After my last email on Silicon Valley Bank (SVB), I received several questions inquiring more specifically why SVB failed (and why are the other banks such a concern).
Before addressing that, I want to emphasize that unlike some other broker-dealers, LPL does not own a bank. Any banking services offered through LPL are offered through contractual arrangements with outside banks. Therefore, LPL does not have the same risk exposure that other banks and some broker-dealers are potentially facing.
The primary reason why SVB failed and why other banks are in the news is an old-fashioned, simple reason: they borrowed short and loaned long. This means they took depositor’s money (borrowed short) and bought long-term U.S. Government bonds (loaned money to the government…bonds are loans).
Unlike 2008, this situation did not involve toxic mortgage debt that was opaque at best. It was simply a poor strategy of tying up capital in long-term assets when depositors could demand their money back at any time.
To be sure, all banks do this to some degree: they take in depositor money and lend it out with the expectation of being repaid over time. But based on what has been reported, this situation was extreme. The bank simply took on too much risk. The modern-day bank run can now take place online with a few clicks of the keyboard. Throw in social media where news travels fast and the takedown of SVB was quick.
As for the bonds owned by SVB, investors generally receive a higher yield (interest payment) on a long-term bond, but these bonds are more sensitive to interest rates. There is an inverse relationship between interest rates and bond prices: if rates go up, bond prices go down (all other things being equal). Longer-term bonds (i.e., 10-30 years) are hit hardest. Using simple bond math, the worst of the long-term bonds in SVB’s portfolio probably went down 25% to 45%.
Now, if SVB could have held the bonds to maturity (10-30 years), then the bond would be redeemed by the U.S. Treasury at its “par value” – no principal loss to the bank. Or, if interest rates were to drop substantially, then the drop in rates could erase the loss. But when depositors show up demanding cash, banks can’t wait. SVB had to sell bonds at a loss to pay their depositors, and it became quickly and painfully obvious that they were in trouble.
Another problem for SVB was their niche customer base, which was early-stage venture capital customers. Apparently, a flood of cash came into SVB during the 2020-2021 tech boom. It was a perfect storm for SVB.
For now, it appears that the banking issues are contained. The authorities have set up a couple of credit lines for other banks who might be facing trouble to borrow funds and pledge their securities as collateral. Expect more headlines, but also expect a vigorous response should further trouble arise.