The Silicon Valley Bank (SVB) Crisis Explained
With the collapse of Silicon Valley Bank (SVB) and the overall banking issues we want to take a deeper dive into what is happening.
How Do Banks Run? - The Nature of Banking
Banking, at its heart, is a process whereby a bank takes short-term money and lends longer-term to individuals and businesses that need the cash. Generally, we all deposit our money at the bank, and they pay us an interest rate on that money. The bank then takes that money and lends it out on a longer-term basis.
This creates what is called in finance “duration mismatch.” Think of the bank as taking loans from all of us depositors and then loaning that money out to other people to buy houses, run business, etc. It is dramatically more complicated than that but it’s a starting point for a discussion.
In addition to making loans when we deposit money at the bank, they can also buy securities. These securities are generally US Government Bonds or “agency bonds” which are Fannie/Freddie bonds. We’ll refer to them both as government bonds because Fannie and Freddie are still nationalized.
What’s Happened and is Happening With The Silicon Valley Bank (SVB)?
What SVB and the vast majority of other banks did during COVID was:
receive a ton of deposits and
buy a lot of government bonds. We are talking about trillions of dollars of government bonds. Government bonds are theoretically the safest investment in the entire world.
However, government bonds still have duration risk just like every other bond in the world. Duration risk is simply that the value of the bond that matures years from now is worth less if interest rates rise. Short-term bonds, those due in say a year or less, have very little duration risk because they pay back very soon.
Let’s say you have a bond that will be paid back in five years and it pays you a 2% interest rate. Now imagine interest rates rise. You now have a loss on that five year bond that you bought. It does not mean that you will not receive the money back from the government in five years. However, it does mean that you are stuck earning 2% while similar bonds are paying 5%, making it worth less on the open market or on a balance sheet.
Imagine an industrial business that saved up a lot of money and needed to invest it somewhere. They took that excess savings, and they bought that five year government bond at a 2% interest. They have a unrealized loss on that bond. They may be frustrated that they could have waited and bought a bond with a higher interest rate, but they can simply wait five years and get their money back from the government.
The Silicon Valley Bank’s Bonds Had To Be Held to Maturity (HTM)
SVB attempted to do something similar with their bonds. In banking, you are allowed to hold securities in an accounting bucket called “held to maturity.” When you hold them in this bucket the value of these securities remain at their amortized cost. In other words they are not marked to market.
Held to maturity rules however require you to hold those securities. You have to have the intent and ability to hold them to maturity. If you sell a HTM security you have to mark the entire HTM bucket to market. The problem for the banks is that if they marked the HTM bucket to maturity many of them (SVB being the worst) would be insolvent.
We can see where the problems can arise because banks borrow from depositors short-term and those loans are callable at any time. You or I can simply log on and wire our money out of the bank. Outside of compliance items to ensure it is correct and/or legal they cannot stop those funds from leaving.
The SVB Crisis Caused A Bank Run
With SVB, the market was spooked by a lot of their actions. First, they sold another bucket of assets for a $2B loss. Next, they went to market and attempted to raise roughly the same amount of capital.
The timing of this was horrible and questions remain around why they did not raise the capital CONCURRENTLY with the selling of those bonds. With the market spooked, the focus turned to the HTM portfolio. Investors quickly realized that if they marked that to market they would be insolvent.
And with that the bank run began. This created a situation where the HTM securities could no longer be held to maturity and the bank became insolvent.
The Government’s Response To The Silicon Valley Bank Crisis
The government stepped in, took over SVB, and did the following two things:
Made depositors whole above and beyond the $250K FDIC limit
The Federal Reserve created a new facility where those HTM securities can be transferred to the Fed, and they receive back par for the bonds. This is a one year facility but the likelihood of it lasting longer than this is high
The purpose of the first action was to stem this from spreading to other banks and to allow the businesses with capital at SVB to continue their operations (payroll, etc.).
The purpose of the second action was to help the banks avoid marking to market their entire HTM securities bucket which would leave many of them close to if not insolvent.
We expect significant additional actions to be taken including:
Raising FDIC levels
Increasing regulation on smaller non-systemically important banks
Significant consolidation of the regional banks where the strong start to take out the weak. This happens with every financial crisis, the question at this point is whether the big banks will be allowed or if it will be the stronger regionals getting bigger
It is worth noting that even if the government does not allow say, JP Morgan, to buy up some of the banks deposits will simply continue to flow to the larger banks (like JP Morgan). So either way the big systemically important too-big-to-fail banks are likely to get larger from this.
The SVB Crisis May Be Averted But There Are Other Implications
There is going to be a lot more to come from the government and the banks in the next few weeks. We will see how significant the disruption becomes, but the current actions taken may not be enough to stem outflows from the weaker banks to the bigger ones.
The other side of the coin is that this has caused interest rates to drop and the unrealized losses for the HTM bucket on the banks books have shrunk (the lower the interest rates go the smaller these losses become). If rates continue to come down, this will partially solve the problem. This doesn’t solve the bank run fear issue as that needs strong governmental action vs. accounting treatments.