The 16th Largest Bank in the United States is No More
Silicon Valley Bank is shut down as FDIC takes over
“But then my partner called to say the pension funds were gone
He made some bad investments now the accounts are overdrawn
I take a walk.” - Take a Walk by Passion Pit
Shockwaves ripped through the Bay Area and beyond on Friday as an old-fashioned bank run took down America’s 16th largest bank. Although just one week prior it had been worth billions with a $284/share price on the New York Stock Exchange, by mid-morning on Friday, March 10th, Silicon Valley Bank was in the hands of the Federal Deposit Insurance Corporation (FDIC). It’s the second largest bank failure in U.S. history, trailing only that of Washington Mutual, whose own failure was a key domino in the cascading 2008 financial crisis. Now depositors are waiting to hear what they will be able to get out, and investors have lost nearly everything. What happened? And how did it happen so fast? And what comes next?
Bad Investments
It is possible someday there will be a blockbuster movie starring Leonardo DiCaprio and Jonah Hill detailing what happened behind the scenes at Silicon Valley Bank over the past year. It will take a long time for all of the details to emerge. But at least on the surface, the bank’s downfall appears to be due to several poor decisions that snowballed on one another. Bad luck played a role too, but bank leadership also appears to have taken very few measures to mitigate against the possibility of this bad luck. If bad luck is the product of poor preparation, Silicon Valley Bank was very unlucky indeed.
The first domino in this chain was the fact that Silicon Valley Bank was known as the bank for start-ups in the California tech and healthcare scenes. This attracted a great amount of dollars in deposits during the frenzy of the last few years because many of the start-ups that banked with Silicon Valley Bank were flush with cash from investors during this time period. This cash ended up in the vaults (electronically, at least) of the bank. It seems like Silicon Valley Bank was the place for these start-ups to be for whatever reason.
The second domino was that to achieve an internal rate of return themselves on this cash that was sitting there, Silicon Valley Bank invested it in what they thought were conservative, virtually risk-free securities. This is common bank practice. If you have billions of dollars sitting in the bank, why not try to earn some return on that money. However, the investments they made were not risk-free. As I’ve detailed before, in “The Perils of Safe Investments,” bonds and other conservative investments can lose money, most commonly when interest rates rise. And interest rates have surged in the last year, far beyond what the cash management team at Silicon Valley Bank must have expected they might.
If you are holding a bond until maturity, the fluctuations in the price of that underlying bond do not matter as much (other than the opportunity cost of having your money tied up in low-yielding assets when newly issued bonds are yielding so much more). The problem, however, comes when those bonds need to be sold. It’s only a paper loss until the underwater asset is sold, which then locks in the loss. And that was the third domino that struck against Silicon Valley Bank: the need to sell at a loss in order to generate cash.
Why did the bank need to generate cash? Well, the tech scene has been challenging of late. 2022 was a bad year for many of the highest performing tech companies, and all the more so for start-ups and less well-established firms. A lot of these companies have been burning through their cash, which Silicon Valley Bank did not anticipate happening at the rate it did. The perilous point that the bank found itself in this past week was that it had invested billions of dollars of its cash holdings in low-yield bonds and treasury notes with long maturity dates. As interest rates rose over the last year, the value of these bonds had plummeted. If the bank could have held these bonds and notes until maturity, it probably would have been okay. But higher-than-expected cash withdrawals from its many business customers sparked the need for the bank to liquidate some of its assets to generate the very cash needed to honor these withdrawals. As soon as Silicon Valley Bank sold off these bonds and notes, it realized billions of dollars of losses.
As the full extent of the losses started to become evident, the fourth domino fell, which was the realization from customers, investors, analysts, and others that the bank might not be able to meet its obligations and might literally run out of money. That is when the bank run took shape, which really happened like a thunderclap over the course of about 30 hours. By Friday morning California regulators stepped in, the company’s stock was halted on the New York Stock Exchange, and the FDIC took over the bank mid-morning, notable in that historically when these situations arise regulators and the FDIC usually wait until the end of the business day. But it appears they did not think the bank had even another six hours of viability left.
So there you have it: a bank flush with cash made bad investments and then when its mostly-business customer base started taking out their cash at abnormally high rates, the bank had to liquidate its bad investments at a loss in order to generate more cash. Panic ensued as the degree of the losses and the chance that the bank would run out of money became evident. Finally, the government shut off the bank and will now either try to force an arranged marriage with another, stronger bank that would take over Silicon Valley Bank, or the bank’s assets will be totally liquidated.
What Comes Next
The sudden failure of Silicon Valley Bank has created an atmosphere of high anxiety if not outright fear in the overall banking community. Bank shares across the board lost significant value in the market on Friday. I am sure cash management teams at banks from Atlantic to Pacific are digging as deeply into their financials as possible to see if similar risks exist in their portfolios (if they are not already aware of them).
Many of the actual ustomers of Silicon Valley have to be extremely worried as FDIC insurance typically covers $250,000 of deposits. But according to some sources 85%+ of the deposits at Silicon Valley Bank were above and beyond the $250,000 threshold including some major holdings from some key tech players. What becomes of those deposits? I expect we will know more by Monday:
It will not be a pleasant weekend or, indeed, “normal” for quite some time to come for the myriad parties impacted by the failure of Silicon Valley Bank. But is there a risk that this spreads throughout the economy? There were several things that were unique to Silicon Valley Bank that suggest this was a somewhat isolated situation and the risk of contagion to the overall banking system, while not 0%, is actually somewhat limited.
First, Silicon Valley Bank was unique in that it catered to so many businesses in similar industries: tech and healthcare. The vast majority of its assets were those of businesses and not individuals. As these businesses in these particularly unique industries needed to withdraw their cash to sure up their own business operations, Silicon Valley Bank suddenly found itself in big trouble.
It also seems that the bank just simply made some terrible choices in their investments 12 to 24 months ago by putting so much of their assets into low-yield notes with long maturity dates. Why? Who knows. It may have just been a complete misread on the interest rate environment, but a fatal one at that.
This raises the question of where the regulators were over the past year? I can say from my experience as a lender at a community bank in Maine that we are audited internally and externally, checked, and double-checked on things all the time. I can’t imagine why certain red flags were not identified earlier on. To me it seems like there is some fishiness in that; either bank regulators willfully looked the other way or they were asleep on the job.
Taylor Marr from RedFin, who writes a Substack I subscribe to myself that you should check out, wrote about an interesting consequence from what transpired on Friday: home mortgage rates dropped by 0.29% over a two-day period at the end of the week. This was after a pretty big bump up in rates over the past three weeks. Marr wrote on Friday:
Today, the collapse of the Silicon Valley Bank (SVB) is the most significant event to impact housing from the week, despite a wealth of anticipated data on the labor market being released. Why? Risk and uncertainty. I won’t get into the specifics of SVB’s failure (read more here), but instead the more important fact is that it is sparking concerns among investors of a potential banking crisis. For now the risks seem contained. The Dodd-Frank Act implemented new rules for banks and regulatory oversight that should (in theory) limit the impact of the situation in contrast to 2008. Nonetheless, there is uncertainty that is notable with what happens next and what ripple effects or parallels might unfold.
If there is one thing markets do not like it is uncertainty. It is possible that the very uncertainty created by the fall of Silicon Valley Bank may give the Fed some pause on whether it should continue to increase interest rates as much as it has over the past year. It was not the Fed’s fault that Silicon Valley Bank made such poor decisions with their own investments, but the surging of rates has created duration risk in portfolios all over the country, with the consequences most acutely felt by the customers, investors, and employees of Silicon Valley Bank this past week.
It is also likely that this bank failure will further impact the struggling tech sector. Not only will some immediate losses be felt by customers and investors, but it seems at least from the outside that at its best Silicon Valley Bank did actually provide important banking services for the start-up community, and their absence in the financial ecosystem going forward will create a hole, for better or worse. Rick Palacios also suggests the acute uncertainty felt in some of the nation’s tech centers will depress housing prices, which have been frothy to say the least over the past several years but are now on their way down:
Addendum
If you want further proof that so-called experts do not always get it right and sometimes do not even know what they are talking about, consider this: Jim Cramer from CNBC called Silicon Valley Bank a buy opportunity just last month.
But he wasn’t the only one. Just this past Monday, Silicon Valley Bank was touting its placement on Forbes’s list of best banks. In what was probably just window washing if not a last-ditch effort to save his bank, Silicon Valley Bank CEO Greg Becker said in a Zoom call with customers and investors on Thursday, “My ask is to stay calm because that’s what is important. We have been long-term supporters of you — the last thing we need you to do is panic.” Nothing calms people down more than someone saying “don’t panic!” Of note, CEO Becker also sold just over $3.5 million of his Silicon Valley Bank stock two weeks ago. Other executives have been similarly selling in recent months. I expect there will be more to come on that. I hope so anyway. That along with one other pressing question remain: can you make a Leonardo DiCaprio and Jonah Hill movie about the fascinating topic of duration risk? Time will tell.
Ben Sprague lives and works in Bangor, Maine as a Senior V.P./Commercial Lending Officer for Damariscotta-based First National Bank. He previously worked as an investment advisor and graduated from Harvard University in 2006. Ben can be reached at ben.sprague@thefirst.com or bsprague1@gmail.com. Follow Ben on Twitter, Facebook, or Instagram. Opinions and analysis do not represent First National Bank. © Ben Sprague 2023.
Thank you, Ben for this very informative article. You explain complicated topics in such a clear and concise way making complex financial issues understandable. Keep up the excellent work.