So, if you’ve paid any attention at all to the news this week you’ve heard about the collapse of several large and medium-sized banks. The biggest bank to go bankrupt, at least as of the time of recording, is SVB or Silicon Valley Bank. And this morning I’m going to focus on SVB because it seems the least controversial and it’s the event that seems most talked about by commentators and it has the most impact on the financial system.
Allright, so, in case you either a) haven’t been following the news, which, good for you OR b) you haven’t had time to look into all the ins-and-outs of this story, let me give you the run-down as best as I understand it. And so I now present to you, Silicon Valley Bank: An American Parable.
SVB is, or should I saw was, a pretty large community bank in, you guessed it, Silicon Valley. Because of its location it catered to the tech world. Its major clients included tech startups and venture capital firms, of VCs, for short. Now, apparently, VCs LOVED SVB and many venture capitalists would recommend SVB above any other bank. And so, SVB had a lot of money to work with—but most of that money, and you have to remember this because this is really important to the story, most of that money was tied up in the tech world.
Now, to tell you the story of SVB I have to go back to 2008. Now, after 2008 there were new regulations placed on banks that were designed to make them more secure and to prevent runs on banks etc.
Ok, so allow me to pause here and say some stuff that some of you is going to think is so elementary that I’m wasting your time, but there are people who don’t know what I’m about to say. You see, friends, and I don’t know who amongst you needs to hear this, but I KNOW some of you do. You see, the banks are not just a bunch of nice people in suits who put your money in a vault for you and keep it safe, you know, out of niceness. Nope. When you put your money in the bank the bank takes your money and they give it to other people who then pay interest. So, you know how banks give out loans? That’s not their money. It’s not as though the loan officer is putting up her own money. The banks are gambling with your money. Now, most of them are pretty good at it and they make lots of money.
OK, so, if this is news to you, you probably have questions. I remember when I first learned about fractional reserve banking. The obvious question was this: if the bank is lending out the money of other depositors what happens if all the depositors want their money back?
You know what my good friend, the banker told me? He said that that’s really unlikely.
But low-probability events happen. Right? I mean, bank runs do happen…as in evidence at SVB.
Anyways, let’s go back to 2008. Post ’08 there were new regulations from the regulators that would regulate banking. Part of this regulatory revamp was that banks needed to keep a larger portion of their investment portfolio in what was considered “liquid” assets. OK. What does this mean. Well, obviously banks need to keep a certain amount of cash on hand—and by the way, please use cash as much as possible, that’s another story for another day—banks need to keep cash on hand, or at least have assets on their ledgers in case depositors need their own money. So, the regulators decided that before 2008 banks didn’t have enough money readily available for depositors, so they said, “look you have to keep a higher portion of your assets in liquid form.”
HOWEVER, liquid didn’t just mean cash. Guess what else the regulators said counted as “liquid?” If you answered treasury bonds, then you’re right. Because treasuries are, in fact, pretty liquid.
OK, remember how I said that SVB catered to the tech world? Remember how I said that would be important? OK, here’s why it’s important.
So, a few years ago there was this worldwide pandemic thing. And remember how with that pandemic thing how the local, state, and federal governments decided to shut down businesses and prevent you from going anywhere? Right, well, the tradeoff was the government shuts down your life and in exchange they give you a bunch of devalued money that will increase the national debt. So now, all the sudden there are people who are flush with cash and are trying to find places to put it, because people know that there’s inflation—how can there not be?
Well, in the midst of all this free money flying around, people think, “boy, o boy, where should I put all this cash? I know, technology—the young people seem to really like computers—I’ll invest in tech.” So they do. And now all these tech companies are flush with cash and they have the enviable problem of having to figure out what to do with more money than they currently need. So, they give it to the bank. Cause, I mean, it’s a bank, right. Nothin’ safer than money in the bank.
So, now because the government shut down everyone’s lives and gave them money instead of freedom, people took that cash and invested it in tech, and the tech companies couldn’t use it so they gave it to the bank, primarily in uninsured bank deposits—and why all these companies were putting they’re money in uninsured deposits is another story for another day I s’pose.
Now, the banks have all this cash, but the economy is cash-rich but there aren’t enough loans to give out because even though there’s lots of cash, there really aren’t a lot of good places to put it. So, the SVB puts about half of this money in government bills and bonds. Now we don’t have time to go into all the nitty-gritty of the government bond market, and, as Hagrid told Harry Potter, I’m not sure I’m exactly the right person to tell you that. But let me give you an extremely oversimplified version that’s probably going to make the bankers and investors in the audience wince. But here goes. The government needs people to invest in it and they issue bonds. A bond is a loan you give the government and the bonds that SVB were buying had a face-value on them, so that let’s say you pay 1 dollar for the bond, when the bond matures in 10 years you’ll have made a buck-twenty-five. Now the bond market has not only direct purchases from the treasury, but these bonds are also traded on a secondary market.
But here’s the deal. The face value of the matured bonds fluctuates every time the government issues new ones. So, because inflation has been so low for so long, the face-value on these bonds is practically nothing. The bond is basically just cash.
Now, the clever amongst you have already spotted the problem. What’s the problem? Well, if SVB has lots of money in bonds that have a face-value that’s very low, what happens when inflation hits? Well, you realize a loss on those bonds is what happens. Now, you COULD sell them on the secondary market, but you’ll sell them at a loss because the person buying them knows that the face-value will be inflated away, so they want to buy at enough of a discount so that they will actually make money when the bond matures.
Now, the obvious answer is to just take the loss, wait for the bond to mature and learn your lesson. But remember how I said that the fact that SVB catered to tech and venture capital was important? Well, it’s important again. You see, tech companies fail. And a lot of them go a very long time before they actually become profitable. A lot of tech companies do nothing but eat money for a good long while until they become profitable. Even large companies might not be as profitable as you think.
So, what happens when these not yet profitable companies who used to be flush with investor cash suddenly stop having all that sweet, sweet money flowing in? They go to the bank…obviously.
Except, here’s where things get really uncomfortable. Because the bank doesn’t just have your money in the vault. It’s tied up in bonds and bills. So, obviously sell the bonds and pay your depositors.
Except you can’t. Because let’s say you bought $91.3B worth of government paper promissory notes that you intend to hold to maturity. Except those aren’t worth $91.3B. They’re worth less than that. How much less than that? Well, they’re worth so much less that you can’t pay your depositors back.
And we all know what happens then.
So, what did we learn?
What is the lesson that we should all glean from this tragedy?
Well, first things first, I think it shows that people in suits and ties and who have fancy degrees from top-tier schools can be fools too. Just because you have a corner office doesn’t mean you can’t do some utterly boneheaded.
You see SVB’s investments required two conditions to lead to catastrophic failure.
The first condition was increased bond-rates. Now, you might want to come to the defense of SVB and say, “well, Fed rates were at all time lows for a very long time so it stands to reason that they would stay low.” OK, if you say that then you need to study up on logic, because that’s called the gambler’s fallacy. That’s basically saying that because the roulette wheel was black 20 times in a row it’s more likely to be black this time…or more likely to be red. It’s not. It’s 50/50 every time. Now, to be fair, Fed rates aren’t pure chance like roulette, and human decision-making skews the results. Fair enough, but then it’s actually worse than that, because Jerome Powell has been saying for a very long time that the Fed was going to increase rates. They said this. And more than that, anyone who’s watched a 5 minute youtube video on monetary policy will tell you that when the government prints money that to slow down inflation they have to slow down the velocity of money, which means they need to slow borrowing, which means they need to increase rates. Everyone knows this. This is not a secret. I know this. And I’m an idiot.
Everyone who has a lick of financial sense knew that there was heavy inflation coming! You know how we knew? BECAUSE IT WAS ALREADY HAPPENING. It’s true that the Fed had said they would keep interest rates low as long as inflation was under 2%. It’s true. But by 2021 if you didn’t predict that inflation was coming and coming hard they you’re no longer qualified to handle other people’s money.
BUT. But there’s a second condition that had to be met for SVB’s errors to become catastrophic. You see banks make bad investments. Even very smart people make bad investments. Even very smart people doing the best things possible suffer because of events outside their control. Just because SVB made a bad bond investment didn’t mean necessarily that they would suffer anything worse than taking a very expensive bath.
Except, remember, the tech startup thing. Yeah, it’s important again. Because remember how startups aren’t profitable right away? Remember how they eat money. Yeah, that brings us to our sufficient condition. The necessary condition of the bank failure was not having enough liquid assets to cover depositor’s assets. The sufficient condition was the depositors wanting their money.
And that condition was met. And maybe all the stupid things SVB led to decreased depositor confidence and maybe the runs on the bank could have been avoided and SVB could have survived. Maybe. But those things didn’t happen. Instead, the depositors actually wanted their money, you know, to run their companies.
So, if we had to summarize what happened in SVB we could say that they had lots of money and they just assumed that the good times would last forever. They looked at all that money coming in and they thought, man, we’re a bank, we can’t just store that cash, we need to invest it in something…you know, because we’re super smart. So, we’ll tie our money up in an asset that can only not lose money if there the Fed doesn’t do what it said it would do. And even if the Fed does raise rates and our low-yield bonds are worth less than their face value, we’ll be OK, because tech companies are a great investment and they won’t need their money for day to day operations because the good times will just keep rolling along.
SVB looked around at the government printing money and giving it away at never before seen rates and they saw tech companies flush with more money than ever and they thought—this will last forever. Now, you might be thinking, “Luke, they couldn’t have been that foolish. There’s no way they thought that low-interest rates and free money would last forever! They’re not fools!” Friends, what’s the alternative? That they KNEW rates would rise and they just made a monumentally stupid investment. I think that attributing this failure to them being fiduciary Pollyanna’s is less insulting to their intelligence than to presume they were clear-thinking hard-nosed doomsday prophets.
But right now, maybe you think I’ve been talking about SVB this whole time. I have. But not really. SVB is a parable of this country. This is the great modern parable of American culture. We have seen what godlessness leads to. We knew it. We knew that godlessness would lead to national moral bankruptcy and all that comes with. We knew it. And we chose godlessness anyways.
Oh sure, the early days of godlessness are glorious. They’re heady days. The early days of godlessness seem like endless summer and eternal sunshine. No more bigotry, no more stuffy preachers moralizing, no more laws—just freedom, nothing but total freedom. Let the good times roll! We’ll live forever and tomorrow will be just like today or even better!
But godlessness may taste sweet as honey in the mouth but it’s bitter as gall on the tummy. And we’ve glutted ourselves. You see our nation saw that godlessness has come with a bitter price everywhere else it’s been tried, but like a fool we said, “it won’t happen to us. We’re special. It’ll never happen to me. That can’t happen here.” Our godless culture could only survive if we would never be forced to pay the price. Our godless culture required that a man doesn’t have to reap what he sows. Our nation’s survival demanded that one of the most basic laws of God’s universe would either be overturned or at least suspended. We wanted God to be mocked so that we would not reap what we’ve sown.
SVB is the American Parable. The difference is that we may still have time to change the story.