Silicon Valley Bank | Explained

As you know by now Silicon Valley Bank, the 16th largest bank in the United States until this past week, has been seized by the regulators due to insolvency.

So what happened?

The best explanation I've read so far is from Marc Rubinstein, as highlighted by Matt Levine in his Bloomberg article yesterday:

Basically SVB ended up with a large portfolio of held-to-maturity?bonds?with an average duration of 6.2 years at the end of 2022,?“and unrealised losses snowballed, from nothing in June 2021, to $16 billion by September 2022.” These losses “completely subsumed the $11.8 billion of tangible common equity?that supported the bank’s balance sheet,”?meaning that SVB was technically insolvent.

But mark-to-market losses on held-to-maturity bonds don't count for bank accounting purposes; the theory is that you will just hold the bonds until maturity, they will pay back par, and you won't have any losses. So SVB was still solvent and fine.

In reality though, if you knew how the accounting works, and knew what the mark-to-market losses were at the time, then you'd have known that SVB was a ticking time bomb due to the dynamic described in the paragraph below.

“Sell even a single bond out of an HTM portfolio, however, and the entire portfolio would need to be re-marked accordingly” meaning that if you have bonds in your held-to-maturity portfolio, you have to be really confident you can hold them to maturity. SVB’s bonds kept maturing and providing cash to pay out depositors who wanted their money back. But: “What neither the CEO nor the CFO anticipated, was that deposits might run off faster” than the bonds.

And after several prominent venture capitalists (Peter Thiel) and venture organizations (Y-Combinator) encouraged their tribe to minimize their exposure to SVB, the run was on and snowballed and that accelerated as SVB's stock price tanked -- causing even more folks to panic and try and get out etc.

THREE BIG TAKEAWAYS:

#1 -- SVB had a big portfolio of bonds (bad).?In interest rate rising environments, fixed-rate bonds are bad. Maybe they got into those positions back when interest rates were still falling. Ok, fine, but that doesn't excuse the fact that their?CFO and their board made?the mistake of assuming?that the interest rate decreasing environment would last as long as the expiration date of their bonds.?That assumption proved very expensive. It is going to cost many people their jobs and all the equity shareholders of SVB will likely get wiped out.

If you own bonds today, either in your individual capacity or in your business, you need to assess whether that makes sense.?In most cases today, fixed-rate bonds are not good investments for the simple reason that they will fall if interest rates continue to go up and their current rate of return is LESS than inflation which means you are locking in losses to your buying power. Why would anyone ever do that if they understood what was going on?

Better to invest in businesses that have a proven model, that generate value -- which then translates into how you will make a return -- instead of speculating on interest rates. [Don't mistake the big rally in government bonds yesterday, which was a function of flight to safety and speculation that the Fed would ease up on raising interest rates due to fears of a bank contagion, as a sign that bonds are good -- the issue of negative real interest rates remains true.]

#2 -- SVB's investment portfolio was not sufficiently diversified.?They got lazy and followed the herd. And the institutional herd had been investing a lot of money into bonds for years because they were lulled into believing that bonds are safe. Bonds are safe if certain assumptions prove true. Bonds are dangerously risky if those assumptions prove false. If you want additional proof that bonds are risky -- see the chart at the top of this letter.

SVB was also not diversified in its client base?-- which made it particularly vulnerable to a stampede -- in the wrong direction. When influential individuals or groups come out and strongly encourage their followers to get out -- it sparks a feeding frenzy because everyone around you is suddenly scrambling and human nature in that situation is to do the same for fear of being the lone guy out.

By contrast, if their client base had been more diversified, then even if all their clients from one client sub-group fled, it wouldn't cause the same panic -- because what Peter Thiel and Y-combinator says despite being near-religion in Silicon Valley might mean nothing to a corn farmer in Iowa or a ball bearing manufacturer in Michigan.

Based on what is known today, SVB got hurt by its own success: they virtually owned the banking brand for Silicon Valley and start-ups nationwide and did not materially diversify their client base.

#3 -- Understand the difference between a Bank and a Custodian (Schwab)

If you have a lot of money, and you want to keep it at a bank, and you want to make sure that your money is not at risk of being lost due to situations like SVB then you need to obtain more insurance (something you can negotiate with to obtain at larger banks, but there is usually a price for that) or you can keep opening accounts so that your balances in each account are not in excess of the FDIC protected amount.

However, a simpler and perhaps better alternative is to park that cash with us (we use Schwab as your custodian -- that's who actually holds your cash -- not us, we never ever directly hold or touch your cash or any other asset for that matter). We can help you get checks and debit cards for accounts and easily move money to other accounts of yours (at other institutions) or wire money as needed. A great alternative.

How? Why?

The answer becomes clear when you?understand the difference between a bank and a custodian:

Banks take your money, mix it with theirs, mix it with other clients' money, and then invest that bigger pot of money hoping to make more than the expense of running the bank and the interest they promised to pay you on your deposits -- keeping the profits for themselves. That's how banks operate.

Custodians on the other hand do NOT ever mix your money with theirs or any other customers.?Money is kept segregated and that protects it.

Second, Custodians do not take customer money and invest it hoping to generate profit for themselves.?Custodians only act on behalf of their customers -- on behalf of you. So when we, as your advisor, place a trade in your account, buying a stock for example, Schwab helps us execute that -- but they make no money based on the appreciation of that stock. And they only do that when you or an authorized representative instructs them to place that trade using the money in your account. Said differently -- your money is inherently safer -- because they never have the discretion to put it at risk for their own gain.

We can also help you earn interest on your cash at Schwab that is generally as high as you'd get at most banks.

Given the enormity of the events in the last 72 hours in our banking sector I wanted to give you a quick update.

Bottom line, I think the banking sector will be ok -- but -- there are a lot of unrealized bond losses held by banks and I'm sure that in the next several weeks, that is going to be getting a lot more attention in the press, and I would be cautious about owning shares in the banking sector for a while, since there is a strong possibility that other banks may ultimately be pushed out of business due to similar problems as those faced by SVB.

The regulators did the right thing to step in and help protect creditors and the banking system itself.

If you have significant sums of cash sitting in banks that are not there supporting loans or other important banking transactions you may want to consider opening an account with us at Schwab.

Likewise, happy to introduce you to banks that I've been working with for years that I believe are more diversified than SVB and have been doing a great job at helping our clients with their banking needs (indeed, we've helped a handful of folks who reached out this last week -- needing to get out of SVB), if you're looking for a new banking partner as a result of this past week.

Stefan Whitwell, CFA