, ,

The collapse of Silicon Valley Bank

If I had to choose which lesson I ever received that had to most long-lasting effect on me, I would pick my high-school physics teacher's. It went roughly like this: when you want to test if you really understood something, take a blank paper and write it down from scratch. Getting stuck or confused means that you deluded yourself and only thought you understood the subject. Go back to the textbook again, study, then take out another blank paper. Repeat the process until satisfaction or exhaustion.

I find this advice a no-brainer. It's simple and generally applicable, and I have always looked with bemusement at people who never use it (that is, most people). As a bonus, it also justifies why one would bother to write an article about a topic she is not an expert of, nor could she hope to summarize it any better than his sources.

And in the following, I give an example.

One of the most reverberating news of last week was the run on the bank of many Silicon Valley types, appropriately named Silicon Valley Bank. SVB wasn't a fancy bank investing in even fancier Silicon Valley startup high-tech products. On the contrary, it was the Silicon Valley companies that parked their money in SVB, which in turn, invested their money mostly in boring, long-term bonds. That is, like any ordinary bank does, it used the short-term loans (aka deposits) from its clients - for which it paid a small interest -  to buy long-term financial assets with higher-interest rates.

To simplify the process to the basics (using numbers conjured from thin air, as I haven't bothered to check what those numbers really were), for every dollar deposited, SVB promised to pay it back with a 3% annualized profit. From the money, it bought government bonds with a longer expiry date and 5% profit. At the end of the year, it reaped a solid 2% profit.

This worked well while the interest rates were low - which was the case in the past twenty years - but the model was completely upended when the era of high-interest rates suddenly dawned on the world. The bonds SVB bought earlier that promised 5% of profit in a year dropped their real value in the world of 10% general inflation.

Imagine that you bought government bonds for $1000 for which the said government promised you to pay another $50 at expiration, in a year's time (5% profit). It looked fine when the inflation was expected to be 3%, leaving you with a 2% real profit. It doesn't look fine at all when inflation is hovering around 10%. Your real profit will be -5%, so this bond you won't be able to sell for $1000 anymore, because your potential buyer can easily find something that safely promises 12% interest in a year (e.g. a newly issued government bond). You bought something for $1000 and it's suddenly worth only $900. 

What banks usually do is that they hedge against such turn of events. SVB did not. It actually has in the past successfully lobbied against regulations that might have forced it to be more prudent.

The second big mistake SVB made is that it has built out its clientele among the incestuous Silicon Valley start-up community where financial (and many other) decisions were often dictated by fashion and everyone is closely watching what the rest does. If someone suddenly takes all his money out of SVB, the others will learn about it in hours, and for purely rational reasons, assuming the guy knew something they did not, they will follow. A single actor could and did trigger a bank run much faster than in the case of a normal bank with a diverse clientele.

So, maybe out of sync with the Zeitgeist, SVB was not running some pyramid scheme or some bogus crypto-based fraud. Its management was simply incompetent. As one commentator put it, it was not a "bank run" by idiots. It was a bank "run by idiots".

What triggered the run and whether SVB was really insolvent or could have weathered the storm if the trust in it remains, are, as far as I know, open questions. The result is the same nonetheless, without intervention the bank would have collapsed as the panicked clients sucked it all dry. 

But the US government stepped in, took over SVB, and provided deposit insurance for all depositors, which was surprising for many. The US government guarantees deposits up to $250,000, but those deposits made up less than 2% of what the bank owed to its clients. Most accounts - which as I said belonged to Silicon Valley companies - were in the tens of millions. For some reason, the government decided that the danger of starting a contagion is a bigger problem that the moral hazard they introduced by saving the skin of super-wealthy techies who didn't bother to check how well the bank is run where they store their money.

0 Comments:

Post a Comment