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Risk. It’s tricky. Try to avoid one set of risks, you may just end up exposing yourself to another. That’s what happened to Silicon Valley Bank.
“Silicon Valley Bank was a very good bank … until it wasn’t,” says Mark Williams, a professor of finance at Boston University and a former bank examiner for the Federal Reserve.
A victim of his own success
Williams says the problem at Silicon Valley Bank really started with its wild success. Many of its tech company clients raised money during the early pandemic.
“Silicon Valley Bank was just flush,” he says. “Its deposit base tripled between 2020 and 2022, with billions and billions of dollars pouring in.”
Many of those billions had come from all the risks the bank took, lending money to startups and businesses that couldn’t get loans from other banks. Those risks paid off.
And Silicon Valley Bank took all the billions it made from taking those risks and stashed them in what is supposed to be the least risky investment: US Treasuries.
Bonds: The risk-free asset
Bonds are like a small loan that you give the government for 3 months, 1 year, 10 years, etc., depending on which bond you buy.
At the end of that time, the government will pay you back that loan, plus a little interest. US bonds are considered the safest investment on the planet. The US always pays back its debt. They are often called a risk-free asset.
The downside? Government bonds don’t pay out much. Super safe, not super profitable. But some of these bonds are a little more profitable than others.
Longer-term bonds (like 10-year bonds) typically pay out more at maturity than 3-month or 1-year bonds, which makes sense: Long-term bonds mean you agree to lend the government your money for years. You get more return – a bigger return – for that waiting time.
“Basically what happened was Silicon Valley Bank wanted a bigger payout,” said Alexis Leondis, who writes about bonds for Bloomberg. “So they basically wanted to reach for longer bonds because I think they felt that what they were going to get from shorter bonds was kind of a joke.”
Silicon Valley Bank locked away billions of dollars in 10-year bonds. But there were risks it didn’t see.
Risk #1: Access. These billions were now locked up for years. It would not be easy to get that money in an emergency.
Risk #2: Interest. As interest rates began to rise, the market value of Silicon Valley Bank’s 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 tied to the interest rate. When interest rates rise, the market price of older bonds falls because new bonds pay higher interest.
As interest rates began to rise rapidly, the price of Silicon Valley Bank’s bonds fell.
Risk #3: Really, really rich customers. When the rumors started about the bank, customers panicked and started withdrawing their money. Because they were wealthy individuals and corporations, this meant that multi-million, even multi-billion dollar accounts were being paid out at once.
Silicon Valley Bank needed a lot of money fast. But of course, much of its cash was locked up in 10-year bonds. Now it should try to sell them now to get cash.
Fire sale of government bonds
This is where the interest rate risk mattered to Silicon Valley Bank: It was not easy to sell the used bonds with low interest at a time when all the new bonds being issued were paying out far more.
“Now the 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’re going to have to discount it.”
Discount as in, a fire sale.
Silicon Valley Bank took huge losses by selling its bonds, and several investors panicked and pulled their money out. Williams says it was a bank run 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 pulled out 41 billion depositor dollars,” 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 lot of very specific mistakes, people across the country got scared and started pulling money out of smaller banks.
“This means that these smaller regional banks are potentially destabilized,” Williams says.
Where are these nervous investors putting their money? Williams says much of it is deposited in large banks, which customers see as safer. Also, many people put their money in US Treasuries.
Demand has increased all week for the risk-free asset.