SVB: How did you go broke if you had the safest investment? – 03/14/2023 – Market

The Silicon Valley Bank (SVB) had a lot of money in US government bonds and the like. How could it have gone bankrupt making the safest investment on the planet, lending money to the US Treasury, in theory with zero risk of default? That’s what many people ask themselves.

SVB didn’t just go broke because it had too much money in US Treasuries, etc. Furthermore, investing in US government bonds or other less reputable ones does carry risk, even if it is not the risk of explicit and direct default (non-payment, pure and simple).

The Bank of Silicon Valley went into crisis 1) because the securities it owned lost value AND ALSO the bank did not have any financial strategy to compensate for these losses (“hedge”) or sufficient capital to cover any losses with these investments, in a situation of “stress” (high interest rates, for example).

2) It also entered into a crisis because the basis of its funding (of the resources it raised) were customer deposits that were not covered by a guarantee fund (or other insurance), more likely to withdraw money in the event of rumors about the bank’s health.

3) It went into crisis because its customers (depositors) were similar (there was more risk that they would go through the same financial and economic problems, at the same time, needing to withdraw their money). The “tech” world has been struggling since 2022.

4) It finally broke down because it couldn’t contain the panic caused by the combined effect of such problems.

Why did the titles that SVB had lose value?

The bonds that the SVB bought lost value because basic interest rates in the United States have risen sharply since March of last year (from almost zero to almost 4.5%, in the case of the basic rate of the Fed, the US BC) . So it was with all the securities held by US banks, a total write-off of perhaps US$ 2 trillion in the value of assets now recorded on the balance sheets, a loss calculated for the last year.

The account that circulated in the financial media was of potential losses of US$ 600 billion, but referring to December 2022. Banks that saw their assets lose value did not go bankrupt, obviously, although some may be at risk.

The estimate, even a little over the top, is from a great, short and very recent study by American researchers (“Monetary Tightening and US Bank Fragility in 2023: Mark-to-Market Losses and Uninsured Depositor Runs?”, by Erica Jiang, from the University from Southern California and four other authors (free online, published Monday).

Any security will lose market value if interest rates rise (see the elementary explanation for a simple case at the end of this text), as well as other assets, by the way.

If the investor holds his bond until maturity and does not default, he receives the contracted amount (what he invested and the yield, the “interest”). If he has to sell it before, “uninvest”, he loses part of the capital if the interest rates on the bond market have increased (or gains, if they have fallen).

If the reader has certain Treasury Direct securities (generally longer term and other than “Selic”), she may have noticed on her statement that her investment lost market value with the rise in interest rates. If she holds the bond until maturity, she will get what she contracted for.

But don’t other American banks also have these bonds?

Other assets, holdings, of banks also lose value with the rise in interest rates (such as loans to finance housing or commercial real estate). Erica Jiang and the authors of the study cited earlier in this text conducted a test to estimate the size of the devaluation of these assets, loans and bonds, in American banks, around 4,800 institutions.

According to the authors, the typical bank has 42% of assets in real estate loans. Government bonds (public debt) and others, such as those that derive their income from real estate, are 22% of assets. Jiang and colleagues found that the devaluation of these assets in one year (from the first quarter of 2022 to the first quarter of this 2023) was somewhere between 10% and 11% (judging by the variation in the market values ​​of these securities in certain funds).

On average, bank assets would then have lost 10% of their value—hence the potential loss account of $2 trillion (at least for that portion of assets assessed in the study, 64% of the total). In the worst cases, in the 5% of the worst performing banks, the loss would be 20%.

He would be. Banks lose only if they have to sell these assets. About 11% of banks could have greater losses than the bankrupt SVB. But they didn’t go bankrupt, at least until now.

If so many banks have bonds, why was the problem with SVB?

What is the likely problem with the SVB? The way in which it raised funds, the composition of its funding. Receiving deposits from customers, whether interest-earning deposits or not, is a way to raise money. Part of these deposits can be secured.

For example, in the US, depositors with up to US$ 250,000 in their account do not lose money if the bank fails (they are covered by the insurance fund). Customers who have no guarantee that they will not lose their money are much more likely to withdraw their funds from the bank in the event of rumors or signs of crisis. It also withdraws its money if the bank does not increase the remuneration of deposits.

According to a study by Erica Jiang and colleagues, the median US bank’s funding is comprised of 65% insured deposits and 26% uninsured liabilities (uninsured deposits). of customers and other debts of the bank). The ratio between “uninsured” liabilities and assets in the SVB was very high. That is, he had a relatively large amount of “uninsured” money to pay back relative to his total holdings, assets.

In 5% of banks, “uninsured” liabilities in relation to total assets was 52% of the total. In SVB, 78%. It was in the 1% of cases with the highest potential risk.

SVB suffered from a confluence of problems, therefore. About 55% of its assets were invested in debt securities that lost value. It ran the risk of having to pay back a lot of money (unsecured liabilities) if there were signs of a crisis. Withdrawals were already taking place, as the bulk of its clientele was made up of innovative companies in the technology sector and their financial partners, who have been in bad shape since last year.

The news that he had to sell securities from his portfolio in order to cover withdrawals, at a loss, provoked more fear in his clientele, already frightened by the crisis in the sector, with layoffs, credit drought, etc. Partners of its clients, “risk investors” (“venture capital”) encouraged withdrawals, with alarmist alerts.

In the final week of the crisis, the SVB still tried to raise capital (selling new shares, etc.) in order to cover the loss with the sale of its bonds. It was advised by Goldman Sachs.

Still it didn’t stick. Hardly anyone appeared as a firm buyer of the new papers. The rush to withdraw money from the bank increased. From Thursday to Friday of last week, the bank lost almost a quarter of its deposits ($42 billion).

WHY DO SECURITIES LOSE VALUE WITH HIGH INTEREST?

A bond is a promise to pay a certain amount in a certain amount of time. This is the security’s redemption value (“face value”). It’s a type of loan. Whoever lends the money buys that security at a discount. The difference between the redemption value and the discounted value is the yield, roughly speaking the interest rate of the business.

Consider a simple school example. An investor buys a bond for 100 bucks with the promise of 110 bucks a year from now. If he holds the bond to maturity and doesn’t default, he gets 110 and earns 10 over 100.

For whatever reason, that investor, the creditor, may want to dispose of the security. Might want to sell it on one of the financial markets. He will not be guaranteed to receive 110 bucks for the title he owns (he may even sell for more, but also for less).

Suppose that the interest rate demanded by investors is now higher, for whatever reason (high basic interest rate, market tension, distrust of that debtor, etc.). To have an income compatible with the new interest rate, a new investor will just buy that 110 money bond at an even greater discount, say 15 money. The bond price then drops to 95.

The rise in interest rates and, by extension, the required yield means that the price of the security must fall. Those who have bonds see the market value of their capital decrease. If you don’t sell those bonds before maturity, you don’t have a loss, in practice. But the market value of your equity declines. If you have to sell your bonds, for whatever reason, you will lose money.