The Fall of SVB 3/17/23
Welcome to The Shepherd Wealth Management Blog! This is the first of many weekly blogs we will post, focusing on market topics that are important to you!
Let’s jump right into a very important topic: the fall of Silicon Valley Bank (SVB). It’s important to acknowledge the human side of this financial failure. We feel terrible for the employees of SVB, the depositors who were worried about losing all their cash, and we feel even worse for the individual investors who sold some or all of their portfolio positions out of fear of a bank contagion.
At the time of writing this blog post, we’re confident this is not a bank contagion like 2008. Silicon Valley Bank collapsed due to three primary factors:
Poor risk management at the SVB
Lack of regulatory oversight by the Federal Reserve
The Fed increasing interest rates at the fastest pace in 40 years
Why are we confident this is not a bank contagion repeat of 2008? Of the roughly $74 billion in total loans SVB held on its books at year-end 2022, almost half - $34 billion – went to borrowers of small technology companies in the Silicon Valley area. Most small businesses are not profitable right away, and in the technology industry, it can take a new tech start-up 10 years or longer to realize sustainable profitability.
When rates are effectively zero, this is less of an issue because as the tech companies burn through cash, the bank can continue to use depositors’ money, or loans from the Fed, to continue to fund those tech start-ups. This was highly profitable for the bank, their shareholders, and tech entrepreneurs for a long time - until now.
Let’s break the problem down one step at a time.
First, SVB was not diversifying their loan portfolio. JP Morgan (JPM) is the second largest lender to these types of tech start-ups, and at the end of 2022, they had roughly $14B on their books for these same kinds of loans. JP Morgan is one of the largest and well run banks on the planet, yet SVB, the 16th largest bank in the USA, had $20B more in similar loans!
Second, SVB was primarily lending to one industry and many of these companies are in the Silicon Valley area. For context, large banks like JPM lend to businesses and individuals globally and across all business sectors. Clearly SVB was not diversified!
Third, SVB executives decided to invest excess deposits in mostly 10-year treasuries at 1.5 percent. In December 2021, the Fed Chairman, Jerome Powell, announced that the Fed would begin to raise rates in 2022, and expected rates to rise by 1 percent for the entire year. Well, as we all now know, the Fed increased rates by 4.5 percent and the majority of those rate hikes happened in 6 months.
So, if you’re the CEO of SVB and not receiving deposits at the rate you did in 2020 and 2021, you have a decision to make: You could borrow from the Federal Reserve Bank to cover your cash reserve requirements (but you will have to pay a much higher interest rate back to the Fed). Or you can sell positions in the bank’s investment portfolio.
As rates go up, the value of the 10-year, 1.5 percent treasuries that SVB bought are going down - to the tune of 60 plus percent losses!
Clearly, some of the blame goes to SVB management for not diversifying and not investing in shorter duration treasuries. But, we can’t let the Federal Reserve off the hook. There are 7 Federal Reserve Governors, each responsible for a “territory” in the USA. Since the Fed’s inception in 1913, their primary responsibility is to provide financial stability for our economy and banking system. You would think that someone overseeing SVB would identify the major dislocation with SVB’s fixed income investments versus the direction the Fed intends to take interest rates.
People suffered because the of the Fed’s need to regain credibility after being extremely late to raise rates in 2021(after printing more money than any other time in the history of mankind).
Let’s all hope that the next Fed interest rate announcement on March 22nd begins with an apology and ends with no additional rate hikes.