Longwave's Thoughts on Silicon Valley Bank
Over the weekend, you might have read about the collapse of Silicon Valley Bank, the 16th largest bank in the country. As this is the first major bank failure since 2008, Longwave wanted to share some thoughts about possible concerns you may have.
What Happened
SVB was primarily a commercial bank serving the tech community, holding around $170 billion of deposits, the vast majority of which were not insured by the FDIC. On Sunday, the US government stepped in to protect Silicon Valley Bank customers' funds in a bid to prevent contagion from spreading across the financial system. The response is a saving grace for startups and other companies whose SVB funds have been locked up in the failed bank. Over the weekend and on Monday, Goldman Sachs began the process of purchasing the assets of SVB by auction.
Why Did SVB Fail
In 2021, when interest rates were low, SVB put much of their customer deposits into longer-term government bonds. Government bonds are safe if held to maturity, however, when interest rates go up, those bonds lose value in the short-term. These paper loses led to an imbalance between bank assets and deposits. Most banks hedge interest rate risk but SVB did not do this.
The bank could have continued to ride out these losses, but due to mismanagement and a panic by antsy depositors, a bank run ensued. Last week, when the bank could not meet redemption requests, bank regulators had to step in to seize the bank, restore liquidity to businesses and to make all depositors whole. Investors in the bank and some bond holders will be wiped out.
What Happens Next
Over the weekend several other banks – First Republic and Signature Bank ran into trouble due to depositor and investor deterioration of trust in smaller regional banks. We believe there is little practical contagion risk to the economy but there will be a temporary souring of sentiment for the bank sector and perhaps the market as a whole.
The Context
Starting in 1982, interest rates gradually declined from 17% until essentially reaching zero in 2021. Since the beginning of 2022, interest rates have been rising rapidly. For savers, this is a benefit in the form of getting a real return on their bank deposits. Nonetheless, there are consequences – lower home affordability, higher defaults by businesses and individuals due to pricier loan terms, and higher debt servicing costs by the federal government, potentially raising the national debt even higher.
Up until now, there hasn’t been much practical economic impact from the Fed’s aggressive rate rising regime. Yet the collapse of SVB could be one early sign of the economy creaking under the weight of higher interest rates. When economic conditions change suddenly, there are always casualties by those that did a poor job of preparation, like SVB. This is one of the Darwinian ways the economy fixes and corrects itself.
Investors and depositors are becoming more aware of interest rate risks. Over the weekend, economists started to predict that the Fed may now slow its rate of interest rate rises as a result of these regional bank troubles. The adjustments have already begun.
Longwave Portfolios
In early 2021, Longwave modified our bond holdings to own shorter duration bonds. This helped reduce the consequences of rising interest rates on our client bond holdings. At some point, interest rates may begin to top out and it would make sense to own longer duration bonds again. We continue to monitor the interest rate environment as we do various other risks that could affect our client’s financial wellbeing.
As always, if you have any questions about your particular situation, don’t hesitate to reach out.