Breaking Down Silicon Valley Bank's Collapse and the Contagion Effect | Top of Mind Series

Hello and welcome back to the Invest Like a Billionaire podcast. I'm your co-host Ben Fraser, joined by fellow co-host Bob Fraser. And today we could not help ourselves. We had to get out an episode on our Top of Mind series on recent events, right? And what's the recent event that everyone's talking about is Silicon Valley Bank, basically within 48 hours not being an operating bank anymore. And so We got a lot of questions from listeners and folks just asking what happened, right? How did this bank that was a behemoth, I think it was what, the 18th largest bank or 15th largest bank in the country and the second largest bank failure in the US history is taken over by FDIC within 48 hours. We want just to kind of jump on, talk about what happened, right? And really break it down and then talk about, is this a broader issue in banking? Is this the beginning of a contagion, right? And what are the bigger implications? So Bob, talk a little bit about SVB. What are they known for? What is SVB?

They're the biggest bank in Silicon Valley. They're called Silicon Valley Bank. So they have a lot of venture capitalists, venture capital firms, venture capitalized firms, but they're just a regular bank. Although they're, they're very, very different from other banks. 95% of their deposits were not FDIC insured. So the FDIC has insurance limits, right? And where the normal bank is 50%. So normally for most banks, 50% of their deposits are FDIC insured, but Silicon Valley Bank, because their depositors, they had so few of them who were so large, they were not FDIC insured.

Yeah.

They had over the last 3 years had explosive depository growth. So their deposits tripled in size. So they got all this cash coming in. And what they chose to do with that cash, most banks, they make money when they loan it out. What Silicon Valley Bank did is primarily bought government bonds, which is considered the ultimate safe investment, right? Because your repayment risk is zero. You're going to get repaid.

I think some people, they hear banking, right? They hear maybe net interest margin in deposits and loans. Let's break down real quick how a bank makes money, right? Because it's pretty simple, but I think it's important to understand. So Banks take deposits, right, from generally businesses or individuals. Sometimes you can buy deposits and then they go and take those deposits and they're paying out an interest rate on those and they go and generally will make loans against those deposits at a higher interest rate. Right. And that becomes the spread between those two is their net interest margin. And that's basically the revenue that they drive to the bank. And so what you're saying is they had deposit growth triple over the course of a few years. And they had an issue deploying that into good loans. And so generally banks will take deposits and make loans. That's their core business. But because of the explosive growth, they weren't able to deploy it into loans. So they decided to buy bonds so they can have a loan portfolio and an investment portfolio, right? And so what they did is they bought mortgage-backed securities, right?

One of the problems with bonds, so everybody thinks bonds are this uber safe investment, which They're just not. Bonds are not safe, and this is why. So if you buy a bond and it's paying, you know, 2% interest rates, but then interest rates go up to 10%, just for example, well, your 2% bond isn't worth as much money because someone could go up, but why not go buy the 10% bond? So what should they, they need to do is discount that bond until the 2% bond is yielding at 10% because of its discount. And those are, that's enormous. And so what happens if you look right now, bonds, because interest rates have risen so much, if you bought a bond and you held it, it's dropped in value and bonds have dropped, you know, anywhere from 25% of their value to half of their value, very safe bonds. And what that means, if you hold to maturity, you're not going to take a loss. If you just take the payments and you get paid off, you will not take a loss. But if you sell it into the market, the market price has dropped.

And so explain hold to maturity, right? So bonds have different durations or length of time that you have to hold them and you buy it at a fixed price. And if you hold during that whole duration, you basically realize the yield that you originally purchased it at.

You're going to get your 2% yield and your principal back, you know, so, right. So there's no, not risk from that regard, but if you have to sell it, there is risk, right? It's like your house drops in value by half according to Zillow. Well, as long as you don't sell that house, you don't have any losses, right? But if you have to sell it suddenly, then you're going to be in trouble. And so that's really where these banks are. So the regulators do not require bankers to mark their losses to market. So they don't have to worry about these losses. They can just, they say, I'm going to carry, hold them to maturity and they don't have to take them as losses. Unless they do sell it, then they have to take it as losses. And that's— and Silicon Valley Bank did that. They actually sold a bunch of their portfolio of bonds at losses and it spooked depositors. And so depositors on Thursday took out $45 billion in withdrawals. That's a lot of money. And so they really pushed on the liquidity problem with Silicon Valley Bank and And so that's when they came in and took it over.

Right. And this is what's called the classic, you know, run on the bank scenario where they cannot meet the liquidity needs. More demand for withdrawals were available than they had cash to provide. And FDIC stepped in, took over. So we've done a little bit of analysis here and, you know, really to We want to assess, is this like the, the first domino to fall in the broader, you know, banking system, right? And are there going to be a lot more of these things that happen? But before we can really answer that question, we got to look at, you know, is SVB kind of a unique, in a unique situation? And, you know, some of the things like Bob already mentioned, the, the, it seems to be yes. So because they had a larger portion of their portfolio in investments. And what was the stat we're talking about before here? Bank of America did some analysis. I think it was 70% of their earnings were coming from investment or their bond portfolio, right? Which I think their bond portfolio was yielding less than 2%.

So that's, you know, which means it was the majority of their asset base by far was government bonds. In the time when the government raised rates and those bonds crashed in value. So it's kind of ridiculous. I mean, honestly, it's kind of ridiculous that these guys failed and there was a lot of missteps and really poor risk management on their part.

Yeah.

But it, and otherwise, you know, I've been through many, many cycles and, you know, it's said when the Fed raises rates, something breaks somewhere and it is always true. You, but It always breaks different than anybody predicts, right? Something breaks because people use that low leverage to do things that they shouldn't do, right? They use the low interest rates to do stuff they shouldn't do. And when the rates go up, it exposes them, right? And you know, I think Warren Buffett said it colorfully, you know, when the tide goes out, you find out who's been swimming naked. And you know, so So they were swimming naked and the tide went out.

What's interesting to me is, as we've, you know, kind of have shared, is that this feels— obviously there's some big issues because a lot of banks hold bonds as part of their portfolios, right? And a lot of banks have unrealized losses, right? But what was so unique about Silicon Valley Bank is the magnitude relative to other banks of investments and specifically mortgage-backed securities that had a long duration, which really matters, right? Because the length of time you have to hold these assets to hold to maturity to get your yield and not take a loss is longer. And then you think about the type of clientele that SVB served are tech companies, right? That have raised a lot of money from venture capital. They go put all that cash in deposits. And you know, as of the past few months, it's a lot harder to raise money. So these companies are now pulling on these deposits to fund cash flow. And so they have what I would consider a much higher withdrawal rate risk than most banks, right? Their clientele have to access the cash in generally higher amounts than other banks. So it seemed like a big mismatch of You know, the investment that they're trying to, investments that they're trying to produce return on and matching really the needs of the client and of the bank. And they didn't have really any hedging in there, right? Because a lot of banks, like they will do interest rate swaps.

Usually that's on their loan portfolio, not on their investment portfolio though.

Right, right.

You know, so, and so what's happening, a lot of banks are probably under pressure. You know, I know banks right now that are not selling, they were wanting to sell, but they're not going to sell because they don't want to take the loss on their, right, on their bond portfolio. They'll just rather hold it and let those things pay off and then they'll be fine. So, but you have banks that are, their equity positions are being suppressed because of this bond portfolio. So it does mean banks are under a little bit of pressure that have a very high bond portfolio like this.

Right. So one of the unique things with this is because I believe these rules on marking to market, which just means writing the fair market value on your balance sheet of what these, you know, loans or investments are currently was changed after the Great Financial Crisis, right?

Right.

And it was, it's helpful in a lot of ways because banks operate off of tier 1 capital, which is how much equity that they have in the bank that they can use to loan against. But these unrealized losses don't really matter generally against the overall health of the bank if they don't need the liquidity, right? So it was kind of this perfect storm where they didn't have a lot of loans. They were producing most of their income from investments. They have clientele that had an inordinate, you know, need for cash and they couldn't meet the liquidity needs and it just snowballed so quickly. I think that's what's so surprising about this is how quickly it happened. But thankfully what we're seeing is the Federal Reserve just announced that they are going to come in and back all the depositors, right? And this is—

which, that's exactly what needed to happen, you know?

Yeah.

You know, just like the 2008 crisis, you know, our regulators and the Treasury Department did the right thing. I mean, we would've been through another Great Depression in 2008. I'm very convinced had they not stepped up with the bailout programs they did, we were in a negative spiral. So our regulators seem to have their act together and very smart. And so the backing deposits is exactly what they need to do.

Yeah. Here.

And, and then they, they've just put in this new program as well. What do they call it? The Bank Term Funding Program. And what that means is they're making short-term loans available to any qualified bank and pledge their bond portfolio at par.

Hmm.

Yeah. So they just fixed the problem. I mean, they basically nailed the problem. These are doctors who figured out exactly what the problem was. They understand these bond portfolios are a giant black hole. Sitting there in the middle, middle of your bank.

Yep.

They just fix it. We'll loan, if you have a dollar's worth of a bond, we're going to loan you a dollar on that.

Wow. So, so basically because the risk here, if you hold, if you hold the bond to maturity, you're not taking a loss, but if you have to access cash in the short term, you will take a loss. But now the Fed is saying, hey, we will—

honestly, they just fixed the program exactly like it should have been fixed. They fixed the problem. And because they just did what they did, my personal opinion is there's going to be no issue. I mean, there might be some fear factor issues, right, of other banks, you know, and right now you're seeing some banks, right? There's a bunch of banks that are under pressure right now that are, their stocks are being sold off. So there may be some banks that, you know, a couple banks that fall, but a broader contagion is not going to happen.

Yeah. And to your point earlier, I mean, So the FDIC is another kind of backstop, but it didn't really help in this case because, because it's so many large depositors, it's so many large depositors. But for most individuals, right? That's even aside from this, this new rule that the Fed just came out with, that's what the FDIC is here for, is to protect the fear factor. So yeah, very, very interesting. I'm sure we'll be seeing a lot more headlines and, and a lot more kind of inside scoop of what really went, went down. I mean, I think we know really the broad strokes of the story here, but our opinion is it's probably limited in its scope and impact in banks. The Fed is sometimes they make good decisions and this seems to be one of those that definitely helps to backstop a broader fear in the market that would cause a bigger issue.

Time to go buy good banks.

There you go.

Fire sale prices.

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