Lessons from SVB

Sender Moses wasn’t directly affected by the collapse of Silicon Valley Bank (SVB); he understood FDIC insurance rules and always kept his personal and corporate cash fully protected by government guarantees. Still, SVB’s sudden collapse was shocking. The company was huge and respected in the tech industry, and it hadn’t engaged in fraud or dodgy investments. Even so, SVB and Signature Bank, another large, entrenched institution, had imploded, sparking panic and government intervention.

What unique factors and lessons can we observe in this modern-day bank run?

Borrow Short; Lend Long

Bank runs are an old problem. The typical bank’s business model is “borrow short to lend long.” Banks profit by “borrowing” money from depositors at rates that are lower than those of the loans they offer. But these loans can’t be recalled for years, while depositors can demand their cash back at any time. If depositors want more cash back than is available, the bank goes bust, spelling disaster for bank shareholders and uninsured depositors.

America’s Most Uninsured

Most people don’t have tons of cash, and regular FDIC insurance is enough for them. It’s also not hard to maneuver and find unlimited government cash protection, even for vast sums. Even so, trillions of dollars in bank deposits are left uninsured and potentially vulnerable to bank runs. Most of it resides virtually risk free at national banks, protected by implicit government guarantees (such as JP Morgan, Citibank, Bank of America, etc.), and many small banks have almost no uninsured deposits. But SVB’s deposits were 96% uninsured, and with one nudge of fear, it toppled in just a few days.

Overwhelmed

For decades, SVB executives did a good job growing the bank, balancing cash availability with the loans and investments into which they invested. Their narrow but solid customer base in tech companies tended to be cash rich. That most SVB accounts were well above FDIC insurance limits was seen as a sign of stability and strength—you can make a lot of money serving wealthy families and businesses—and the bank grew steadily. Then the government overstimulated the economy during Covid and SVB’s deposits exploded from $75 billion to $220 billion in just two years.

SVB executives used those gushers of cash to buy loads of government bonds (mainly mortgage-backed securities). These bonds were low-risk, low-return investments if you held them to maturity, in this case over 10 years. But if you were forced to sell the bonds early and interest rates rose in the interim, you faced steep losses. Still, SVB figured that rates were not going to rise and the new deposits that had flowed in would stick around for the most part, as they usually did. It was wrong on both accounts.

As the Federal Reserve jacked up interest rates, tech companies, SVB’s primary client base, were burning through their savings. SVB’s deposits were shrinking quickly, so it began selling off those long-term bonds early, but since rates had increased, they suffered steep losses. Word spread like wildfire via social media that SVP was short on cash. Since most SVB deposits were uninsured, its collapse would be catastrophic for depositors. No one wanted to be left holding the bag, so the bank run began. And since bank apps make moving funds so easy, SVB was toast in just 48 hours.

Signature Bank, also largely funded by uninsured deposits from a narrow client base, quickly found itself in a similar situation. Concerned about further bank contagion and systemic failures, the government stepped in with emergency measures. The FDIC took over the two tottering banks, declaring that all SVB and Signature deposits would be covered. SVB and Signature clients heaved big sighs of relief and the financial panic eased, but it remains to be seen if these limited emergency interventions have solved the crisis or just put a Band-Aid on deeper underlying issues. Many suspect it’s the latter.

Illiquidity Dangers Abound

Besides the obvious lesson of protecting cash in the bank, what can we learn from the collapse of SVB?

First, the risk of borrowing short to lend long or mismatching one’s cash liquidity with potentially imminent cash obligations extends far beyond banks. It’s become popular for investment managers to offer their clients cash-like liquidity for investments that get tied up for many years. If too many clients ask for their money back at once, the investment managers will be forced to sell assets in a hurry, typically at bargain prices. This can then trigger a run on the “bank.” As more investors realize that losses may in the horizon, they also ask for return of capital, forcing even more losses, and so on.

BREIT Freeze-up

Blackrock REIT (BREIT), a 70 billion real-estate fund, recently found itself in such a cash crunch. The investors were originally told that they were entitled to significant cash liquidity even though their money was tied up in real estate. In January 2023, cash-redemption requests were greater than what the fund had on hand. Managers chose to turn down those redemptions, which the fine print allowed in case of emergency, rather than be forced into selling assets in a fire sale.

BREIT, which is backed by one of the world’s largest financial institutions, will probably do okay, though its claimed returns on investment are questionable. After temporarily halting withdrawals, they were able to secure financing from elsewhere and will eventually allow investors to withdraw their funds if they wish to. Investors were inconvenienced and spooked but not catastrophically harmed.

A Hedge Fund Bust

Investors in a certain hedge fund popular with our crowd weren’t so lucky. The fund claimed to have constant liquidity but was actually invested heavily in illiquid assets. A couple of years ago, that mismatch in cash availability turned into a huge, painful mess for everyone involved. When the price of those assets collapsed, investors panicked and the fund ran out of cash. When a financial fire starts and everyone races for the exits at the same time the crush becomes deadly. It would surprise me if investors recover more than pennies on the dollar.

Note the Emergency Exits

During a widespread financial crisis, even investments that would normally be liquid can freeze up. The adequacy of exit doors needs to be considered in an emergency context. The Gemara understood that cycles vary and recommends maintaining a hefty dose of liquid cash. Investors, business owners, and even households need to have a financial emergency plan. The time to think about safety and liquidity is before the fire starts. If everyone is already rushing for the exit, it’s likely too late.

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