What happened with Silicon Valley Bank? A quick explanation

Last week's market sell-off that began on Thursday was triggered by a bank run on one of California's biggest bank, and one of the most important banks of the start-up community, the Silicon Valley Bank. Due to the ongoing run, it failed on Friday and had to be taken over by FDIC to ensure protection of depositors (which they did, over the weekend).

How did this happen?

Usually, when a bank fails, it fails due to credit risk. They give out bad loans or make bad business/investment decisions (like filling up balance sheets with triple-AAA rated but in reality high risk and close to defaulting MBSs and CDOs prior to 2008). This time, however,?it wasn’t the credit risk, it was interest rate risk.

Silicon Valley Bank (SVB), like all banks,?holds a large portion of low-risk US Treasury bonds?in its portfolio. As it should, and as encouraged by the regulators. These are considered to be assets with zero risk of default (they default in case the US government defaults which never happens - or at least has an extremely low probability of happening), meaning that banks can maintain a good capital adequacy ratio when holding such assets, whilst maintaining at least some return.

Keep in mind that over the past 10 years of low interest rates, bonds were the low performing asset, as yields were suppressed to an average 1-2% (depending on duration). So holding government bonds was basically a risk-mitigating strategy.

However, as you know, 2022 was a bad year for bonds.?High inflation meant that investors were massively selling bonds, pushing their yields up to over 5% on the 2-Year T-Bill and over 4% on the 10-Year (remember, bond yields and prices are inverted, because you calculate current yield by dividing the coupon rate, which is fixed, with the current price of a bond, determined by supply and demand). No one wants to hold bonds yielding a few percent return with inflation closing in to double digits. Hence the sell-off of bonds. On average bond portfolios were down between 10% to 15% last year, and this rout continued into 2023.

Now, this isn’t a problem if you hold these bonds to maturity, as you then get paid back the full principal plus interest. But, if you are forced to sell them prior to maturity, you may sell them at a lower price. This is exactly what happened.

SVB experienced a?classic run on the bank. Its depositors wanted to withdraw money en masse, which forced the bank to sell its bond portfolios at a loss. As more depositors were flocking in after the word quickly got out that the bank is experiencing liquidity issues, the bank was soon facing an insolvency issue, and the government had to step in and shut it down on Friday.

SVB is (was) a specific bank.?Its niche customers were start-ups and VC funds?backing these start-ups. And most of these start-ups aren’t really selling enough (or any) products to keep them operational. They need VC money to keep their runways (the amount of money needed to continue making payroll and covering opex). Most of this money was parked on SVB bank accounts (and accounts of similar banks supporting fintech and crypto start-ups like the bank Silvergate or Signature bank, another bank that went under this week).

So in the wake of the 2022 tech rout - hurt most by rising interest rates - and continued layoffs in the tech space from even the biggest tech companies, it’s easy to see how many start-ups at once were desperate to pull out their cash and use it to fund their operations. As more and more piled in, the bank was running out of options.

The market started to price in a recession quickly, as was exemplified by the?rapid change in expectations of the Fed cutting interest rates?already by the end of this year. At the start of last week, after Powell’s Congress testimony, markets were pricing in 5.6% rates by the end of 2023. On Monday, the expectation was 3.9% by the end of 2023.

That's why there is worry right now of a greater contagion effect. Especially for the smaller, regional banks, much more sensitive to a similar run and with their hands tied due to interest rate risk.?Not a lot of these smaller banks did interest rate hedging, so the exposure to this risk now became quite obvious to investors.

Overall, it's hard to maintain a bullish outlook for this year in markets. Banks don't typically fail in bull markets. Especially not due to interest rate risk.