Interest Rate Hikes Break Silicon Valley Bank [VIDEO]

When the Fed raises rates, something breaks

This adage has been a primary source of anxiety for investors over the past year as the Fed has raised interest rates to combat inflation.  Despite these hikes, the economy has remained surprisingly resilient with solid GDP growth, low unemployment, and healthy consumer spending.  As elevated inflation persisted, the Fed continued to crank interest rates higher and faster than any other tightening cycle since the 1980s:

While stock and bond prices slumped with this climb in rates, it took 8 interest rate hikes totaling 4.5 percentage points to finally break something. That “something” was Silicon Valley Bank (SVB). 

Silicon Valley Bank was not your average regional bank

On the surface SVB looked like most banks.  They took in deposits, paid interest to their customers, made loans and received interest payments on those loans.  They held reserves to meet anticipated withdrawal requests and invested excess deposits.  Their goal, like all banks, was to earn a healthy net interest income (NII).  NII is the difference between the interest income a bank earns on its assets (loans and investments) and the interest it pays on its liabilities (deposits).

It turned out  Silicon Valley Bank differed from most other regional banks in three critical ways. First, its deposits were largely from start-up technology companies and venture capital firms.  Second, deposits from this niche industry skyrocketed over the last few years as start-ups raised vast amounts money from investors and parked it at the bank.  Third, instead of using those deposits to make new loans to consumers and businesses, SVB purchased U.S. Treasury bonds and agency mortgage-backed securities with long maturities.  While long duration bonds offered relatively attractive yields during the pandemic and contributed to SVB’s NII, these bonds were primed to decline in value as interest rates rose.  These three characteristics would ultimately lead to the bank's untimely demise.

Fast forward to 2023

Tech companies struggled, start-ups needed their cash and SVB experienced a flood of withdrawal requests.  At the same time, the value of the bank’s bond portfolio was depressed as a result of the rise in interest rates over the last year.  SVB  found itself caught in an asset/liability mismatch.  The bank’s assets (loans and investments) were unable to cover their liabilities (deposits).  The bank was forced to sell large bond positions within its portfolio and realized billions of dollars in losses in the process.  The losses drained the bank’s capital cushions and pushed SVB to insolvency.

Similar scenarios played out at Silvergate and Signature Bank, two niche banks that focused on the crypto industry.  These two banks took deposits from crypto exchanges and other industry participants that lacked access to traditional banks due to regulatory constraints. Both banks experienced bank runs related to their own asset/liability mismatches fueled by the volatility in the crypto markets. Silvergate voluntarily ceased operations, while Signature Bank and SVB were both taken over by the FDIC.  The stock market swooned on the news.

Regulators stepped in this week to guarantee all deposits for SVB and Signature Bank. The Fed and Treasury quickly enacted emergency measures, including the Bank Term Funding Program, to restore confidence in the banking system.   It has been a volatile week.

Looking ahead

The current environment has the potential to expose additional regional banks with undiversified depositor bases, poorly positioned bonds portfolios, and sub-standard risk management.  That said, we believe regulators and the Federal Reserve have taken the necessary steps to contain a wider spread banking contagion. 

The silver lining

These developments will certainly shape the outcome of the Fed’s next monetary policy meeting March 21-22.  Barely a week ago, Jerome Powell suggested the Fed would debate the merits of a half a point hike vs. a smaller quarter point increase due to the tight labor market and persistent inflation.  While a quarter point increase is widely expected, there is an outside chance the Fed could hold rates steady to counter the after-effects of the last week. The silver lining may be that the end of this rate tightening cycle is closer than previously thought.  

Portfolio Positioning

We remain focused on stress testing portfolios, evaluating individual positions and managing cash positions, especially in light of FDIC insurance levels and the benefits of purchased money market funds. 

If you would like additional guidance or insight, please click the button below. 

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