News about Silicon Valley Bank’s failure has been somewhat of a nerve racking moment for those who remember the Lehman Brothers collapse before the crash in 2008. It’s an especially unnerving moment considering the economic challenges involved in unwinding the covid stimulus passed out over the past several years. We’ll continue to see turbulence for some time from these events in the coming months, but we’ve been well prepared for economic growth to slow under the pressures of inflation since 2020 and for a period rapidly rising interest rates long before that. So when we look at a bank failure in the context of our economy, and more specifically considering the specific businesses our clients own in their portfolios, we need to do so carefully and methodically. While there are a few similarities between the SBV and the Lehman Brothers collapses, the differences are far more striking and SVB’s failure will not do substantive damage to the economy and financial markets on its own.
Bank failures are actually quite common. According to the FDIC, there have been 73 failures in the past 10 years. These can happen for a variety of reasons, but the overwhelming majority are isolated problems that are the result of the failed bank’s business practices. Silicon Valley Bank’s failure is a perfect example of such and isolated, run-of-the-mill failure. Failures from systemic problems, like the Lehman Brothers collapse, are quite rare.
Most people struggle to understand the “bad loans” that caused the 2008 crisis. When congress established Fannie Mae and Freddie Mac to buy packaged loans from banks, they altered the mortgage industry forever. Instead of Banks making loans from their own capital, they had an instant investor—the Government. To stay competitive, banks had to adjust their business models so that they could originate loans and sell them according to Fannie or Freddie’s standards. These standards dramatically lowered standard requirements for a borrower. No longer on the hook for the a long-term, banks began to make loans and move on. This legislative action affected all banks, so it was systemic rather than isolated.
Fannie and Freddie package these loans together to be sold to private investors in investment vehicles called CMOs. Lehman Brothers was heavily invested in these complex investments. The problem was, congress had established a rule that forced the CMOs to be valued in a way that did not reflect the quality of the mortgages in each CMO. Because of these “mark-to-market” accounting requirements, investors had to way to understand the real value (or lack thereof) of what they owned. As a wave of foreclosures began, banks that were significantly tied to these CMOs struggled greatly. Lehman Brothers and others collapsed as a result.
Silicone Valley Bank is a different case. Sure, it’s a larger bank than most that fail and rapidly rising interest rates have affected it to a degree, but real reason for its failure has to do with its own business practices. Most banks diversify their products, loans, investments, and customers across a wide range of businesses and individuals. They also tend to be relatively conservative with their capital investments. SVB focused much of its business on venture capital and small publicly traded companies. These are both very high risk categories that have faced significant struggles post-covid, and SVB did not appropriately staff its risk management department, operating for nearly 8 months without a Chief Risk Officer. These are problems few banks face, and when they are well managed and diversified they will not have problems.
Rising interest rates have affected the banking industry, but we believe that most of the financial sector is quite healthy looking out a year or two. Think of how much more profit a bank can make on an 8% interest loan vs a 3% interest loan. The challenge, in the short term, is that depositors are expecting more interest when the bank’s loan portfolio is still producing at lower rates. For a simplified example, the bank made a loan to a customer last year at 7% at that time, they were paying interest on to customers CDs at 2%. That CD gave them the capital to make the loan, and the bank profited 5%. Now, the bank needs to pay 5% on their CDs to customers, but the loan was locked in at 7%, so the bank’s profit margin is only 2%. Soon, they will make a new loan at 10%, and be able to achieve their previous level of profit, or their variable rate loans will adjust and mitigate some of the impact of rising rates. Banks also have many other ways to generate income. Rising rates have been inevitable for some time now, and we’ve had confidence in banks with diverse revenue sources, substantial variable rate loans, and a strong deposit base.
All that to say, the banking system is in-tact. At the same time, its an important reminder to make sure if you have substantial assets at a particular bank, that you are fully covered by FDIC insurance. They will cover up to $250,000 per account category at each institution. Your accounts we manage at TD Ameritrade or Schwab have spread the cash balance among multiple banks so that you have sufficient coverage for cash. If you’re unsure about your situation, feel free to reach out to us at any time and we can help you evaluate your FDIC Insurance coverage.