losses effectively overwhelmed the bank's equity, causing the bank to fail.

This all happened over the course of a week and really over two days. The stock was worth $267.90 close of business Wednesday and worthless by the close of business Friday.

Did Silicon Valley Bank do anything wrong? 

The bank did not break any rules as they are written, but they also did not effectively hedge their interest rate risk. Their poor risk management ultimately spelled their doom. It would have been easy enough to reduce purchases of so many long-term bonds back in 2021, but the appeal for the bank to make a little bit more money on their deposits was likely too strong. Also, how many market participants expected the Federal Reserve to raise interest rates so much so quickly? They were caught offside.

Some have said it was a “bank run.” Is that right? 

Yes, there are really three reasons why depositors pulled their money out. Some depositors wanted higher interest rates they could achieve with a money market fund (4.5% vs. 1% at many banks). Many depositors needed money because their startup businesses were not as successful due to the market environment. And importantly, when depositors realized that the bank’s tangible equity was falling, those who had more than the FDIC-insured limit of $250,000 decided to take their additional savings out to be safe.

Is this a risk for the big banks (over $250B in assets)? 

Big banks are stress-tested regularly and are required to hedge their interest rate risk. As a result, those banks are not at risk of the same problems as Silicon Valley Bank.

What about smaller banks? 

Yes, some smaller banks with more aggressive treasury operations (what they choose to do with the deposits and how they hedge or not) are at risk. Signature Bank of New York has also been seized by regulators, and there are other midsize (less than $250 billion in assets) banks that seem to have low tangible equity. Banks can be notoriously hard to analyze, so I expect many who invest for dividends to find greener pastures.

Impact to the market? 

We’re not sure yet how this will impact the market other than introducing more volatility. Some think the Fed must stop raising interest rates immediately to stem the losses of these poorly performing long-term bonds on bank balance sheets, while others think the Fed needs to continue to raise rates to combat inflation. One thing is certain – bond market volatility as measured by the MOVE index is likely to be heading higher. Last year, when the MOVE index went higher, financial conditions tightened, the stock market declined, and the economy slowed. That could be the case again in 2023.

Conclusion

It’s important to recognize events like this do happen and keep in mind that investing is a long term game. Depositors will end up being okay. Equity holders of the banks may not. 

It’s best to follow reputable, non-biased news sources for more minute-to-minute developments, but rest assured, we’re paying careful attention and will reach out again if needed. And if you have any questions please give us a call or drop us a message below.