This article is an excerpt from a 4,000 word analysis that Keith wrote over the weekend. To read the full version on our website, click here.
Silicon Valley Bank (SVB) was seized by the California Department of Financial Protection on Friday, March 10. This came after a frenetic two days, when the bank announced a big loss, tried to raise capital, and then faced an accelerating run-on-the-bank. Customers tried to withdraw about a quarter of the total deposits on Thursday alone.
The regulator said the bank was in sound financial condition on Wednesday(!) two days before they shut down the bank. Moody's also rated the bank investment-grade until it was shut down. Let's explore how it's possible SVB went from hero to zero in such a short time span.
What Happened
The answer to what caused SVB's collapse is long, and complicated. For the full treatment of why and how SVB collapsed, click here. During the recent zero interest rate environment, startups in Silicon Valley were able to raise massive amounts of capital. Credit was cheap! Many of them deposited it into SVB. SVB's deposits doubled, then doubled again.
SVB needed to get a yield on their assets that was greater than the cost of their deposits including the overhead of administering the program, employing people, etc. If you have deposit inflows in 2020, then you buy what's available at that time. You are a price-taker.
And banks don't necessarily have discretion over what to buy since they are regulated by government officials, who forcibly order banks around based on "macroprudential" (and other) considerations. So what was SVB supposed to do with all that cash under such circumstances?
It seems to have largely bought Treasurys and mortgages. The government, after 2009, guarantees most mortgages so these investments are deemed "risk free" by conventional analysis and SVB loaded up.
Hidden Duration Risk
But this meant duration risk. This is the risk that the market price of an asset may drop, or the market could even go no-bid, uncovering huge losses. This should be of particular concern to a bank which funds long-term assets using demand deposits.
Let's say you borrow money for one day, but you buy a 10-year bond. Tomorrow, instead of repaying the loan—you cannot repay it—you roll it over. You take out a new loan, at whatever the new rate is for that day. And you keep doing this, a total of 3,650 times. At the end, you finally repay the loan because the bond matures, and the Treasury repays you.
Most would scoff at this. "Bah! You don't have to wait for the bond to mature—you just sell it if you need the cash!" This presumes that the market price will always be greater or equal to the price you paid.
For SVB, it was not. The Fed is hiking rates, destroying bond prices.
A Slow-Motion Bank Run
Duration risk is one prong of the pincer that trapped SVB. The other prong is that the Silicon Valley startups who had been raising so much cash during the binge years, were not raising so much during the purge. Higher interest rates pinch them, too. Many of those companies are cash-flow negative. That is, they are spending cash on net.
SVB had a slow-motion run, notbecause anyone thought that it was failing, but because its depositors were spending their cash. Due to its unique position, the payees of this cash were mostly notSVB customers. If, for example, 100,000 customers of Chase spent money, many of the recipients would deposit it right back with Chase. If customers of other banks were also spending, Chase wouldn't see a net outflow.
But SVB was different. It had net outflows. So it was forced to sell Treasurys since they are the most liquid. And mortgages, apparently, too. All of a sudden, the theoretical mark-to-market losses, which were previously unrealized because of government accounting rules, became formally realized. If they bought a bond for $1,000,000 in 2020 and sold it for $800,000 in 2023, they really lost $200,000 of capital or 20%.
In 2020, SVB had growing inflows of cash and was forced to buy bonds at historically low yields / high prices. In the second half of 2022, and early 2023, SVB had growing outflows and was forced to sell bonds at higher yields / lower prices. Duration mismatch along with higher interest rates incentivized SVB customers to take out more of their deposits than they had historically, trapping the now busted bank.
SVB's Brutus
There is another synergistic force. Rates on Treasurys have risen considerably. But rates on bank deposits, not so much. Perhaps, this is because banks are trying to arbitrage and make up for the lost capital of rising rates by not paying depositors rates anywhere near what they are currently getting.
Is your bank paying you almost 5% on your deposits? Probably not.
The result is that many companies were seeking an easy way to sweep their cash balances out of accounts paying 0.1% (like banks) and into the Treasury Bill markets (out of banks) currently paying 4.8% on a 1-month bill and 5.2% on a 6-month bill.
It is somewhat ironic that a Silicon Valley startup, Brex, offered this exact service. Brex offers Silicon Valley (and other companies) a cash management solution that may have pulled some of the deposits out of SVB and into the higher Treasury Bill market, speeding up the deposit outflow.
The Marginal Bank Failure
Change occurs at the margin. That's how economies work. The marginal worker is the first to be unemployed, if conditions change. The marginal firm is the first to go under. The marginal debtor is the first to default.
SVB was the marginal bank, the one which failed first (let's ignore Silvergate, as its failure seems more due to its exposure to the crypto space). It was the marginal bank due to its unique flows, first inbound at the wrong time and massive size, and then outbound at the wrong time and even faster. Additionally, it may have made some bad risk management decisions.
However, the same forces are operating on all other banks. I assume they all had deposit growth during the stimulus of 2020-2021. They all must be experiencing deposit outflows now, as the Fed has shrunk the M0 measure of the quantity of dollars from $6.4 trillion in December 2021 to $5.3 as of this January. This is a staggering decline of 16%. M0 includes bank deposits, and we do not assume that the number of printed pieces of paper would change much (it's not a big component anymore, anyways).
Who Will Fall Next?
Sweeping cash into Treasury Bills is essentially Fed-arbitrage. Now that rates are dramatically higher, but banks cannot and will not match them, savers want to move their balances and earn the current, higher market rate. This arbitrage would not exist in a stable monetary system, based on gold. It may not even exist when rates plummet again (as they must). But for now, it will be hoovering deposits out of the banks. Which is the next marginal bank?
There are many other banks that may have some elements of the SVB story. Other specialty banks, and community banks may have had inflows during covid and outflows now. Depositors must be warily looking at them, wondering if it is better to be prudent and move their cash to a Too-Big-to-Fail bank, while they still can. Even if they are wrong initially, such outflows will collapse the bank in the end.
The Root Cause of SVB's Collapse
The root cause of the collapse of SVB was not stupidity at the bank, insufficient regulation, or corruption at the ratings agencies. The root cause is government interference in money and credit, especially including its irredeemable currency which necessarily inflicts interest rate instability upon the world.
The regime of irredeemable currency is enormously destructive.
During periods when interest rates are falling, most people love it. Who would dislike endless bull markets and hence capital gains, and rising transaction volumes and hence profits for investment banks? Economists praise it as a "strong economy."
But it was not strong, it was in a false boom. Then, when the Fed went into purge mode, the boom turns to bust (this is starting to happen, but not fully realized yet). In the bust, banks fail, depositors lose their cash, etc. And the pressure grows to bail everyone out, thus leaping back into binge mode and another boom phase.
Whither the price of gold?
As always, crises like this lead to the question of whither the gold price?
There will certainly be sellers of gold, especially those who are forced by liquidity problems. However, something bigger is likely going on now.
Everyone in the market has to come to grips with what just happened. They have to consider the risks of things that previously they may have thought absolutely safe. Such as bank deposits, and Treasury bonds (and government-guaranteed mortgages).
This line of thinking has but one destination. Gold is the financial asset that is not the liability of a suddenly-not-risk-free counterparty such as a bank.
The raison d'etre of Monetary Metals is to provide an off-ramp from the unstable interest rate, destabilized banking system, and mad irredeemable currency. A way to save in gold, and compound one's wealth via earning a fair and reasonable interest rate.
If you have concerns about how the fallout of SVB may impact you, please give us a call or an email.
