The Real Reason Silicon Valley Bank Collapsed

T he fall of Silicon Valley Bank should not be minimized, even by those of us who believe contagion will prove limited or nonexistent. Idiosyncratic events like this still have knock-on effects. There are parts of what has happened to Silicon Valley Bank that could only happen to a, well, “Silicon Valley” bank, but there are other elements hardly as isolated. A little unpacking is in order.

We now know the catalyst that set this chain of events in motion. Moody’s, reportedly responding to the mark-to-market losses in the value of SVB’s bond portfolio, had notified the bank of a pending credit downgrade. In response to that news, the bank began a mad-dash search to raise equity capital. But when the word hit the street that SVB was attempting a rushed capital raise, depositors began their own mad dash of withdrawing money.

This is the first truly idiosyncratic part of the story. The depositors in question were almost entirely start-ups, and they were being encouraged in this bank-run-fueling activity by their capital partners, namely, the who’s who of Silicon Valley venture-capital funds. So the deposit base that SVB lived off of began eroding quickly, and any hope that they would raise equity capital now was a fantasy.

Part of the bank’s plan to limit the impact of the Moody’s downgrade was to raise liquidity with a sale of assets SVB held on its balance sheet. The bank initially sold more than $20 billion of bonds, but did so at a $1.8 billion loss.  The bonds had been purchased in a lower-rate environment; the present higher-rate environment had caused downward pressure on the marketable value of the bonds; and that downward pressure translated to realized losses in this sale. So far, so not good, but certainly not fatal. (Anyone holding bonds purchased at 2 percent yields is underwater on the value, but there is no credit impairment whatsoever and holding to maturity generates a return of par value.)

Needing to raise capital to deal with some funding issues, only to lose depositors at the word of your needing to raise capital, and in turn losing the ability to raise capital at word of losing depositors, is obviously a vicious cycle. It can only be offset by one thing: an antidote that is truthful, not hopeful. In SVB’s case, no such antidote was forthcoming. Its bond portfolio held a larger share of long-dated (therefore, underwater) maturities than expected. Worse, there appears to have been no hedges on the books whatsoever — no interest-rate swaps to hedge that rate risk they were clearly carrying. The duration on the hedged and unhedged portfolio was the same.

Now, did some BASEL or Dodd-Frank–style restriction on how derivatives are treated in Tier 1 Capital (a bank’s core equity assets) disincentivize the use of swaps as a hedge in this case? We may never know the answer to that. But one can only hope that the risk-management “A teams” at other banks have a better feel for matching duration of assets and liabilities than this banks’ team did. Wall Street is certainly hoping that’s the case.

Another idiosyncratic aspect of SVB’s failure is the level of assets and risk positions the bank had in and tied to tech start-up equity. Silicon Valley Bank’s balance sheet was, shall we say, not your grandmother’s bank’s balance sheet. Its long-dated mortgage-backed securities will get a lot of attention, but again, there was no credit impairment whatsoever. How in the world does a bank fail without a credit impairment, such as an asset that failed to perform? No assets go bad, and the bank goes under? The prospect is stupefying to even think about. But to understand why what happened to SVB happened, you have to also factor in the equity side of its balance sheet, where it was accumulating assets (as one macro-analyst friend of mine put it) “as if Dave Portnoy ran it.”

As of press time, we do not know if a “white knight” will surface to play a similar role for SVB that JP Morgan played for Washington Mutual in 2008, in taking over certain obligations to depositors. The FDIC is far less likely to accommodate such a thing now with backstops, aid, and guarantees, because they are well aware that the systemic risk is nowhere remotely near what the world financial system was dealing with then. The FDIC’s mandate is to guarantee depositor health and well-being, not systemic health and well-being. A company taking on the entirety of this balance sheet in these circumstances is not going to be easy absent Fed, Treasury, or FDIC interventions that would be politically toxic.

So we will likely go into the week ahead unsure of what the wind-down of SVB will entail. The fact that not many banks could possibly have been so tethered to the geography and sector that Silicon Valley Bank was is a great argument for the idiosyncratic nature of this situation. It also vindicates Alexander Hamilton’s argument for why a bank should not be tethered to one geography and one industry. It is always great for a bank to have more and more deposits, but when your growing deposit base is limited to one group of depositors that are highly likely to need to withdraw their deposits in the future, you simply do not have the deposit funding mechanism that a traditional bank would have.

Silicon Valley Bank appears to be the depositor haven of the “shiny objects” I have been bemoaning for three years now. Crypto. Tech start-ups. SPACs. IPOs of companies not yet profitable. We are talking about a buffet of shiny-object depositors, and while 2022 decimated their equity value in the marketplace, apparently the actual cash-deposit level of these over-capitalized shiny objects was never considered until it began eroding at the speed of light. And here we are.

In terms of knock-on effects of SVB’s collapse, speculation is likely to be less about other banks’ lending hand over fist to VC-backed tech start-ups and more about the bond portfolios of these banks. Did they get their LGBTQ hires right but somehow forget to hedge interest-rate risk? At this time, no one knows what the state of bond portfolios on smaller bank balance sheets means for their capital positions. The politics of this are tough, too, because the Fed and FDIC and Treasury simply cannot state with any credibility that they will (or should) do anything other than enforcing the basic legal backstops already in place. I don’t believe that many banks are backing all the Pets.coms of 2023, so I don’t believe this becomes “systemic.” But I wouldn’t say that I want to work for the FDIC right now.

As the SVB fallout continues, too much focus will be on the Fed’s raising of interest rates over the last nine months and its impact on the market value of SVB’s bond portfolio. Yes, that puts the Fed at the scene of the crime, but what about the Fed’s first involvement in this sordid affair? Namely, the maintaining of the zero-interest-rate world for so long that it enabled and facilitated the shiny-object mess that became the bread and butter of Silicon Valley Bank’s business model? You cannot get a shiny-object depositor orgy without the Fed’s enabling it, try as you may. No Fed action justifies this colossal failure of risk management or even basic banking competence, but on both the way up (rates down) and the way down (rates up), the Fed is there, pouring kerosene on a fire.

As is the case with most episodes like this, there is not one story at play, but many — there is not one lesson, but many. Here’s what I see those lessons as so far:

1. Shiny objects are just as bad for banking as they are for risk-asset investors, and when those two things get inter-mixed, the results are usually FDIC suits coming into your office.
2. Long-dated assets don’t match well to short-dated liabilities, and banking 101 calls for some form of risk management that transcends the woke and diabolically incompetent.
3. Panics become self-fulfilling prophecies very easily in a leveraged financial system, and the best way to avert such a thing is to have truth on your side, when that truth is actually good news (i.e. capital strength, etc.).
4. Aggressive interventions into the cost of capital distort our financial system, both with excessive accommodation and excessive tightening. The Fed’s role in SVB’s failure is not insignificant, and yet it will either be missed, or will be discussed incompletely. Their insistence on over-tightening now is a major policy mistake, but we must never forget that their first policy mistake was the “too low, too long” era.

It was that era that gave us Silicon Valley Bank.