The irony of it all.
Unlike the debacle surrounding the collapse of Sam Bankman-Fried’s crypto kingdom FTX late last year, the sudden demise of Silicon Valley Bank (SVB) last weekend has its origins at the other end of the financial spectrum.
This wasn’t down to the unruly behaviour of a gang of undisciplined and inexperienced tech geeks who had deluded the world, and themselves, into believing in the fantasy of a new financial paradigm.
Instead, the sudden implosion of SVB has its roots in a desire to be uber cautious, by investing in the “safest” of all investments: US Government Treasuries.
These are the instruments that deliver the “risk-free” rate of interest, the instruments that determine investment decisions globally and the benchmark for conservative trading behaviour.
They may have been lending to high-risk venture capital firms and start-ups out there on the fringes of the technology universe. But, on the other side of the ledger, they were playing it super conservative. And that has been SVB’s downfall.
This has been the most significant US bank collapse since the meltdown of Lehman Brothers during the global financial crisis and comes almost 15 years to the day since the demise of US investment bank Bear Sterns, the forerunner to that terrible turn of events that we now refer to as the GFC.
Like Bear Sterns, it highlights the cracks beginning to emerge in the system. After a year of unprecedented interest rate hikes and tightening, following a decade of money printing and ultra-loose policy, something had to give.
Three little words – hold to maturity
So, how did it all go horribly wrong?
Essentially, it all gets down to an accounting trick. Yep, that hoary old phenomenon.
But first, a bit of history. Stock markets may have gone haywire last year when central banks globally, led by the US Federal Reserve, started raising interest rates at a rate of knots. You’ve no doubt seen the carnage on your superannuation balance in recent months.
It wasn’t just stock values that plunged, after a decade of being buoyed by ever-declining interest rates.
Bond markets tanked as well. They may not attract the kind of headlines that show-pony stock markets get, but bond markets are far bigger, more influential and have far greater social and economic ramifications than stocks.
Normally, bonds and stocks work in opposite directions. When stocks hit the skids, bonds usually do well, such as when the pandemic first hit.
But that didn’t happen last year. When the US Fed started hiking rates, the US bond market went into freefall and the contagion spread globally.
It culminated in global bond markets notching up their worst performance in more than 300 years. We’re talking about well before Captain Cook was born, let alone embarked on his round-the-world cruise.
Unfortunately, SVB had its balance sheet loaded up with US government bonds.
Why did it take so long for the excrement to hit the fan?
That’s where the accounting trick comes into play.
A government bond essentially is an IOU. The government borrows your dosh, agrees to pay you a specific interest rate for a given period of time – say 10 years – and then promises to repay the loan after the given period.
The thing is, once you buy a government bond, you can trade them on the open market. Just like stocks, or cars or anything else for that matter, their value changes daily, or even by the nano-second.
That means the value of the bonds you hold changes. Sometimes, such as last year, the value plummets. Given the amount of US Treasuries on the SVB books, that should have caused alarm bells to ring.
But there’s a neat little trick banks can use to get around that. For accounting purposes, they claim they are holding the bonds until they mature or expire, that they have no intention to trade them and they will retrieve all their cash from the government at the end of the term.
So, their value never fluctuates, at least on the books. In real life, that’s not the case. As tech stocks came under pressure last year, depositors wanted to retrieve their cash. That meant SVB had to liquidate bonds, at a serious loss, to repay their cash.
According to former investment banker and funds manager Mike Mangan, SVB by December last year had notched up $US16 billion ($23 billion) worth of write-downs on its $US57 billion government bond portfolio.
Unfortunately, a ratings agency scouring the SVB accounts a few weeks back wasn’t overly impressed by this and instead decided that, given so much of its assets were held in a deeply discounted security, it would downgrade the credit status of the bank.
That then caused a run on SVB. Depositors decided they wanted their money back. Ultimately, the only way the bank could honour those withdrawals was by selling even more governments bonds, which had plummeted in value. So, in reality, they weren’t holding them to maturity.
The situation snowballed. SVB couldn’t meet its withdrawals and the whole thing collapsed.
Are other banks in the same position?
That would be a yes.
A large number of American banks hold US government bonds to cover their deposits and other commitments.
Just like SVB, almost all of them hold a proportion of government bonds in their Hold To Maturity accounts.
Unlike SVB, none of the others hold anywhere near as a big a proportion of total equity in this manner. Regulators, however, are likely to be poring over the books to make sure others won’t be following.
Bank of America, State Street, Wells Fargo and Bancorp are just some of the larger banks that have significant holdings of bonds in these accounts.
The problems, however, are more likely to emerge in smaller, regional banking operations. A run on deposits can quickly place a financial institution, particularly a smaller one, in jeopardy, no matter how well it’s run, and that was reflected on Friday night on Wall Street as regional banking stocks plunged.
While the US Fed and Treasury have averted a crisis by guaranteeing the deposits of SVB, the real test will only come when and if the Fed wants to continue raising rates.
They’ve papered over the cracks for now. But they may need a little more time for some engineering reports into the system.