moneyFYI
Financial Freedom Is Merely Organized Common Sense
Overview Of The Silicon Valley Bank Failure
The Silicon Valley Bank failure has brought tremendous attention to how banking works, or. in this case, doesn’t. The lessons learned are easily applicable to our business and personal lives.
Background
The bank was a depository for cash in the start-up high-tech businesses and others who had large cash holdings to fuel their businesses. Of all deposit accounts in the bank’s care, fewer than 10% were less than $250,000, the FDIC limit for guaranteed recovery.
The bank actually paid interest on the deposits, which while still tiny, was immensely more than they could have gotten at JP Morgan Chase, which was as little as 0.001%. Even paying 0.1% is a hundred times more, and if you have hundreds of millions on deposit, it adds up.
The bank made some loans, but as a percentage of assets, their loan holdings were unusually low for a bank.
Their excess cash was a burden, and earned nearly nothing. The bank began buying long treasury bonds, which were returning less than 2%, but still enough margin to be profitable.
Until the world changed.
The problem.
There are clear lessons.
- Avoid duration mismatches. The life of the asset should be the same as the life of the financing put in place to acquire it. If the asset has a fixed return, so too must the financing have a fixed cost and exist for the time of the asset. It works the same with your finances. If you acquire an asset with a 5-year life, you should not use 10-year financing. You will owe money when the asset is used up. How long do you intend to own your car?
A business student would cover that in the first week of finance 101. What happens when the assets that support the deposits comes due in 10 years and the depositors could want money today? Nothing good, it seems. - Rising rates reduce the value of long bonds. As interest rates increased, the older bonds lost value. Who wants a 1.75% bond when you can get one at 3.75%? That value loss reduces the bank’s apparent equity, which is the margin of safety for depositors. People notice.
- Assets must pay for themselves. If you borrow, the asset purchased must earn enough, or produce other value enough, (like cost reduction) to liquidate the debt and its interest. Be fussy when choosing a college course and pay careful attention to its financing.
- Beware of volatility. People with large deposits rely on the bank’s solvency more than the FDIC guarantee. Some monitor the bank’s condition and will flee at the first hint of weakness. Withdrawable financing, or financing with adjustable terms, is very risky if assets are committed elsewhere.
We have seen the effects of people financing long-term assets like a house with floating-rate mortgages. SVB bought long bonds with short-term money. Same effect.
The future
Banks hold liquidity that, in normal times, is enough to meet routine withdrawals. Those resources are likely less than 15% of all assets. When a large account takes their money, the relative effect on liquidity is much higher than on assets. If a few do it, liquid resources approach zero very quickly. When that happens, the FDIC takes over and they are the most action-oriented agency of the government. Even the military is a sloth by comparison. In SVB’s case, they were in action within a few days.
- Expect some banks to get extra scrutiny.
- Expect some shotgun mergers.
- Expect some bank executives to have sleepless nights.
- Expect the problem to get worse. Rising interest rates make the problem more severe.
- Expect inflation to not be “transitory.” The Fed cannot shrink rates to protect the weak banks and control inflation in the face of profligate government spending.
- Expect politicians to deny their complicity in creating the problem. So no structural change will come.
- Expect taxpayers to foot the bill.
The fundamentals of finance are the same for banks, businesses, and people. Be cautious with your own financing to protect your flexibility. Be sure new income or cost savings can liquidate the financing. Paying a little more for predictability is smart.
Minimize your exposure to the kind of risks that doomed Silicon Valley Bank.
I build strategic, fact-based estate and income plans. The plans identify alternate and effective ways to achieve spending and estate distribution goals.
Be in touch at 705-927-4770 or by email at don.shaughnessy@gmail.com.
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