Top of Mind: Breaking Down Silicon Valley Bank’s Collapse and the Contagion Effect | Aspen Funds
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Top of Mind: Breaking Down Silicon Valley Bank’s Collapse and the Contagion Effect

Join co-hosts Bob Fraser and Ben Fraser as they break down the factors that led to Silicon Valley Bank’s collapse and analyze the potential ripple effects on the market. You’ll learn the answers to these top of mind questions – How did Silicon Valley Bank get taken over by the FDIC within 48 hours? Is this a broader issue in banking? Is this the beginning of a contagion? What are the bigger implications?

Connect with Bob Fraser on LinkedIn https://www.linkedin.com/in/bob-fraser-22469312/

Connect with Ben Fraser on LinkedIn https://www.linkedin.com/in/benwfraser/

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Transcription

Ben Fraser: Hello, and welcome back to the Invest Like a Billionaire podcast. I’m your co-host Ben Fraser, joined by fellow co-host Bob Fraser, and today we could not help ourselves. We had to get out an episode on our Top of Mind series on recent events. Right? And what’s the recent event that everyone’s talking about Is Silicon Valley Bank basically within 48 hours not being an operating bank anymore.

And so we’ve got a lot of questions from listeners and folks just asking what happened, right? How did this bank, that was a behemoth, I think it was what, the 18th largest bank or 15th largest bank in the country and the second largest bank failure in the US history. Is taken over by FDIC within 48 hours.

We wanna just to kind of jump on talk about what happened, right? And really break it down. And then talk about is this a broader issue in banking? Is this the beginning of a contagion? Right? And what are the bigger implications? So Bob, talk a little bit about SVB. What are they known for? What is SVB?

Bob Fraser: They’re the biggest bank in Silicon Valley. They’re called Silicon Valley Bank. So they have a lot of venture capitalists, venture capital firms, venture capitalized firms, but they’re just a regular bank. Although they’re they’re very, very different from other banks.

95% of their deposits were not FDIC insured. So the FDIC has insurance limits. Right. And where the normal bank is 50%. So normally for most banks, 50% of their deposits are FDIC insured. But Silicon Valley Bank, because they’re depositors, they had so few of them who were so large they were not FDIC insured. Yeah. They had over the last three years had explosive depository growth. So their deposits tripled in size, so they got all this cash coming in, and what they chose to do at that cash, most banks, they make money when they loan it out.

What Silicon Valley Bank did is primarily bought government bonds, which is consider. The ultimate safe investment, right? Because your repayment risk is zero. Um, you’re going to get re repaid. 

Ben Fraser: I think some people, they hear banking, right? They hear maybe net interest margin and deposits and loans.

Let’s break down real quick how a bank makes money, right? Because it’s, it’s pretty simple, but I think it’s important to understand. So banks take deposits, right? From generally businesses or individuals. Sometimes you can buy deposit. And then they go and take those deposits and they’re paying out an interest rate on those, and they go, and generally we’ll make loans against those deposits at a higher interest rate.

Right? And that becomes, the spread between those two is their net interest margin, and that’s basically their revenue that they, they drive to the bank. And so what you’re saying is they had deposit growth triple over the course of a few years and they had an issue deploying that into good loans. And so generally banks will take deposits and make loans.

That’s their core business. But because of the explosive growth, they weren’t able to deploy it into loans. So they decided to buy bonds so they can have a loan portfolio and an investment portfolio. Right. And so what they did is they bought mortgage backed securities, right? 

Bob Fraser: One of the problems with bonds, everybody thinks bonds are this uber safe investment, which they’re just not.

Bonds are not safe, and this is why. So if you buy a bond and it’s paying, you know, 2% interest rates, but then interest rates go up to 10%, just for example. Well, your 2% bond isn’t worth as much money cuz someone can go up. But why not go buy the by the 10, by the, uh, buy the 10% bond. So what should they, they need to do is discount that bond until the 2% bond is yielding at 10% because of its discount.

And those are, that’s enormous. And so what happens if you, you look right now bonds because interest rates have risen so much. If you bought a bond and you held it, it’s dropped in value and, and bonds have dropped, you know, anywhere from 25% of their value to half of their value. Very safe bonds. and what that means, if you hold to maturity, you’re not gonna take a loss.

If you just take the payments and you get paid off, you will not take a loss. But if you sell into the market, the market price has dropped. 

Ben Fraser: And so explain, explain hold to maturity, right? So bonds have different durations or length of times that you have to hold them and you buy it at a, at a fixed price.

And if you hold during that whole duration, , you basically realized the yield that you originally purchased it at. Right. You’re, you don’t, 

Bob Fraser: you’re gonna get your 2% yield and your principal back, you know, so, right. So there’s no, not risk from that regard, but if you have to sell it, there is risk. Right?

Right. It’s like your house drops in value by half according to Zillow. Well, as long as you don’t sell that house, you don’t have any losses. Right. But, but if, if you have to sell it suddenly, then you’re gonna be in trouble. And yeah. So that’s really where these, the, these banks are. So the regulators do not require, Bankers to mark their losses to market so they don’t have to worry about these, these losses.

They can just, they say, I’m gonna carry, hold them to maturity and they don’t have to take ’em as losses unless they do sell it, then they have to take it as losses. And that’s, and, and Silicon Valley Bank did that. They actually. Uh, sold a bunch of their, their, their portfolio of bonds at losses, and it spooked, um, depositors.

And so depositors on Thursday took out 45 billion in withdrawals. That’s a lot of money. And, and so they really pushed on the, the, the liquidity problem with the, with the Silicon Valley bank. And, and so that’s when they came in and, uh, and took it. 

Ben Fraser: Right. And this is, this is what’s called the classic, you know, run on the bank scenario where, um, they cannot meet the liquidity needs, more demand for withdrawals, uh, were available than they had cash to, to provide.

And, um, F D I C stepped and took over. So we’ve, we’ve done a little bit of analysis here and, uh, you know, really to one assess is. Like the, the first domino to fall in the broader, you know, banking system. Right? And are there gonna be a lot more of these things that happen? Um, but before we can really answer that question, we gotta look at, you know, is SVP kind of a unique, in a unique situation?

And, you know, some of the things that Bob already mentioned, the, the, it seems to be yes. So because they had a larger portion, of their portfolio in investments in, what was the, the stat we’re talking about before here? Uh, bank of America did some analysis. I think it was 70% of their earnings were coming from investment bond or their bond portfolio.

Right. Which I think they’re, their B bond portfolio was yielding less than 2%. So that’s, that’s, you 

Bob Fraser: know, which means there was, it was the, the majority of their asset base by far was government. and the time when the government raised rates and those bonds crashed in value. So it’s kind of ridiculous. I mean, honestly, it’s kind of ridiculous that these guys failed and there was a lot of missteps and really poor risk management on their part.

Yeah, but it, and underlies, you know, you know, I’ve been through many, many cycles and you know, it said when the fed raises, raises, rates, something breaks somewhere. And it is always true. You, but you, it always breaks different than anybody predicts, right? . But something breaks cuz people use that low leverage to do things that they shouldn’t do.

Right. They use the, the, the low interest rates to do stuff they shouldn’t do. And when new rates go up, it, it exposes them. Right? And, uh, and you know, I, I think Warren Buffet said it colorfully, uh, you know, when the tide goes out, you find out who’s been swimming naked, , and, uh, you know, so, so they were swimming naked and the tide went out 

Ben Fraser: What’s interesting to me is as we’ve, you know, kind of have shared, is that this feels, obviously there’s some big issues because a lot of banks.

Hold bonds as part of their portfolios. Right. And a lot of banks have unrealized losses. Right. But what was so unique about Silicon Valley Bank is the, the magnitude, uh, relative to other banks of investments and specifically mortgage backed securities that had. A long duration, which really matters, right?

Because, uh, the, the, the length of time you have to hold these assets to hold the maturity, to get your yield and not take a loss is longer. And then you think about the type of clientele that S V P S V B served are tech companies, right? That have raised a lot of money from venture capital to go put all that cash.

in deposits, and you know, as of the past few months, it’s a lot of harder to raise money. So these companies are now pulling on these deposits to fund cash flow and so they, they have what I would consider a much higher. , uh, withdrawal rate risk than most banks, right? The, their, their clientele have to access the cash in generally higher amounts than other banks.

Um, so it, it seemed like a big mismatch of, you know, the investment that they’re trying to, investments that they’re trying to produce, return on and matching, um, really the, the needs of the client and of the bank. And, uh, they didn’t have really any hedging in there because a lot of banks. They will do interest rate swaps.

Bob Fraser: Usually that’s on their loan portfolio, not on their investment portfolio though, right. , you know, so and so what’s happening? A lot of banks are probably under pressure. You know, I know banks right now that are not selling, they were wanting to sell, but they’re not gonna sell because they don’t want to take the loss on their right, on their bond portfolio.

Um, they’ll just rather hold it and let those things pay off, and then they’ll be fine. Um, so, but you have banks that are, their equity positions are being, are being, are being suppressed because of this bond portfolio. So it, it does mean banks are under a little bit of pressure that have a very high bond portfolio like this.

Ben Fraser: Right. So one of the unique things with this is because I believe these rules on marketing to market, which just means writing the, the fair market value on your balance sheet of what these, you know, loans or investments are currently was changed after the great financial crisis. Right, right. And it’s, it’s helpful in a lot of ways because banks operate off of tier one capital, which is how much equity that they have in the bank that they can use the loan against, but these unrealized losses don’t really matter generally against the overall health of the bank.

they don’t need the liquidity, right? So it was kind of this perfect storm where they did have a lot of loans. They were producing most of their income from investments. They have clientele that had inordinate, you know, need for, for cash, and they couldn’t meet the liquidity needs and it just snowballed so quickly.

I think that’s what’s so surprising about this is how, how quickly it happened, but, Thankfully, what we’re seeing is the Federal Reserve just announced that they are gonna come in and back all the depositors. Right. And 

this is which, that’s exactly what needed to happen, you know? Yeah. You know, just like the, the 2008 crisis.

You know, our regulators and the Treasury Department did the right thing. I mean, we, we would’ve been through another Great Depression in 2008. Yeah. I’m very convinced. Had they not stepped up with the bailout programs they did. We were in a negative spiral. So our regulators seem to have their act together and very smart.

And so the backing deposits is exactly what they need to do. Yeah. Here. And, and then they, they’ve just put in this new program as well. What do they call it? The bank term funding program and what that means is they’re making short-term loans available to any qualified bank and pledge their bond portfolio at par.

Hmm. Yeah. So they just fixed the problem. I mean, they basically Wow. Nailed the problem. These are doctors who’ve found exactly what the problem was. They understand these bond portfolios are a giant black hole sitting there in the middle, middle of your bank. Yep. And they just fix it. We’ll loan, if you have a dollar’s worth of a bond, we’re gonna loan you a dollar on that.

Wow, so, so basically because the risk here, if you hold, if you hold a bond of maturity, you’re not taking a loss. But if you have to access cash in the short term, You will take a pause, but now the Fed is saying, Hey, we will, 

Bob Fraser: honestly, they just fixed the programming exactly like it should have been fixed.

They fixed the problem and because they just did what they did. My personal opinion is there’s gonna be no issue. I mean, there might be some fear factor issues, right, of other banks, you know? Um, and, and right now you’re seeing some banks, right? There’s a bunch of banks that are under pressure right now that are, their stocks are being sold off.

So there may be some banks that. You know, a couple banks that, that, that fall, but a broader contagion is not gonna happen. Yeah. 

Ben Fraser: It, and to your point earlier, I mean, so the FDIC is another kind of backstop, but it didn’t really help in this case because, because it’s so many large deposits, it’s so many large depositors, but for most individuals, right, it’s even aside from this, this new rule that the Fed just came out with. That’s what the FDIC is here for, is to protect the fear factor. So, yeah, very, very interesting. Um, I’m sure we’ll be seeing a lot more headlines in, in a lot more kind of inside scoop of what really went, went down. I mean, I think we know really the, the broad strokes or the story here, but our opinion is, it’s probably limited in scope and impact in banks. The Fed is sometimes they make good decisions and this seems to be one of those that definitely helps to backstop a broader fear in the market that would, cause a, a bigger 

Bob Fraser: issue. Time to go buy good banks on.

There you go. Fire sale prices. 

Ben Fraser: There you go. All right, well thanks so much for tuning in everyone and uh, would love to hear your thoughts. So we have a way for you to ask us anything on TheBillionairePodcast.com. And as always, we appreciate your feedback and reviews to help us spread the word and get this podcast out to more folks that you think would be interested.

Please share it and, uh, thanks so much for listening.

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