“Keep calm and carry on.”
– Great Britain Wartime Propaganda Department, Circa WWII
In last month’s article, we explored the many ways in which Mr. Market can punch investors in the mouth if we are not careful. This month, we examine the implications of the failure of Silicon Valley Bank.
A Run on the Bank
For most of us, the words “bank failure” immediately trigger the same recent memory: the financial crisis of 2008. That was a year no investor could ever forget; the year some of the largest, most storied financial institutions in the world — think Lehman Brothers, Bear Stearns, and others — collapsed, never to return.
Similarly, for anyone who has studied history, the words “run on the bank” immediately trigger images of the early days of the Great Depression. For others, it’s perhaps scenes from It’s a Wonderful Life or Mary Poppins. Dramatic moments of panic from days past now consigned to the waste bin of time. We comfort ourselves in the knowledge that these events are surely not something that could happen in this day and age.
But on Friday, March 10, a genuine old-fashioned bank run actually happened to the Silicon Valley Bank in northern California. It’s an event that has many investors, scarred by the memory of 2008, wondering if the same thing could happen to other banks. An event that has only added to the fearful mood currently pervading the markets.
As you probably know, when the news broke on Friday morning, all three major equity market indices immediately tumbled, capping off a rough week for the markets. So, we would like to briefly explain what’s going on with this semi-obscure bank, why it spooked investors, and what we can learn from it.
The SVB Story
Prior to collapsing, Silicon Valley Bank was the 16th largest bank in the country, holding approximately $209 billion in assets. If you’ve never heard of it before, it’s probably because the bank specialized in lending money to start-up companies; the kind of fledgling tech firms Silicon Valley breeds each year. Now, it has the dubious distinction of being the largest bank to fail since 2008.
So how did a bank this large fail so suddenly? It’s a tale that anyone who lived through 2008 remembers well: the bank simply made too many bad decisions at the wrong time. During the pandemic, tech companies saw a surge in business. This led to a host of new, hopeful tech companies popping up, each flush with venture capital. As a result, banks that specialize in serving these types of companies enjoyed their own surge: a surge in deposits.
Silicon Valley Bank (SVB) was one of these banks. But while business was booming, this was also when the problems started. Like most banks, SVB only keeps a fraction of its deposits in-house at any given time. The rest of the capital is lent out or invested. In this case, SVB purchased tens of billions of dollars in U.S. Treasury bonds.
To be fair, Treasury bonds are historically seen as one of the safest investments in the world. Given the market uncertainty we saw during the pandemic, the bank probably thought it was prudent with customers’ money. Unfortunately, the bank forgot one important detail: While Treasurys don’t usually see the kind of volatility that stocks or other securities do, they are vulnerable to a very specific kind of risk. The risk of rising interest rates.
While this was going on, the economy started changing. Inflation skyrocketed. Interest rates, in turn, rose to the highest levels in decades. That meant all those Treasurys purchased when interest rates were low were suddenly far less valuable. (Newer government bonds pay far more in interest than those purchased before the rate hikes began.) At the same time, those tech companies that profited during the pandemic saw business – and their stock prices – fall. For SVB, that meant fewer and fewer deposits coming in. Suddenly, SVB was faced with a nightmare scenario: a lack of liquidity and a lack of new funds.
None of that might have mattered as long as customers didn’t start withdrawing their money. But, of course, that’s exactly what happened. Faced with their own economic distress, all those tech companies – and their executives – started asking for their money back. Given that they only kept a fraction of that money in reserve, SVB had no choice but to sell its capital investments at a major discount in order to meet depositor withdrawal requests. The result was a major loss of nearly $2 billion, which the bank revealed earlier in the week.
When news of the situation got out, customers began panicking. This led to a classic, seldom-seen, but much-feared scenario: a run on the bank.
In the days that followed, the bank was unable to stop the bleeding. So, on Friday, the government stepped in and took control of the bank’s remaining $175 billion in customer deposits.
Okay. That’s the story. But why the impact on the markets?
Equity Market Reaction
Aside from being eerily similar to what happened in 2008 to so many financial institutions – banks made risky financial decisions at the exact wrong time and crumbled – the situation has investors wondering if there are other banks out there that might soon experience the same problem. No surprise, then, that shares of banks with similar business models have fallen sharply over the last two days.
But it’s more than that. Right now, investors are gripped with fears of a recession. On the surface, that may seem counterintuitive, as most areas of the economy remain in decent health. But until the economy cools down, inflation will continue to run hot … which means the Federal Reserve will continue to raise interest rates. Indeed, the Fed chairman announced on March 8 that he expects rates to rise “higher than previously anticipated.”
With each rate hike, the threat of a recession grows larger, and the concern of equity investors grows greater.
Right now, investors are hyper-sensitive to anything that looks like the first sign of a recession. And the failure of a major bank certainly qualifies. Hence the turmoil we’ve seen in the markets this week. Hence the volatility we may keep seeing.
What Now?
So, what can we learn from this? In our opinion, there are a few lessons to keep in mind:
- The first lesson is one from the financial crisis of 2008, which is that “risk happens fast.”. When it comes to issues like credit risk and the solvency of financial institutions, so much of the normal function of banks is based on the confidence of the depositors who keep their money there. And confidence can disappear in an instant, even for institutions that are deemed to be “safe.” This is why the Federal Reserve has stepped in over the weekend to release a statement that it will be providing a “backstop” to bank deposits in order to restore confidence in the overall banking system.
- Although the financial media will most likely put a great deal of effort into making us believe that this episode is comparable to the failures of Bear Stearns and Lehman Brothers, which sparked the 2008 financial crisis, at the moment, we do not see it that way. Certainly, anything can happen at a time like this, and we will be watching conditions closely, but at the moment, we believe it is highly unlikely that this will lead to anything like the crisis of 2008.
- Our confidence stems from the following important points:
- We believe that the failure of SVB had a great deal to do with the fact that its depositor base was highly concentrated in one industry, and the high-tech startup community was highly susceptible to recent economic conditions. This crisis came about not so much because SVB had a capital problem but more because many of its depositors needed their cash at once. This was a unique problem that may not be true for other similar banks.
- As discussed above, the Federal Reserve has stepped in to shore up confidence and backstop deposits, which should lead to a significant restoration of confidence.
- Overall, the banking system in the U.S. has been quite well capitalized in recent years, thanks to regulations put in place after 2008, as well as the massive increase in the money supply after the Covid crisis.
- Ironically, as fear has struck the markets, there has been a “flight to safety,” as many investors have dashed to the safety of the bond market. As this has happened, bond prices have risen, which is improving the value of the capital base at most banks.
- For investors who are worried about the safety of their deposits, it is worth keeping in mind:
- Banking deposits are insured up to $250,000 at any bank, so any deposits below this limit should be considered insured by the government.
- Even above this limit, the Federal Reserve has indicated that it will “backstop” deposits at the banks that are currently considered troubled.
- Although this “backstop” is only temporary and may not be extended to other banks, it is our view that large national institutions that most investors use to deposit funds are very safe at the moment. In particular, we have little to no concern about asset safety at our primary custodian, Charles Schwab.
- For investors who have over $250,000 in deposits at their bank, it may also be worth considering the use of “money market” funds, which can invest in outside securities, and are typically not part of the capital base of the financial institution where they are held.
In our view, it is considerably more important to understand the impact of all of this on the equity market itself, as equity prices are likely to be volatile and subject to major swings as the news develops this week.
The near-term impact of this event on the equity market is likely to be unpredictable. On the one hand, investors are likely to be somewhat spooked by the failure of SVB and the implications for a future recession. On the other hand, many investors believe that this event will cause the Federal Reserve to “hit the brakes” on future interest rate increases, which may be favorable for equity prices.
In the big picture, none of this changes our fundamental views on investing in the equity market. Short-term events like this one will be seen as nothing more than “noise” when we look back in the fullness of time, and equity investors with a reasonable time horizon will continue to be rewarded with attractive returns for being patient. It is times like this in which we “earn” our equity market returns by refusing to panic.
As always, we are available any time to discuss this viewpoint and any concerns you may have about the safety of your wealth. In the meantime, our best advice is to turn off the TV.
Having a Plan
The very best investors have a disciplined approach to making portfolio decisions and always stick to their plans, no matter what the rest of the world is doing. They are able to live through the peaks of euphoria, as well as the depths of terror, with a healthy understanding that a well-designed written investment and financial plan will get them through both.