Why You Should Be Worried About The Silicon Valley Bank Crash
Brace yourself for pessimism.
Slightly different newsletter today – we’ll be diving into the recent Silicon Valley Bank crash. The second biggest bank crash in US history.
Currently, thousands of companies and individuals are not able to draw money from their bank after it was seized by the US government on Friday due to a liquidity crisis. I’m not trying to fearmonger, but this could be a catalyst for a pretty disastrous chain of events, and I wouldn’t write about something I find so dull if I didn’t think it was important ya’ll knew about it…
Interest rates, a primer.
To understand what happened, we have to understand interest rates. For the last decade or so interest rates have been at an all-time low. Low-interest rates encourage borrowing (because the cost of borrowing is so low), in theory, this fuels growth in the economy as businesses and individuals take on cheap debt in order to finance growth or spending.
The downside of low-interest rates is inflation, demand for spending drives prices higher. This was also compounded by money printing during the covid epidemic, particularly ‘stimmy cheques’ issued by the US government to individuals affected by the pandemic.
Enter the Federal Reserve. These guys are the central bank of America, all currencies have a central bank, and their job is to control the inflation of its currency. The Federal Bank has a particularly important job because the dollar is the reserve currency of the world, basically the way the value of all other currencies are measured. In order to control inflation the Fed, led by Jermone Powell, have been fairly aggressively raising interest rates, to encourage saving, decreasing spending and therefore controlling inflation.
Mortgage Backed Securities
I used to think that when you put money in the bank, the bank just holds that money in a safe just for you, then when you want to take the money out, they go that safe and give it to you, kind of like Gringotts. Of course, this isn’t how banks work. What they actually do is take your money and invest it, keeping a return for them and giving you a portion of the return in the form of an interest rate. Banks are regulated and must put this cash into ‘safe’ assets, usually, that means government bonds and mortgages.
Mortgages are popular due to their higher interest rates. But banks don’t invest in individual mortgages, for efficiency they package them all up into something called a mortgage-backed security (MBS). A security is just an abstraction of the underlying asset. I can wrap up 10,000 individual mortgages at a similar interest rate and sell and buy that as one asset. As you can imagine, this is a lot simpler than having to buy and sell mortgages individually.
What Happened at Silicon Valley Bank
Now we understand interest rates, banks and MBS we can tie the pieces together to see what happened at Silicon Valley Bank (SVB).
SVB is the bank of choice for most tech startups, particularly in the USA. Due to insane investing into Venture Capital over the last 10 years, SVB has done very well. When a startup raises a $20m Series A round, they don’t spend it all at once, the idea is it lasts them a number of years, so they deposit that money into SVB, where it is safe (in theory) and returns a small interest. As startups raised more and more capital, SVB saw its balance sheet of cash grow and grow.
So what to do with all this cash? SVB made the decision to invest it into 10-year+ fixed mortgage-backed securities. This means that after 10 years their cash would return a fixed amount once the mortgages mature. Of course, as it’s a security this can be bought and sold on the open market at any point, but the underlying value won’t change. SVB did this when interest rates were at historic lows, 1.6%. This means a $10bn security compounded over 10 years would return $11.7bn.
Of course, interest rates are higher now. That same 10-year fixed mortgage today gets 5%, which returns $16.5bn at maturity. This causes, the value of old MBS to drop, because there is now an opportunity cost to holding them – why not just sell old MBS and get the higher interest rate MBS?
Last week, Silicon Valley Bank realised they had a problem. As startups were raising less money, they were withdrawing more money from their bank to fund costs, and deposits (new money) weren’t coming in to match them. To cover these withdrawals, and to safeguard for more withdrawals in the future, Silicon Valley Bank sold $21bn of bonds at $1.8bn loss
What happens next is quite interesting, and where game theory, rather than underlying economics comes into play. In theory, if withdrawals had continued at a normal rate, SVB would have had enough cash to cover costs. But withdrawals didn’t continue normally.
Peter Thiel told all his startups at Founders Fund to get out of SVB. His thinking was that if SVB is selling stuff at a loss, they must have a severe liquidity crisis, and even if they didn’t it doesn’t matter, if everyone thinks they can’t pay their customers, then everyone gets out. Its kind of the like the toilet paper shortage of Covid. There was never actually a shortage of toilet paper, but as soon as people like my mum started buying 40 rolls at a time, and the news reported on the shortage compounding it, it exposed how our ‘just in time’ logistical system only stockpiles the bare minimum, causing a real shortage.
And that’s exactly what happened last week. After Thiel told his founders to get out, everyone did. This caused a run on the bank, they didn’t have enough cash to pay the mass outpouring and, on Friday, the bank was seized by the Fed, who will look to do the best they can to pay back customers of the bank by selling what is left of its balance sheet.
As it stands, thousands of companies and individuals look to lose at least 50% of their cash, unless there is a government bailout.
Who’s to blame?
SVB. SVB are obviously at huge fault here. The job of risk managers is to model for increased interest rates and ensure that if they do spike, the bank will not have issues. Clearly they massively fucked up.
The Fed. Some would argue the fed has been too aggressive with its interest rate raises. If you start raising rates at this steep a level, then there is going to be fallout. Also, the Fed shilled its own bonds before it started raising rates, so many banks bought low-interest treasury debt thinking interest rates would remain low.
Venture Capital & Startups. It was quite dumb for pretty much the entire tech industry to use one bank.
Regulators. As far as we know nothing SVB did was in breach of the law, isn’t the point of regulators to audit companies financials to make sure this kind of stuff doesn’t happen?
Doesn’t this sound a lot like 2008?
While I think there is a good chance this could be the catalyst for a major market crash, it’s quite different to 2008. In 2008 the underlying assets (the mortgage-backed securities) were worthless because people were defaulting (not paying) their mortgages. This doesn't seem to be the case here, people are paying their loans, it’s just that the interest rates are so low these original securities aren’t worth much, but they’re worth something.
What Could Happen Next
Here’s my thoughts on potential likely outcomes. This would be based on no bailout. But even with a bailout many of these would hold true.
Tech suffers. A lot. All money in the tech ecosystem is going to be going to established companies that are already profitable that have been affected by this crash. Existing companies that aren’t looked at favourably will find it much harder to get support from Venture Capitalists, so thousands won’t be able to make payroll. There will be mass redundancies. New companies won’t have a hope in hell of raising cash, because all the cash will be going to Venture Capitalists’ existing portfolio companies. This will affect everyone. The potential Amazons, Netflix and Airbnbs of the current cohort of startups may not get a chance to thrive. Tech is also fundamentally deflationary, without new technology driving the cost of goods and services down, inflation could be an even bigger risk.
This bleeds into other banks. We’re already hearing about other banks and products (such as USDC, the stablecoin) which had a large exposure to SVB. These companies may never get their money back, causing collapse.
More bank runs. My prediction is that on Monday, there are going to be more bank runs, and likely more banks facing a liquidity crisis. I think this for two reasons, namely that all my founder friends and I are moving any uninsured cash into a new bank, I’m seeing this happen on the ground. Also, I’m skeptical SVB was the only bank to be overexposed to these long-term fixed rate mortgages. If they’ve been ignorant enough to lump so much cash into them. Surely other banks will have as well.
Actions You Should Look at Taking
Not financial advice. Please speak to your Financial Advisor. These are just the actions I am taking.
The first thing is to know your limitations. I can’t read a bank’s balance sheet, I doubt many can, they are a complete black box. The safest assumption is to realise that your bank could be at risk of a run, and may not be able to pay you.
Find out how much of your cash is insured. In the UK deposits up to £85k are insured by the government. You will be getting this money back, anything over that, there is no guarantee. Find out what this number is and if any of your banks are holding over that amount. This applies to your business account as well, if you have one
Open multiple banks and transfer any uninsured money to an insured bank. Your insurance isn’t individual (at least in the UK) its per bank. There is no downside to having multiple accounts with the max insured limit in each. You’d be foolish not to do this at this stage for the sake of a few hours of work.
Buy T-Bills. For short-term savings, I don’t know why no one talks or buys US Treasury Bills. The interest rates on these reach 5%, and they are backed by the US Treasury (which pays this back by printing money). The only way these fail is if the US Treasury fails, in which case you’ve got much bigger problems, apart from cash under your mattress, this is the safest way to hold money
This might all seem a bit extreme, and I do think the chance of any single bank failing over the next few weeks is small, but these actions have no downside, only upside. Also by the time people reach a consensus on this kind of stuff, it’s already too late, better safe than sorry!
Good luck and godspeed,