How does the SVB collapse affect your money?
How did Silicon Valley Bank (SVB) make money?
It has been a tumultuous week in the stock and bond markets as investors have responded negatively to the news that the California based Silicon Valley Bank was unable to meet the demands of their clients to withdrawal funds and subsequently became “illiquid”, which is jargon for “we don’t have enough money to give our clients their money back”.
It’s important to understand that SVB was not a normal retail facing bank. SVB was a bank used by primarily venture-backed tech startups. What does that mean practically? It means they were providing funds to early stage (extremely risky and likely to fail) start-up companies that focused on cryptocurrency exchanges, blockchain technology, artificial intelligence, and other software initiatives. Most of these types of companies fail in their first two years, and only a select few become large publicly traded companies. Most banks follow a standard playbook to make money. They take money from their depositors, then loan money to people (or companies in this case) that need funds.
During the past several years as the tech and venture capital industries exploded, SVB received billions in deposits, but had very little demand for loans, especially when compared to consumer banks that focus on mortgages, personal, and auto loans. So, what did SVB do with all this extra money? They invested it. Sounds reasonable on the surface. But the problem is how they invested it. They purchased billions in illiquid, long-term treasury bonds right before interest rates started rising. Imagine buying a bond that only pays 1.5% interest and is locked in for 30 years. SVB put themselves in a very precarious position because they were focused only on an industry that had so much outside funding, they didn’t need to make loans to make money like most normal banks. High interest rate environments tend to help banks for exactly this reason. They pay more interest on deposits, but they also get paid way more on loans, so they profit from high interest rates. SVB put themselves in a position where they were in the opposite position of most normal banks; higher rates hurt more on the liability side than they helped on the asset side.
Why did Silicon Valley Bank (SVB) collapse?
Most banks have a lot of diversity in the types of people or companies that deposit with them. This makes sense from a business perspective because it helps protect the banks from industry or demographic specific financial problems. SVB on the other hand had an extremely close relationship with a handful of venture capital firms. Most of the companies they were lending to were California-based technology companies with the same wealthy venture capitalists on their boards. One of those wealthy venture capitalists was Peter Thiel, co-founder of Paypal, and current partner at the venture capital firm The Founders Fund. To make a long story short, the Founders Fund pulled out their money from SVB bank, then encouraged all the companies in their venture portfolio to do the same. As word spread, more companies pulled their money creating a “bank run”, where billions of dollars were requested to get pulled from the bank all within the same day.
Many banks have enough liquid assets to handle this type of event, but the problem was SVB’s bizarre strategy to purchase extremely low interest rate long-term bonds last Fall, even as it was clear that interest rates were going to be rising quickly. When interest rates increase, the prices of bonds fall (why would anyone pay the same amount for a lower interest rate bond?) accordingly. Investors get their full return if they hold the bond to maturity. SVB had 3 billion dollars in long-term bonds that had to be sold at a huge loss to produce the funds to give depositors their money back. In addition, most of their other deposits (over 165 billion) were either uninsured or tied up in federal home loan bank advances. So, to make a very complicated scenario simple, SVB had illiquid assets that needed to be sold at a huge loss of billions to meet the demand of a “bank run” that was created by a billionaire pulling out money and then encouraging others in the venture capital industry to do the same.
Should I be concerned about the SVB bank collapse?
SVB was the largest bank failure since Washington Mutual failed in 2008 with 307 billion dollars in assets. U.S. bank failures tend to be uncommon, so many people are rightfully concerned about their local bank having problems. It is important to note that all SVB depositors will receive their full deposits and the bank is re-opening today as the Deposit National Insurance Bank of Santa Clara. The bank is now controlled by the FDIC, with full FDIC protection, and even a plan to refund some uninsured deposits as SVB’s assets are liquidated and become available. SVB’s unique position as being much more exposed to the tech industry and being doubly sensitive to rising interest rates makes it unlikely that large bank failures will be widespread. However, there is certainly a risk that industry specific banks, and small regional banks that have invested their assets in a way that leaves themselves vulnerable to massive interest rate risk (locking in billions at low interest rates and having “paper losses” on long-term bonds) are vulnerable. To help combat this risk, the Federal Reserve announced an emergency lending program to help banks meet the demand of their depositors and to eliminate the bank’s need to quickly sell those assets in times of stress.
While some banking regulations were relaxed by the Trump administration in 2020, the majority of banks are still subject to much higher stress tests and cash reserve requirements of the Dodd-Frank Act. Combined with the new Federal Reserve lending program, it seems very unlikely that large consumer focused banks are exposed to the same type of risks as a tech oriented venture bank like SVB. SVB was in unique position where it wasn’t lending assets for loans like mortgages and personal loans, which is one of the main reasons banks tend to benefit from high interest rate environments.
To protect yourself, it’s always important to use FDIC insured bank accounts, SIPC insured brokerage accounts, and to also use accounts that purchase additional private insurance over and above those coverage limits. Arrow investment accounts for example use FDIC money markets, SIPC insured brokerage accounts, and have additional insurance through Lloyds of London.