Silicon Valley Bank closed on Friday when it was unable to meet depositors’ large withdrawals.
Silicon Valley Bank (SVB) seems to have failed through the following chain of events. Customers deposited large amounts of cash at a time when interest rates were historically low. The bank took an abnormally large portion of these deposits and invested them in longer-term bonds. Investing in longer-term bonds gave SVB a small increase in yields, but at the cost of taking on massive interest rate risk. That is, if bond yields increased, the value of their bonds would fall. Bond investors observed this phenomenon last year. SVB's holdings in bonds were safe, as long as they didn’t need to sell them until maturity when they would receive their initial investment back. Unfortunately for SVB, when their depositors started withdrawing their funds – partly to take advantage of higher yielding CD’s and Treasuries – the bank was faced with selling their longer-term bonds at a loss. Such sales would worsen their financial condition. As depositors caught wind of the situation, they began withdrawing more of their cash, which exacerbated the problem. This all happened very quickly.
The Federal Deposit Insurance Corporation (FDIC) guarantees all deposits up to $250,000, but a significant portion of depositors held deposits in excess of this limit.
After originally stating there would be no bailout, the federal government announced late Sunday that it will make all deposits available to SVB customers this (Monday) morning. Even those over the FDIC limit. Also on Sunday, U.S. regulators took control of a second bank, Signature Bank and stated that their depositors will be made whole.
IS THIS SITUATION UNIQUE TO A SMALL NUMBER OF BANKS OR IS THIS SYSTEMIC?
As of now, it seems that SVB's situation was extreme in nature, but it shines a light on a weak spot for banks.
SHORT-TERM / LONG-TERM
As is often the case with government intervention, there is a short-term and long-term aspect.
In the short-term, the market and investors are relieved that the federal government is stepping in to bolster these two banks. This should have a positive impact on markets and reduce the risk of further failures by smaller banks.
In the long run, we have again increased the moral hazard associated with taking risk. Bank customers knew that their deposits were insured up to the FDIC limit of 250k. The bank itself knew (or should have known) the risk of taking deposits that could be withdrawn at any time and investing in long-term government bonds, especially at historically low rates. The market saw last year the massive price risk in long-dated bonds when interest rates rose dramatically and prices plummeted.
This failure was swift, but for those involved, it must have been foreseeable.
In situations like this it is easy to get tunnel vision and focus more and more narrowly on the problem directly in front of us. It is important to step back and try to see the bigger picture. Large banks are well capitalized.
REMEMBER YOUR STRATEGIC INVESTMENT PLAN
Every Stembrook client has a Strategic Investment Plan. A key part of that plan is balancing short-term liquidity needs with long-term investments. This is to make sure that you have the cash available to fund short-term spending needs when markets vacillate. If you have any questions about his, or would like to discuss something that has changed, please reach out to us.
With volatility comes opportunity. We are looking at areas of the market that were attractive prior to this development. This turn of events may present an opportunity. One area we are looking at is small cap US stocks, which are selling at significant discounts to their own history and to larger cap stocks.