It’s Not a Wonderful Life: Silicon Valley Bank Collapse and Bond Investing
Well, the financial system almost collapsed- almost.
The weekend of March 11-12 in 2023 will be remembered as a moment of terror for thousands of SVB customers. Fortunately, the federal government stepped in to take over the bank and guarantee access to all customer deposits.
Defining a Run on the Bank
Panic spread like wildfire before the weekend, leading to a “run on the bank”- a huge number of depositors trying to withdraw money within a few days. Frank Capra’s film classic, “It’s A Wonderful Life” includes a bank run on the Building and Loan.
Customer deposits are a bank liability, and depositors can withdraw money at any time (generally speaking). During the SVB bank run, the bank had to liquidate assets to pay customer liquidations.
And that’s where the problems began.
Selling Assets to Pay Depositors
If you were going to pay $15,000 for a down deposit on a home in three months, where would you keep that money?
Well, you need an investment that allowed you to access the cash right away, and without incurring fees and penalties.
You’d probably just hold cash. Makes sense.
There are two tricky things about banking:
· You have to forecast the dollar amount of depositor withdrawals each month, and how you will fund those cash withdrawals.
· Banks have to maximize the return they earn on deposit dollars while they are on deposit
Back to the home down deposit. Why wouldn’t you buy common stock with the money?
Well, the price can change quite a bit over three months.
What about buying bonds- say, Treasury or mortgage-based bonds that carry a AAA-rating (the highest credit rating)?
That investment sounds safer, but don’t those investments change in price, also?
Yes, they do. And to understand why, let’s talk about bond prices and bond yields.
Understanding Bond Prices and Bond Yields
Assume that IBM issued a AA-rated $5,000 6% corporate bond at par, or $5,000. Each year the investor earns 6% on $5,000, or $300, and that $300 payment never changes.
Now, assume that interest rates increase- which is what has happened in the months before SVB had to sell bonds to pay depositors. If comparable corporate bonds (same AA credit rating,) can be issued at 8%, the 6% IBM bond will decline in value.
Why?
Because investors can buy a new bond issue at 8%. As a result, the $5,000 IBM 6% bond might be worth only $4,800.
And that’s a big problem if the owner is forced to sell the bond. Which is exactly what happened at SVB bank.
What Happened
Here’s what happened. SVB received a flood of deposits from venture capital (VC) investors, and from startup companies that are funded by VC firms. According to Forbes: “Its assets quadrupled in five years to $209 billion, making it the 16th-largest bank in the country.” What did SVB do with the money?
Forbes explains that: “Its management took excessive risks by buying billions of dollars of mortgage-backed securities and Treasury bonds when interest rates were low. As the Fed continually raised interest rates to fight inflation, leading to higher rates on Treasurys, the value of Silicon Valley’s bonds steadily lost value.”
SVB sold bonds at a loss- and the losses got bigger as more depositors requested their funds.
Ouch.
While it’s difficult to predict the amount of customer withdrawals, buying long-term bonds that might be needed to pay depositors is a bad idea.