With last week’s failure of Silicon Valley Bank and its impact on the banking system – or at least perceptions related to it – the financial landscape looks somewhat different today than it did as we entered March.
This blog rarely comments in detail about current market events. I frequently encourage clients to do their best to ignore the market noise and focus on what matters most to them. When market-related events increase investor angst, I do not get a flood of emails or phone calls. I haven’t since the Silicon Valley Bank failure either. I have received a handful of questions though. That’s more than I normally get, and I’ve had a few discussions about the situation with others as well. As a result, I’m going to share some insights about the situation. Hopefully, they will help you understand the situation better and also help relieve any concerns.
Financial news networks often look to capitalize on investor emotions, especially fear. Why? It increases the number of eyeballs viewing their programs. They often get louder when talking about events such as the Silicon Valley Bank failure as that makes it more likely they will capture your attention.
Any time market volatility and investor uncertainty increase it’s important to remember the value of maintaining a level head and focusing on the long term. I regularly remind clients of the importance of owning a diversified portfolio and focusing on their financial plans.
Silicon Valley Bank – What Happened?
Since it was a prominent financial institution, the failure of Silicon Valley Bank has caused many to question the stability of the overall banking system. Let’s take a closer look at what happened.
In short, Silicon Valley Bank grew deposits too quickly. It also did a poor job of matching the maturity of its investments with its potential cash needs. When you deposit money in a bank, you, in effect, loan your money to the bank. The bank pays you interest in exchange. Then banks loan that money out to others, also in exchange for interest. Silicon Valley Bank also lent some of this money to the government in the form of long-term Treasuries. A profitable bank charges more for the loans it makes than the interest rate it pays to depositors. As interest rates increased, the fair market value of its loans fell. (See Bond Values and Interest Rates below if you’re not sure why.
Silicon Valley Bank used to primarily lend money on a short-term basis. But in a quest to increase yield, in 2021, the bank shifted to longer-term securities. Especially with the benefit of hindsight, this was a critical mistake.
Bonds Values and Interest Rates
It’s important to understand that bond values move in the opposite direction of interest rates. Why? Assume you own a bond that matures in five years and pays 2% interest. If the current interest rate for a similar bond is 4%, nobody will want to buy that bond from you for its stated value. They would rather own the bond that pays 4% interest. They will only buy the bond paying 2% interest if they can pay less for it. According to my financial calculator, they will pay $910.17 for that bond.
On the other hand, if interest rates fell to 1%, they would pay $1,048 for the same bond.
In order to earn a higher yield on its investments, Silicon Valley Bank purchased long-term treasuries and mortgage-backed securities. Oftentimes, banks look to match the potential maturity of their investments with future obligations. Silicon Valley Bank did not do this. They primarily held long-term securities with similar maturities.
Silicon Valley Bank – An Accounting Issue
Forgive me, but I’m going to discuss some accounting-related issues. When banks make an investment, they can be accounted for in one of two ways:
- Available for Sale (AFS)
- Held to Maturity (HTM)
There are important distinctions associated with how an investment is classified. Under the AFS classification, you adjust for changes in market value on a current basis. You can also hedge to protect yourself from any changes in value. When the HTM classification applies, you do not adjust for changes in market value. You also cannot hedge the investment. In order to get a sense of the change in market value for an HTM asset, you must read the footnotes to the company’s financial statements.
Silicon Valley Bank classified its investments in long-term Treasuries and mortgage-backed securities as HTM. A thorough review of Silicon Valley Bank’s financial statements would have shown that the company had significant unrealized losses on its HTM securities.
Why This Mattered
Under normal circumstances, this would not have caused a big concern. But the circumstances were not normal. A significant segment of Silicon Valley Bank’s customers were tech startups. They deposited the cash they received from investors. This amount was unusually high over the last few years due to the money that flooded the system after COVID. Much of it found its way to the tech sector.
When these companies were taking in cash, Silicon Valley Bank had little need for its long-term investments. But as its customers started needing more cash, the situation changed.
As interest rates increased, Silicon Valley Bank took in fewer deposits as venture capital funding largely stopped. Plus, the market value of its securities tumbled. A Treasury paying 1% became a lot less desirable when you could purchase a new one paying 3.5%.
A Run on the Bank
A run on the bank occurs if a bank does not have sufficient cash to repay all of its depositors simultaneously. This can happen if the bank has distributed those assets elsewhere as loans. As its customers demanded increasing amounts of cash, Silicon Valley Bank was put in a position where it would need to start selling its HTM securities. This would result in losses that would jeopardize the bank’s financial position.
A run on the bank can become a kind of self-fulfilling prophecy. If depositors worry that a bank is short of liquid assets, they often react by quickly pulling their funds. This can make the problem even worse. Plus, as word gets out that depositors are pulling their money from the bank, others follow. The biggest concern is that this could become a contagion, spreading to other banks.
The biggest bank run occurred during the Great Depression. In 1929, 650 banks failed. More than 1,300 more banks failed in 1930. In sum, more than 9,000 banks failed in total. The Federal Deposit Insurance Corporation was established in 1933. The FDIC was funded by member banks. At that time, it insured $2,500 per account. This meant that even if a bank went out of business, depositors would get their money back. Today depositors have $250,000 of FDIC insurance. But the FDIC guaranteed all of Silicon Valley Bank’s depositors in full.
Before its doors were shut, Silicon Valley Bank attempted to issue shares to increase its asset base, but it was too late. Ultimately, the bank was in a position where its assets were less than its liabilities (after adjusting for the decline in value of its HTM securities.
What’s Next?
The short answer is that no one can say for sure. But it almost goes without saying that the banking sector’s recent turmoil in the banking sector is raising renewed fears of a recession and a resumption of last year’s bear market. The odds of a recession increase if the turmoil roils the banking system significantly. Bankers could become more cautious lenders, particularly among the smaller regional and community banks. On the other hand, the Fed probably stabilized the situation with its announcement last Sunday, March 12, of the new Bank Term Funding Program. It is aimed “to help assure banks have the ability to meet the needs of all their depositors.”
While another bank failure cannot be ruled out, it seems unlikely that the problem will continue to spread. The actions that a number of large banks took to provide First Republic Bank with an additional $30 billion of deposits strengthened its financial position significantly. To at least some observers, First Republic’s long-term viability was also in question.
Recent Economic Data
While the pace of inflation slowed modestly to 6% in February, the Fed could at least slow the pace of interest-rate increases if not put a temporary halt to them. It’s important to note that after letting interest rates stay at depressed levels for a period that at least some would argue was too long, the Fed has embarked on an aggressive program to increase rates. The rapid increase in rates only aggravated the situation for Silicon Valley Bank as well as many other banks.
While many fear a recession, the economic indicators have yet to indicate the U.S. economy is in recession.
Although America’s largest banks injecting $30 billion of deposits into First Republic Bank might appear to be a positive, it confirms some of our worries about what has occurred. Until this happened, we did not know for sure if First Republic had indeed experienced a true run on the bank. Disclosures made by First Republic regarding this liquidity injection remove all doubts that a significant runoff of deposits has occurred. Based on the potential range of deposits that may have fled, it’s possible the bank could already be unprofitable on a go-forward basis. First Republic’s future will be determined by its ability to get depositors to return once the initial panic has worn off. Unfortunately, there are no guarantees this will happen. If it doesn’t, First Republic may need to be acquired.
Potential Implications for Long-Term Investors?
However, it’s crucial to remember that investing in this environment requires a level head and a maintaining a long-term focus. While it’s understandable to feel anxious or fearful during times of uncertainty, acting on those emotions can result in dangerous and irrational decisions.
Maintaining a diversified portfolio can help mitigate risk. Apprise spreads your investments across a variety of assets, industries, and markets. This can reduce your exposure to any one particular risk. It can also help to protect your portfolio from sudden market fluctuations or unexpected events like a bank’s failure.
So, what can we learn from the failure of Silicon Valley Bank and other recent banking crises? Perhaps the most important lesson is to remain calm and rational, even in the face of uncertainty. By sticking to a well-thought-out investment plan and maintaining a diversified portfolio, we can weather the ups and downs of the market and emerge stronger in the long run.
Closing Thoughts
Apprise’s process is designed to weather these types of storms. We have diversified portfolios that are tailored to your individual needs and risk tolerance. We use strategies that help minimize taxes and fees. And most importantly, we have a long-term perspective that allows us to stay focused on your goals, even when the markets are choppy.
Of course, it’s natural to feel emotional during times like these. Fear and greed can be powerful motivators, and it’s easy to get caught up in the ups and downs of the market. But I urge you to remember the wisdom of the Irish and to stay the course. Stick to your plan, and trust that things will work out in the end.
For additional thoughts on investing in difficult market environments, you can also check the following blogs:
- The Market Is Down. Should I Change How I’m Investing?
- Pullbacks Are What Markets Do?
- Thoughts About Increased Stock Market Volatility And Higher Interest Rates
I’ll be back next week with “Apprise’s Five Favorite Reads of the Week.”
Our practice continues to benefit from referrals from our clients and friends. Thank you for your trust and confidence.
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For firm disclosures, see here: https://apprisewealth.com/disclosures/
Phil Weiss founded Apprise Wealth Management. He started his financial services career in 1987 working as a tax professional for Deloitte & Touche. For the past 25+ years, he has worked extensively in the areas of financial planning and investment management. Phil is both a CFA charterholder and a CPA.
Located just north of Baltimore, Apprise works with clients face-to-face locally and can also work virtually regardless of location.
