Silicon Valley Bank – What happened?

You may have noticed in the news the failure of Silicon Valley Bank, in America. We wanted to share our thoughts explaining what happened recently and what we think the implications and fallout are going to be in the coming weeks.

This is, in many ways, very simple, it’s a classic bank run, but in other ways, it’s more complicated.

Some of our clients are extremely sophisticated and understand and invest in hedge funds and private equity, but for the majority of our clients this is not their thing, so we’re going to start very basic and then get into the reality of what happened.

Silicon Valley Bank is just a bank, although the name sounds very venture capital related, at the end of the day, it’s a bank. Clients make deposits and keep savings there, and it also has a lot of business accounts. The challenge is that it is the 16th largest bank in the United States in terms of deposits, there is a lot of money sitting at that bank. When the markets closed on Friday, it was the second-largest banking failure in the history of the United States.

To understand what happened, we have to start with how banks basically work.

Most banks make their money by borrowing money at low-interest rates over the short term and lending it out at higher rates over the longer term. The practical way that most of us understand this is we deposit money in our account at the bank and we’re basically lending the money to them, they pay us a modest interest rate, and then the bank goes out and lends that money in the form of a loan or mortgage, for example, at a higher interest rate, the difference in interest rates is how banks make a lot of their profits.

The issue with that is if everyone wants their money at once, they can’t get it because it’s tied up in long-term loans and mortgages. On the very rare occasion when everyone says, “I want all my money” that’s called a bank run, think Northern Rock in 2008, when this happens the bank cannot deliver and it collapses, this is what’s happening with Silicon Valley Bank now.

So what happened with Silicon Valley Bank? 

A lot of customers deposited their money with the bank and as the name suggests, many technology and venture capital funds put their money there too. There are a huge amount of business accounts at Silicon Valley Bank. They pay very low interest on business accounts and they lent the money to the US government in the form of U.S. treasuries (the US equivalent of British Government Gilts) paying around 1.6%, which is where the yield was a few years ago.

Silicon Valley Bank lent about $80 billion to the US federal government at 1.6%.  If this was an individual investor and you just bought a U.S. treasury paying 1.6% and then interest rates went up, it’s no big deal, you can just hold your treasuries until they mature and then you get your capital back, and then you can go and buy a new higher yielding treasury.

Silicon Valley Bank loaned $80 billion to the US federal government at 1.6%. Just like in the UK, the US Federal Reserve (the US equivalent of the Bank of England) keeps raising interest rates, to curb inflation and today, if someone wants to loan money to the US federal government, they get 5%. If Silicon Valley Bank felt like selling their $80 billion of treasuries that don’t mature for several years, no one’s going to want to buy them at the price they paid, because they pay 1.6%, compared with new treasuries that pay 5%.

So if Silicon Valley Bank, wanted to sell some of them, they would have to sell them at a discount.  Quite understandably Silicon Valley Bank didn’t want to sell them at a discount, but that’s not the issue, the issue is the bank has a balance sheet that shows how strong they are and they have to put the fair market value of all of their investments on that balance sheet and so they can’t say this $80 billion is worth a full $80 billion today, because the reality is if they want to sell those bonds today, people would not pay that much for them because they could get higher yielding bonds elswhere, so Silicon Valley’s balance sheet looks weaker.

At the same time as all this happened, Silicon Valley Bank have a lot of venture capital and tech firms as clients, using them as their bank.  A large percentage of their accounts are businesses in the tech industry that are backed by venture capital and private equity investors. We all know that tech is not doing great, so technology companies, can’t go out and raise money the way they could a year or two ago, meaning the market is much tighter, so what are the tech firms doing? They’re spending the money they have at the bank, which also makes Silicon Valley Bank look weaker.

Silicon Valley Bank then sent out a letter, to raise money from investors.  It wasn’t the most eloquent letter in the world and it raised some eyebrows. Consequently, Peter Thiel, who is one of the most famous venture capitalist investors who runs a fund called Founders Fund, told all of the companies in that fund that they should move their money away from Silicon Valley Bank, and that sentiment spread like wildfire. This is a community where everybody’s talking to each other and following each other.

When there’s a bank run, the bank collapses because they don’t have enough cash to meet all of these short-term needs, the shareholders lose all their money, the companies that lent money to Silicon Valley Bank almost certainly are going to lose their money, and then you have the depositors (all the people and companies that had their money at the bank).

• The US has a similar, but more generous, depositor protection scheme to the UK, it’s called the Federal Deposit Insurance Corporation (FDIC), which insures up to $250,000 per deposit.
• However only 7% of the deposits at Silicon Valley Bank were insured, because there are a lot of businesses accounts which aren’t covered.
• Many of their customers are small biotech technology companies and to run a business of that kind, you might have a million dollars or several million dollars because you’ve got payroll to cover which likely includes some unique and talented (read: ‘expensive’) individuals, plus the substantial Research and Development (R&D) costs, and cashflow in small companies is uncertain in any case.
• 93% of accounts were uninsured or about $150 billion of deposits.

To give you a perspective of how much this impacts the venture capital technology community, a venture capital fund is just a fund that invests in companies that are really small and just starting out. Once they get a little bigger, they might get bought by private equity companies, then when they get a little bigger, they might go public and list on the stock exchange.

Venture capital is very early-stage investment and there are about 120,000 venture capital funded companies in the United States; half of them were at Silicon Valley Bank, so this is just a stunning percentage.

It’s important to remember these companies have products people buy and use, they have employees with rents and mortgages to service and unless something happens in the next couple days, there are going to be some major issues.

What would happen next?

So what are the implications? What should we expect from here? Is this going to be like 2008, 2009?

Let’s look at the options for the FDIC and the US government:

1. They could do nothing.  I would be very surprised if they do nothing, because every person in America that doesn’t bank with one of the few largest banks is likely to take their money out of the smaller banks and you will have this cascading bank run all across the United States.
2. We get a quick sale, in the next few days, a Goldman Sachs, JP Morgan or Bank of America comes in and buys Silicon Valley Bank they get an incredible customer base. They’ve got a balance sheet and can afford it and I think it’s most likely to happen.
3. The third option is the FDIC or the federal government could come in and guarantee everybody’s deposits and prevent further runs.

Now, just to point out, the biggest collapse in history was Washington Mutual in 2008 and when this happened 100% of depositors got their money back.

For UK investors what will the impact be and what can we learn from this?

We have already seen the UK government and investment grade bonds appreciate in value because there is a flight to safety, meaning more money flowing to these assets.

• For individual investors, what you can do from a practical point with your UK bank accounts is to ensure you use both the UK deposit guarantee of £85,000 per licences institution or deposit money with National Savings & Investments which is 100% backed by the HM Treasury.
• If you’re thinking “what’s going to happen to my portfolio?”, things like this happen all the time, this isn’t the first bank failure and it’s not going to be the last. During periods of uncertainty, you see a lot of short-term movement that’s completely unpredictable and usually to the downside because a lot of speculators see their positions get blown up or they try to move money to protect certain positions.
• As a long-term investor, this is not something to spend time on. As a Lexington client you’ll have cash and bonds to cover you for at least five years of income, and you’ve got equities that are for five years from now onwards. 
• Over the next five years we’re likely to have at least 5-10 more mini crises or big crises come our way. It doesn’t matter if it’s a bank failure, a pandemic, a terrorist event, a tech bubble or whatever. There’s always going to be something and you really have to step back, look at it from 40,000 feet and ask yourself “are people not going to be going to McDonald’s, buying Apple products, or watching Netflix in five years over this?”  The answer is, of course not. One way or another, we’re going to get through this and the markets are going to move on.

Make sure your investments match your goals and you don’t have to worry about these things day to day.

No predictions, but I’ve walked you through the three scenarios. I would be surprised if we saw what we’re seeing right now, which is the actual failure of the bank without everyone being guaranteed.