What Can SVB Teach Us About Building Wealth?
The bank’s failure offers four key learnings for the practice of protecting and building wealth.
The events are well known by now. Silicon Valley Bank failed the morning of March 10th. At approximately 10:30am CST, the California Department of Financial Protection and Innovation closed the institution and appointed the Federal Deposit Insurance Corporation (the “FDIC”) as receiver. The closure came after depositors withdrew $42 billion the prior day, leaving the bank with a nearly $1 billion negative cash balance. Unable to secure additional funding, Silicon Valley Bank could not repay its remaining depositors. The bank was insolvent. Put simply, there was a run on the bank and the bank failed.
Two days later, the FDIC, the Federal Reserve and the Secretary of the Treasury jointly announced that all depositors, not just those below the $250,000 limit for FDIC insurance, would be fully protected and have immediate access to all of their funds. Investors in SVB Financial Group, the parent company of Silicon Valley Bank, however, received no such protection. Instead, shareholders are likely to be wiped out, while debtholders are likely to receive only a small fraction of what they are owed.
This was a shocking collapse. Just a week prior, SVB Financial Group had a market capitalization of nearly $17 billion and its bonds were trading anywhere from 70-95% of par value. In total, $20 billion of wealth was destroyed, almost overnight. How had so much wealth been so abruptly destroyed? If, as philosopher George Santayana said, “those who cannot remember the past are condemned to repeat it,” what must be remembered from this ordeal to avoid repeating such an outcome?
Understanding and learning from the answers to these questions is vitally important to the practice of protecting and building wealth, the focus of this column. To do so though, it is necessary to first understand how a bank functions.
At a very high level, a bank takes in equity capital from shareholders and debt capital from lenders, including depositors. The bank then uses that capital to make loans and purchase investments. To turn a profit for shareholders, the bank must earn more interest income from its loans and investments than the interest expense it must pay to its lenders, including depositors.
To earn an acceptable level of profit for shareholders, banks do two things. They utilize a fractional reserve banking system and employ leverage. Utilizing a fractional reserve banking system means that only a fraction of deposits is held at the bank in cash. The rest are used to make loans or purchase investments, increasing the profit for shareholders. Employing leverage means borrowing money to make additional loans or purchase additional investments, thus increasing the profit for shareholders without requiring additional equity capital.
However, utilizing a fractional reserve banking system and employing leverage creates risk for the bank. If the bank receives more deposit withdrawals than it has cash on hand, the bank is illiquid but solvent. It is capable of satisfying all withdrawals, just not right now. One function of central banks, such as the Federal Reserve, is to help otherwise solvent banks survive a short-term period of illiquidity until the necessary funds can be raised.
Alternatively, if the value of the bank’s loans and investments declines far enough that the bank is no longer capable of satisfying all withdrawals and repaying its borrowings, neither right now nor in the future, then the bank is insolvent and is closed by regulators. The more leverage that the bank employs, the smaller the decline in loan and investment values necessary to render the bank insolvent.
Silicon Valley Bank, as mentioned above, became insolvent and was closed. Ultimately, this was triggered by rising interest rates. However, the bank had several unique attributes that made it uniquely susceptible to this risk. First, the bank had enjoyed rapid growth since the pandemic, with total deposits rising from $55 billion in January 2020 to $186 billion at the end of 2022. Second, the bank held a high mix of investments versus loans, electing to invest deposits in long-term government bonds and mortgage-backed securities rather than make loans. Investments were 57% of total assets at Silicon Valley Bank versus 24% of total assets at peers. Third, only a small percentage (11%) of the bank’s deposits were insured by the FDIC. The vast majority exceeded the $250,000 limit. In some cases, deposits were in the hundreds of millions of dollars. Fourth, the bank’s depositors were concentrated in the venture capital, technology and life sciences/healthcare sectors. These sectors comprised at least 60% of total deposits.
As the Federal Reserve steadily raised interest rates from zero in March 2022 to 4.75% in February 2023, several things began to happen at Silicon Valley Bank. First, the market value of the bonds in the bank’s investment portfolio, with a duration of 5.6 years, began to decline. Second, funding to venture capital companies began to slow, requiring these companies to increasingly withdraw their deposits from the bank. Third, the bank was slow to raise the interest rate paid on deposits, leading some customers to withdraw their money to invest in higher-yielding alternatives. At this point the bank remained liquid.
With withdrawals mounting and the value of its investments falling, Silicon Valley Bank sold $21.0 billion of investments on March 8th, realizing a $1.8 billion loss. Concurrently, the bank’s parent announced plans to raise $2.25 billion of equity. The moves were intended to bolster the bank’s liquidity. However, the combination of the investment sales, equity raise and known losses on the bank’s remaining investment portfolio (more on this later) shook confidence in the bank’s solvency. The following day, depositors rushed to withdraw their money and the bank run was underway. As a result of the bank run, the equity raise was never completed. Unable to secure additional funding to meet withdrawals, the bank failed and was closed by regulators. Prior to its failure, Silicon Valley Bank had $209 billion of assets, making it the largest bank to fail since Washington Mutual in 2008. Since its founding in 1983, Silicon Valley Bank had built great wealth for its shareholders. Anyone who participated in the 1987 SVB Financial Group initial public offering and held until March 3rd would have realized a 19% annualized return for more than 24 years. However, Silicon Valley Bank failed to protect its wealth. Its demise offers many important lessons for those willing to learn.
The first lesson is to manage your liquidity appropriately. This includes both known liquidity needs, as well as potential future liquidity needs. If you do not, you may be forced to sell assets at an otherwise avoidable loss to satisfy an immediate cash need, as happened at Silicon Valley Bank. By understanding your liquidity needs and structuring your investment portfolio correspondingly, you not only avoid having to sell assets at a loss, but also allow the rest of your wealth to grow undisturbed over time.
The second lesson is to use leverage appropriately. Leverage, as I wrote in the inaugural Investment Insights, “has great power both to create and destroy” by magnifying both positive and negative investment returns. At Silicon Valley Bank, due to high leverage, just a small drop in the value of the investment portfolio left the bank insolvent. Thoughtfully employed, modest leverage can help build wealth more quickly over time. A home mortgage is a good example of this, with a manageable amount of borrowed money, secured by the home itself, used to purchase a stable asset. However, to avoid the fate to Silicon Valley Bank, leverage should not be used excessively nor used to purchase volatile assets.
The third lesson is to appropriately diversify. Silicon Valley Bank failed in two respects here. Its investment portfolio was concentrated in only a few types of securities and its deposits were concentrated in only one sector of the economy. This left the bank particularly vulnerable to adverse shocks in those two areas, which ultimately materialized. Proper diversification, though, builds resiliency to shocks and reduces the potential harm to your overall wealth from any one particular risk in any one particular area.
The fourth lesson is to invest only in what you understand. Silicon Valley Bank’s troubles were well known for many months, publicly disclosed in the footnotes to its quarterly financial statements filed with the Securities and Exchange Commission. As early as July 2022, the bank reported unrealized losses of $11.2 billion on held-to-maturity investments versus equity capital of $12.3 billion. Should those investments need to be sold, realizing the associated losses would have reduced equity capital to a scant $1.1 billion. By October, that number had declined further, to negative $4.0b. The bank was technically insolvent, but not functionally insolvent, at least not yet. For at least some shareholders and debtholders then, the resulting loss of wealth could have been avoided had they only understood what they were investing in.
One of investor Charlie Munger’s pithier quotes is: “All I want to know is where I’m going to die, so I’ll never go there.” There are many ways to learn how to protect and build wealth. One way is to learn what not to do by studying examples of how wealth has been rapidly destroyed. By learning how to avoid a bad outcome, you improve your odds of realizing a good outcome. As an added benefit, such wisdom comes vicariously rather than with the pain of firsthand experience. For the practice of protecting and building wealth, there is indeed much to be gained from the failure of Silicon Valley Bank.
Thoughts? I would love to hear them. Email me at investmentinsights@zuckermaninvestmentgroup.com.
Written By Keith R. Schicker, CFA