What Happened?
SVB, like all banks, was highly leveraged. Before the collapse, SVB had only 8% capital, which in the world of banking, is considered well-capitalized.
When a bank is highly leveraged, even a relatively routine loss in on the asset side of the balance sheet can wipe out its equity. That’s what happened to SVB.
SVB’s management invested too much of their portfolio in “safe” mortgage-backed securities.
Although these assets are usually considered “safe” from the point of view of credit risk, the “safe” ignores the important factor of interest-rate risk.
Interest rate risk is measured by a number called “duration.” The duration of a bond is, approximately, the amount that the bond will fall in market value if the interest rate rises by 1%. When interest rates increase, the value of fixed-income assets such as bonds or mortgage-backed securities decreases. (That is a fact of finance.) Mortgages typically have a duration of over ten years. They also have a nasty characteristic called “negative convexity” which means that their duration gets longer (everything else equal) as interest rates rise.
These financial characteristics of mortgages are well known to anyone with any degree of fixed-income experience. The duration mismatch on SVB’s balance sheet would have been obvious to a first year finance student. It remains to be determined who at SVB made and approved these high-risk investments.
When the Fed hiked interest rates, the value of SVB’s portfolio declined. At the end of 2022, SVB had lost 15.9 billion dollars on a mark-to-market basis. This means that if they tried to liquidate their entire bond portfolio by selling it at market prices, they would’ve lost 15.9 billion dollars.
Simultaneously, startups were having trouble raising money, so they had to withdraw deposits from SVB.
Higher interest rates, therefore, hit SVB with a double-whammy: the value of their mortgage-backed investment portfolio declined, and depositors wanted to withdraw money. To pay all the depositors, SVB sold $21 billion of bonds at a $1.8 billion loss. Then SVB’s management announced that SVB would raise capital to cover the loss. Depositors freaked out and began withdrawing their money, and SVB could not pay all the depositors. The FDIC seized SVB.
If Silicon Valley Bank had exposed itself to less interest-rate risk by keeping its investment assets with a much shorter duration, it would not have lost as much money when interest rates increased.
The Fed and FDIC policies suggest inflation will continue
In addition to SVB, two other banks failed in the past week. Multiple bank failures led the former chair of the FDIC to advocate for the Fed to stop hiking interest rates.
Fed chairman Powell has been increasing interest rates because he believes (though why is not clear) that raising interest rates is the way to fight inflation. (Paul Volcker, the Fed Chairman who brought down the inflation of the 1970s, explicitly said in his memoir Keeping At It that he never targeted interest rates to bring down inflation. Inflation is proven by thousands of years of history, and by economic theory, to be the result of rapid increases in the money supply. See our book HERE.) Powell seems to view interest rates as his only tool for fighting inflation. If he is right, and if he stops increasing interest rates, inflation might accelerate.
Inflation is primarily a function of the too-rapid increase in the money supply. In the banking system today, bank deposits are a huge part of the money supply.
That’s another reason why inflation is likely to continue: the FDIC is going to bail out SVB’s (and other banks’) depositors.
If the FDIC did nothing, many depositors would lose a large fraction of their deposits. This would reduce the money supply, and everything else equal would tend to bring inflation down.
Instead, the FDIC is going to compensate depositors for everything that the bank was supposed to pay. This will prevent the contraction of the money supply that would otherwise occur.
The FDIC claims this won’t cost taxpayers, but where else is the money going to come from? If it doesn’t come from taxes, the money must be printed. So, rather than allow this natural consequence of increasing interest rates to reduce the money supply, the FDIC, no doubt with the approval of the White House, has decided to create new money. The creation of new money causes inflation.
How can you protect yourself?
You can protect yourself in a variety of ways, including diversifying your assets so they’re not subjected to one risk (such as interest rate risk).
If you have clients with big gains, chances are one excuse they have for not diversifying is the reluctance to pay big capital gains taxes.
For these clients, a 664 Stock Diversification Trust could be their best option.
Here’s how it works. A stock owner contributes stock to the trust, tax-free. The trust then sells the stock, also tax-free. In fact, the trust is tax-exempt, and you can use it as a tax-deferred investment vehicle. Your clients only pays tax when they receive income from the trust.
If you think a 664 Stock Diversification Trust could be right for one of your client situations, please reach out to us. You can use the form on our website to schedule a meeting with us, or call our office and ask for Connor.
This post was written by Katherine Silk and Roger Silk. Roger D. Silk holds a Ph.D. in applied economics from Stanford, and is the author of the recently published book explaining inflation,Politicians Spend, We Pay, available here. Katherine Silk holds a MA in history from Stanford.
Click here for to enter a drawing for a free copy of the book.