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Risk. It is complicated. Try to avoid one set of risks, you may end up exposing yourself to another. That’s what happened to Silicon Valley Bank.
“Silicon Valley Bank was a great bank…until it wasn’t,” said Mark Williams, a Boston University finance professor and former Federal Reserve Banking Examiner.
Victim of his own success
Williams says the problem at Silicon Valley Bank really started with its crazy success. Many of his tech company clients were raking in the money at the start of the pandemic.
“Silicon Valley Bank was just flush,” he says. “Its deposit base has tripled between 2020 and 2022, with billions and billions of dollars pouring in.”
Much of those billions came from all the risk the bank took, lending money to start-ups and businesses that couldn’t get loans from other banks. Those risks paid off.
And Silicon Valley Bank took all those billions it made taking those risks and put them in what is supposed to be the least risky investment: US government bonds.
Bonds: the risk-free asset
Bonds are like a small loan that you give to the government for 3 months, 1 year, 10 years, etc., depending on the bond you buy.
At the end of this period, the government will repay this loan to you, plus some interest. US bonds are considered the safest investment on the planet. The United States always pays off its debts. They are often referred to as risk-free assets.
The wrong side? Government bonds don’t pay much. Super safe, not super profitable. But some of these bonds are slightly more profitable than others.
Longer-term bonds (like 10-year bonds) generally pay more at the end than 3-month or 1-year bonds, which makes sense: long-term bonds mean you agree to lend your money to the government for years. You get more return – a bigger payoff – for that wait.
“Basically what happened was that Silicon Valley Bank wanted a bigger payout,” says Alexis Leondis, who writes about bonds for Bloomberg. “So they basically wanted to look for longer-dated bonds, because I think they felt like what they would get from shorter-dated bonds was kind of a joke.”
Silicon Valley Bank has locked up billions of dollars in 10-year bonds. But there were risks he didn’t see.
Risk #1: Access. Those billions had now been locked up for years. It would not be easy to get this money in an emergency.
Risk #2: Interest rate. When interest rates started to rise, the market value of Silicon Valley Bank bonds fell.
This is because the bank bought its government bonds before interest rates started to rise. The price you get from bonds is directly related to interest rates. When interest rates rise, the market price of older bonds falls because new bonds pay higher interest rates.
When rates began to climb rapidly, the price of Silicon Valley Bank bonds fell.
Risk #3: Really Wealthy Customers. When rumors started about the bank, customers panicked and started withdrawing their money. Because these were wealthy individuals and corporations, this meant multi-million or even multi-billion dollar accounts cashed in at one go.
Silicon Valley Bank needed a lot of cash fast. But, of course, much of its cash was locked up in 10-year bonds. Now he had to try to sell them now to get some money.
Government Bond Fire Sale
This is where interest rate risk bit Silicon Valley Bank: Trying to sell those used bonds at low interest rates at a time when all new bonds issued were yielding much more was not easy.
“Now that same bond and the yield would be about 20 times higher,” says Mark Williams. “So to encourage investors to even think about your old bond, you should discount it.”
Discount as in, a clearance sale.
Silicon Valley Bank suffered huge losses selling its bonds, and more investors panicked and withdrew their money. Williams says it was a bank on a scale the United States had not seen since the Great Depression.
“In a single day last week, depositors knocked on the door and withdrew $41 billion from depositors,” Williams says. “That’s about a quarter of their total deposits. No bank, no matter how strong, could ever survive that kind of withdrawal…that kind of run on the bank.”
The rest of the Silicon Valley Bank depositors were bailed out.
Guilt by association
Mark Williams says that even though Silicon Valley Bank made a bunch of very specific mistakes, people across the country got scared and started withdrawing money from smaller banks.
“That means these smaller regional banks are potentially destabilized,” Williams says.
Where do these nervous investors put their money? Williams says much of it is deposited in big banks that customers consider safer. Also, many people put their money in US government bonds.
Demand has increased all week for the risk-free asset.