The Fall of SVB and Signature

During the past week, we have seen a return to the volatility trends that were prevalent through much of 2022. The past two trading days have been especially active, with the S&P 500 going negative on the year for a brief period on Monday before ultimately turning positive.

Over the weekend, you likely saw headlines relating to bank closures in the U.S. This started with California's Silicon Valley Bank on Friday and was followed by New York's Signature Bank on Monday. Both of these banks were taken over by government regulators, who immediately cut ties with the senior management teams.

Bank closures are a scary thing to see plastered on the news. Especially when the headlines read like this…

However, some context must be added to paint a complete picture.

The premise behind this return to volatility is mainly due to the rapid rise in interest rates during 2022. In our 2022 recap, we wrote the following summary on how a rise in interest rates affects bond prices…

Bond markets operate on a different landscape than stock markets. Bond prices rarely fluctuate to the extent they did last year. The thing that makes 2022 an outlier is the rapid rise we saw in interest rates throughout the year. At the start of 2022, the Fed had the Fed Funds rate at 0%. By the time the year finished, this number had reached 4.5%.

The decline we saw in bonds largely came as a result of repricing. In September last year, we wrote that a new 5-yr treasury bond purchased just one year earlier would have come with a 1% interest rate. On the other hand, a new bond with the same term (now 4-years), could be purchased with a 4% interest rate.

In the example above it’s pretty easy to see that the new 4-yr bond at 4% would be more valuable than the original 5-yr bond (now a 4-yr bond) at 1%. When this gap in interest rates is created the original 5-yr bond reprices itself to have the same forward looking yield as the new bond. This results in the current price of the bond falling.

At the time, this was written to describe how your portfolios were affected by Fed decisions. However, this can also help to explain how these bank insolvencies happened.

This is an oversimplification, but banks' primary way to earn money is through their ability to store deposits and lend cash. They will pay their customers/members a certain interest rate to hold their cash. That cash can then get lent out to borrowers at a higher interest rate. The spread between the interest rate provided to depositors and the interest rate charged to borrowers provides the bulk of revenues.

Another way for banks to earn money is to purchase investment vehicles, such as government bonds. These are the government bonds we referred to in our 2022 recap.

There are two primary risks that these banks exposed themselves to. The first is that their client base was not very diverse, with Silicon Valley Bank having a niche among tech start-ups and Signature Bank having a niche among Crypto investors.

These niche areas benefitted from low-interest rates from 2010-2022. They relied heavily on leverage from their assets and funding from venture capitalists, who had low-interest-rate debt of their own. Getting access to cash was very easy to do, and a lot of that cash ended up at Silicon Valley Bank and Signature. This resulted in both banks being among the top 20 largest in the U.S in terms of deposits.

However, most start-ups and Crypto investors don't have a lot of stable assets to use as collateral to get access to bank debt. As such, Silicon Valley Bank and Signature didn't have much opportunity to earn money from their lending department. This meant they needed to make money from the government bonds they purchased.

Which leads to our second risk, termed interest rate risk. Interest rate risk is created from holding long-term bonds at low-interest rates. This type of risk can generally be managed by purchasing bonds at different maturities. For example, the bond portfolios (also called bond ladders) that we currently have at Pitzl Financial get structured over a 5-yr period. This means we will have a new bond redeemed at the end of year 1, at the end of year 2, and each year until year 5. If the proceeds at the end of year one are not needed, they get reinvested into a new 5-yr bond, ultimately creating a 6th year on the ladder. This process gets repeated until the cash is required for spending purposes.

Similarly, if bond mutual funds are used instead, we seek bond portfolios with similar “duration,” which is simply a bond market term for how long the bonds have until they mature.

By structuring bond portfolios over shorter durations, you can reduce the risk of rising interest rates. As a reminder, when interest rates rise, the price of existing bonds decreases. The longer the bond term, the more a rise in interest rates affects the price.

The problem that these banks had was they invested the bulk of their newly acquired deposits in 10-yr bonds that carried interest rates of about 1.5%. When interest rates rose, the value of the bonds they owned fell sharply, resulting in significant paper losses. When presented on required filings, these losses showed that both banks had liabilities in excess of the assets they owned.

Start-up founders and crypto investors rely a lot on herd mentality. When the leaders at the top of each herd do something, the people under them tend to follow suit. Last Thursday, a few well-known founders and investors discovered the on-paper problems that these banks were having. This led them to pull out all their money and advise their followers to do the same, which turned into a run on both of the banks.

Most of the banks' assets were held in now-depressed government bonds. Because they had to come up with cash to meet withdrawal needs, banks were forced to sell the bonds for a sharp loss. Government regulators were forced to step in when the losses became too great, and it looked like customer demand couldn't be met.

In a sad stroke of irony, the same low-interest rates that built these banks ended up being their downfall.

One of the biggest worries coming out of this weekend would be how regulators would handle customer deposits. The Federal Deposit Insurance Corporation (FDIC) was created in 1933 to help insurance against runs on a bank. Since its creation, no depositor has ever lost a penny of FDIC-insured deposits.

Under current law, deposits up to $250,000 per ownership registration are fully insured. If you have more than $250,000 in deposits at a bank, you could potentially have some of your funds unguaranteed.

Over the weekend, this looked like a huge problem for customers of Silicon Valley Bank as roughly 90% of the deposits held at the bank were in excess of FDIC insurance levels. Those concerns were addressed on Sunday night. The Federal Reserve, Treasury Department, and FDIC issued a joint statement that all depositors would be paid back in full. Most of this payback will come from the FDIC Insurance Fund, while the remaining will be paid back by what is termed "special assessment on banks."

So where do things go from here? In the short term, this does not look to be a domino effect. We may see a few additional regional or specialty banks falter, but the large US Banks all look to be stable. Additionally, the government stepped in to help in a big way. Direct investments and ownership in these banks may be affected, but the deposits in cash accounts appear to be protected.

It also seems like the Fed may slow its rate hikes. The past couple of weeks have seen a continuation of strong employment levels, which led many to assume the Fed would increase rates by another .5% during their March meeting. Given the recent news, the increase will likely be .25%, or even 0%. This should provide better news for existing bonds and possibly even stocks.

An event like this also reinforces the importance of maintaining cash levels under FDIC insurance limits. Over the past six months, we have referred many of you to Flourish Cash. The accounts held at Flourish have FDIC insurance limits of $1.25mm on individual accounts and $2.5mm on joint accounts. As long as your cash balance at Flourish is less than those levels, it is 100% guaranteed yours.

If you have your cash at a regional bank, we strongly recommend keeping the balances under the $250,000 limit in any one account. FDIC insurance limits follow what is termed registration guidelines. This means that a married couple can have a joint account with $250,000 in FDIC insurance, an individual account for spouse 1 with a $250,000 FDIC insurance limit, and an individual account for spouse 2 with a $250,000 FDIC insurance limit. If you carry high levels of cash, then making multiple registrations may be prudent.

Finally, you'll likely see a lot of headlines comparing these closures to those of 2008. It's important to remember that we've come a long way in the past 15 years, and the economic conditions are very different. When Lehman Brothers and Washington Mutual fell in September 2008, our GDP was about $14.5 trillion. Since then, it has increased by more than 50% to over $25 trillion. The numbers today are just bigger than they were in 2008. Additionally, in the 12 months before Lehman and Washington Mutual fell, the economy had lost over 1 million jobs. Over the past 12-month period, we have seen 1 million jobs added to our economy.

All of this news is undoubtedly frightening, but it reminds us that risk is what we don't see coming. The best thing we can do is maintain appropriate levels of exposure and insure against the things we can't afford to lose.

As an add-on to this writing, Jared Kizer, Head of Investment Research at Buckingham, shared a 6-minute video offering his thoughts on recent activity. Buckingham is also offering a special office hours session at 1:00 PM CST on Tuesday, March 14. This is free for anybody who would like to attend. Should you want to attend, Click Here.