Why Silicon Valley Bank Failed
On Friday regulators shuttered Silicon Valley Bank (SVB) and seized its deposits in the largest U.S. banking failure since the 2008 financial crisis and the second-largest ever. We shouldn’t be surprised. Neither should we relax.
To recap: Between June 2006 and December 2008, the Federal Reserve’s target for the federal funds rate was cut from 5.25% to 0.00-0.25% as the economy crumbled and it stayed there until December 2015. By the end of 2019 it was still only at 1.50-1.75%.
Then, in 2020, the Federal government borrowed vast sums of money in the name of fighting COVID-19. To keep the cost of all this borrowing down, the Federal Reserve printed a load of money and used it to buy Treasuries, effectively capping the government’s borrowing costs. This infusion of new money led to inflation, with the year over year change in the Consumer Price Index rising from 0.2% in May 2020 to 8.9% in June 2022. To fight this, the Federal Reserve is now stamping hard on the monetary brakes. Despite a December 2020 median forecast for 2023’s rate of 0.1%, the target range for the federal funds rate has actually been raised from 0.00-0.25% on March 16, 2022, to 4.50-4.75% now.
As monetary loosening pushed Treasury yields down in 2020, so tightening has pushed those yields up in 2022. The Market Yield on U.S. Treasury Securities at 10-Year Constant Maturity, Quoted on an Investment Basis, has risen from less than 1.00% through 2020 to over 4.00% more recently. These gyrations have roiled markets and led to the collapse of SVB.
A financial institution, like SVB, essentially raises funds either wholesale (from capital markets) or retail (from depositors) at a rate of X% and makes loans that generate a return greater than that. When it seeks to raise funds, it is in competition with, among others, the Federal government. The government cannot go bankrupt – it can always get the Federal Reserve to print the money needed to cover its liabilities – so the rate at which the government borrows is a benchmark: If the government will pay you 4.00% to borrow with no risk of default (nominal, at least), you won’t lend to anyone at a rate below that. So, as Treasury yields – the price government has to pay to access capital – have risen as a result of the Federal Reserve’s monetary tightening, financial institutions find that the price they have to pay to access capital is rising also. In addition, rising bond yields pushed down bond prices – the two move in opposite directions – so that the bonds SVB was holding as assets, including 10 year Treasuries, fell in value further eroding its capital.
This is the squeeze that caught SVB. Catering to fintech companies which, like the rest of the tech sector, have been taking a battering recently – look at all those job losses – SVB found that its depositors were withdrawing their capital. SVB Needed to access new capital but faced the higher cost to do so consequent to Federal Reserve rate hikes. In the end, it tapped out. When, late Wednesday, it surprised investors with news that it needed to raise $2.25 billion to shore up its balance sheet, the end soon followed.
SVB might be a one off. It was heavily exposed to a particular sector which seems to be at the forefront of the market liquidation following higher rates. But all financial institutions will be facing a similar situation, it will differ only in degree. Rate hikes preceded both the recessions of 2002 and 2008-2009. As Warren Buffet famously put it, “Only when the tide goes out do you discover who’s been swimming naked.”