Episode 15
THE SILICON VALLEY BANK FAILURE: THE WHAT, THE WHY, AND 4 KEY LESSONS WE CAN
Episode Description
In episode #15 of The Big Bo $how, Big Bo (a.k.a. Jason Blumstein, CFA®) discusses the recent sudden collapse of Silicon Valley Bank, the 2nd largest bank failure in US history. The $how takes a deep dive into:
What happened?
How and why this happened?
What's next and where do we go from here?
4 Key Points you can learn as it relates to personal finance
Hope you enjoy the $how!
Episode 15 Key Takeaways:
00:00 A high-level look at how the digital age makes it easier for a run on banks to occur.
03:56 Analyzing how banks make money, and how Silicon Valley Bank’s practices differed from other banks.
09:50 Diving into the data behind Silicon Valley Bank’s poor risk management.
16:11 Comparing past economic crises to learn from the different causes and outcomes.
21:53 Lessons individual investors can learn from Silicon Valley Bank and apply to their own financial futures.
25:11 Understanding the risks and limitations of FDIC insurance.
Episode Transcript
Welcome to Episode 15 of The Big Bo $how. We have a timely show with the collapse of the Silicon Valley Bank, and the takeover of Signature Bank. There has been a lot of hysteria, a lot of information out there. So I thought a nice show. I would go over what happened, how this happened, what I believe is next, and stick around to the end, where I give four key points that we can all take away from this lesson on your path to long term sustainable wealth. So sit back, relax, and welcome to a special episode 15 of The Big Bo $how.
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Alright, let's get started with episode 15 of The Big Bo $how. We're gonna kick off and we're gonna go into what happened. So what happened is that last week, Silicon Valley Bank, the nation's 16th largest bank was taken over by the regulators. And over the weekend, we learned that Signature Bank was also taken over by the regulators, this was back to back the third and fourth largest bank collapses in our country's history. Without going into too much about the types of clients they served. Silicon Valley served a lot of clients in the tech and venture capital community. What simply happened was that there was a classic run on the bank, there were some issues that were going on in Silicon Valley Bank. And then there's bloomed into some mass hysteria in the digital age. And there's a big difference between the digital age, which has a lot of pros. But there also are cons and news moves fast and things happen quickly.
So if you think about a classic run on the bank, which is what happened here, in both cases, even if we go back to 2007, to 2009, digital banking wasn't as prolific as it is today. And it definitely definitely wasn't happening as big as it was in the 80s, or even battled back to the 30s. So if you had a classic run on the bank, even going back to 2007, people would literally have to line up at the bank to get their money back. And most people, or a good amount of people will probably see those lines and say, You know what, I'm not going to wait on those lines, nevermind the people that are waiting for 5, 12 hours to get their money back. And it's a slow process. These days, with digital banking, you don't even have to show up at the bank, you can log into your app, press a couple buttons and request your money back. So when people had mass hysteria, it only took a matter of moments for everyone to start requesting their money back. So that was the top of sort of what happened.
So let's dig deeper into the fundamentals of how and why this could take place at Silicon Valley Bank. Because if we understand the why, and we understand the knowledge, we can see how we can potentially fix this going forward and if this is going to potentially affect you. So let's take a step back and let's just understand the blocking and tackling. Being a former offensive lineman, I always like to understand the blocking and tackling what goes on in the trenches and understand the business models of how a company operates.
So how does a classic bank operate? a bank operates by simply taking in deposit your cash, which is an asset to you is actually a liability to a bank. When you deposit $1 into a bank, the bank has what's called reserve ratios, and they have a 10% reserve ratio. This number has been around For many, many, many years, so every dollar that you deposit into a bank, they only have to keep 10 cents of it, and they can lend out 90 cents of it. And this is how banks start to make money, they take your deposits in, which are liabilities, and then they make assets to try to make money off of your deposits. And the way they simply make assets is they typically convert them to loans. They either can give people, mortgages, car loans, different types of loans, that the bank will earn a spread on. So if they're writing a loan, let's just say a 4% interest, and they're paying depositors 1%, or 0%, they make that spread. Now, there's another way that a bank can also make money, they can invest these deposits into highly secure government backed securities, whether it be treasury bonds, municipal bonds, mortgage bonds, backed by Fannie and Freddie agency bonds. So they can typically do fairly simple one or two things alone to make interest or an investment to make a return.
Now, in the case of Silicon Valley Bank, I took a look at how they broke down their assets between loans and investments, compared it to a few other banks to try to get an apples to apples comparison to see if what they were doing was normal. And I took a look at a few banks that are competitors, or people who also think they're like to like in the First Republic, and also signature which got taken over. And then I also looked at it, versus a behemoth and JP Morgan, to try to get a little more nuanced to see if what they were doing was similar to what other banks would be doing. So in the case of Silicon Valley Bank, they took their deposits, and created assets. In the case of loans or investments. The big difference between Silicon Valley Bank and everyone else is that all of their assets, they only lent out 32%, or converted 32% into loans. And the rest were investment. This compares to First Republic, which had 77% of their assets in the form of loans, Signature Bank, which was at 61. And if you drill down into JP Morgan's, they're just our Consumer Bank, from what they disclose that number is 89%. So you see a huge difference between Silicon Valley's assets, and their blocking and tackling of what they did as a bank versus everyone else, again, their loans 32% First Republic 77 signatures 61 JP Morgan 89. So that means the rest of their assets, or in this case, roughly, call it 68%. We're in investments.
Now, before I get into the investment side. The other issue with them was that if you break down their accounting, pretty simple, and accounting number one equation you'll learn is assets minus liabilities equals equity. So you have your assets, you have your liabilities, which we already discussed, or your deposits. And the difference is equity. Now, that equity gives you a buffer in case something ever happens to your assets. In the case of Silicon Valley Bank, their equity percentage of their assets was 3.2%. This compares to First Republic, which is closer to nine Signature Bank, which is closer to eight, and JP Morgan, which was closer to 10. So again, smaller amounts of equity, not doing the plain vanilla loans that most banks do with their assets. So now, let's just dive a little bit deeper. And I know this stuff is very technical, but I want to make sure that we fully understand what's going on here to see if something like this can happen at another bank or a lot of questions that people are asking, are my deposits safe.
So let's dive deeper into Silicon Valley's investment. They were investing in Treasury bonds, highly safe bonds and the issue that they took on was that when you buy a bond, you can either buy a short term bond, a medium term bond, or long term bond. And all these bonds have different risks. And as the further you go out, when you purchase a bond, what you're doing is you're typically taking on this concept called duration risk. And duration is simply a measure of how fast you're going to get your cash flows back from those bonds. And duration is typically bad in a rising interest rate environment. So what Silicon Valley Bank did was that a lot of their investments that they bought weren't necessarily risky investments, they just bought medium long duration bonds, which from what I've read, had a duration of about six, and the interest rates on their bonds was roughly 2%.
So again, getting very technical here, but I think it's a good way to help people understand. So the way this equation will work is if you have if your bond portfolio had an interest rate of 2%, and a duration of six, if interest rates go up 1%, the value of your bonds will go down 6%. Interest rates and duration are directly or indirectly correlated 100%. So a 1% interest rate movement up your duration, six, the value is going to go down 6%. And it works on the flip side. So last year, as the Fed was raising interest rates, as interest rates went up. And last we checked the interest rates on the 10 year treasury, which is a good proxy for medium to longer term dated Bonds, was about three to 4%. So let's say three and a half percent. So if interest rates went up one and a half percent from the two that they had locked in, that tells me that the value of their bond portfolio went down 9%.
So let's take a step back here, because earlier, we talked about how they only had equity of three. So if the value of your assets go down by nine, and you only have a 3% equity buffer, you have negative equity, essentially, the bank starts to become insolvent. Now, is this bad, it gets a little bit more complicated there. Yes, and no, see, these bonds, if you hold the bond to maturity, you will get your money back to par. So even though it went down, in the short term, this 9%, if you hold the bond to maturity, will eventually go up to the preceding value or what's called par, so where you will eventually get your 9% back. So it doesn't become bad, unless people start demanding their money back. So if you have a long duration, asset, and a short duration liability, again, their liability or deposits, which people can request back whenever they want. And you have a long duration asset, which, again, you're not going to get back. In this case, on average, it's for six years, you have what's called an asset liability mismatch. So in my opinion, what happened to Silicon Valley Bank was just terrible risk management by the management team. There's no other way to sugarcoat it. This is not economics, one on one or finance one on one. But if you're the CEO or CFO of a bank, you have to understand this stuff.
So this was just terrible risk management by the management team at Silicon Valley Bank. And if you check their numbers, you check your disclosures and you look at it versus other banks. It's there you can see it. So the question then comes into what's next. So what we saw over the weekend, is that the government came in and gave an implied backstop of all deposits to come the hysteria of what's going on. And the thing I think people need to understand or people need to do to do due diligence on is to understand if other banks have this asset, liability mismatch in duration and how deposits are structured from the comparison I did for a few other banks. Silicon Valley seems unique to me. I have not gone through all of them. Just a couple of likes for a while. ones that were taken over and signature, and one that people have started to hit in the first republic, compared to a huge bank and JP Morgan.
So if you want to think about it, someone texted me this morning and said, Hey, what type of regulation do you think is going to come out of this? And I said, well, first of all, with regulation, the issue with regulation is that it's always backward looking, you will make regulation on what happened in the past. And then that won't happen in the future, but something else inevitably will. So you can't regulate the fact that you're never going to have problems. Because you're not going to ever think about the problems. That's why you have problems in the first place. However, one thing that I think can be looked at is this simple asset liability mismatch, and them taking their deposits, instead of loaning out the money, investing it in long duration, assets, that does not seem to be what a bank should be doing, relative to every other bank that I looked at here. Seems like Silicon Valley was an anomaly.
Now, for what’s next in the marketplace, well no one can tell the future. However, another one of my friends last night said, Just give it to us straight. I'm sick of everyone telling me things are gonna get rosy, give it to me straight. And I always try to give it to people straight. And I also try to tell people to separate the emotions from creating long term sustainable wealth, because in times like this, there are a lot of emotions. Happiness happens again, another bank failure, another bailout, let's take a step back. And let's take the emotions out of it and just look at the numbers. So when I think about what took place with Silicon Valley, and signature, and what people were all talking about a lot of our regional banks in our country, the biggest thing that comes to my mind is what happened during 1986, through two sorry, through 1995 86, through 95. In the savings and loans crisis in our country, during that time, roughly 32%, or 1,043 of our savings and loan banks went under, and it was similar, you had higher interest rates. But in this case, and in the case of the financial crisis, a lot of those were created by bad loans. So I think that's an important distinction between what took place here in Silicon Valley Bank, and even in signature, and what took place during the savings and loan crisis and the financial crisis in 2007-2009. A lot of those issues were because people were and banks were taking out bad loans.
Again, a bank can either give a loan or invest in a security. If you give a bad loan, and people don't pay that loan back, well, that's a huge issue. Because you're fundamentally always gonna have this asset liability mismatch with giving a loan, but if you've underwrite and you give a good loan, you're gonna get your money back. So that's not what took place here, you had a duration mismatch of buying investments or highly liquid such bonds securities by Silicon Valley Bank, coupled with a massive stereo digital digital focused era run on the bank. So there's two big differences in my opinion of what took place here. And what took place during the savings and loan crisis. And during the financial crisis, one was a credit problem. One was a digital speed of age and a poorly managed company run by Silicon Valley Bank.
The other thing that I look at is, well, what happened during the marketplace, or markets as a whole during the time period of the savings and loan crisis? Because again, again, people get caught up and oh, the banking industry Oh, one bank, two banks, third largest bank crisis in our history, or fourth largest? Guess what I mean, listen, money today is obviously a lot, the value of money today is a lot higher than it was in the 80s. And obviously a lot higher than was in the 30s. So just by time, you're gonna get larger numbers. Additionally, we're just talking about the banking sector, which is important, but it's not the entire economy again, and this is not a pure credit issue. So the s&p 500 takes it back to what happened during the savings and loan crisis. The s&p 500 was actually up 114% during that time period from 1986 to 1995. During the savings and loan crisis when 32% of the banks In our country failed, the s&p 500 was up 114%. And there's only two down here, it's that in 1991, it was down about six and a half percent. And then 1994 When it was down 1.5%. So, I hope during this segment, you get to understand the what, the how, the why, and what I believe is next. So I want to take a quick break. And when we come back, I'm gonna give you four key points that I think you can take for your path to creating personal, long term sustainable wealth.
Okay, welcome back. So we're gonna wrap up episode 15 of The Big Bo $how here, where we dive into what took place over the past week with the takeover of Silicon Valley Bank, and the third and fourth largest bank failures in our country. And in an effort to always share knowledge, we're going to now provide four takeaways that you can use and lessons that you can learn from this episode. Because in life, it's always important to learn from either your mistakes, or other people's mistakes. Because if you make a mistake, and no one learns about it, that's an issue.
So let's go with the 4 key takeaways here. The first one is stretching for yield, or stretching for return yield. Similar basic concept, the higher the yield, the higher the risk, what took place with Silicon Valley Bank was that they got such a huge rush of deposits. And instead of taking the time to underwrite and have good loans, which is what a bank should do, or sit in short term treasuries that match the liabilities of their deposits, they stretch for you, and they stretch for return. And they took on longer duration assets that had a higher yield, but also had unnecessary risk that they should not have taken. So a lot of times when people stretch for yield, or stretch or return, you get yourself into trouble. Because the higher the risk, the higher the return, and vice versa. Number two, understand the concept of duration and asset liability matching in asset liability matching, you have a liability. In the case of personal finance, a lot of times it is either you're looking to start a business at a certain point, buy a house at a certain point, retire at a certain point, that is essentially a liability you have to get there. Now you have your assets or your cash or your investments to help close the gap between how you're going to get to that liability. Well, when you have a short term liability, but just say you're looking to buy a home in the next one to two years. Well, you want to match it with an asset that has similar duration.
Now retired, many people who are working with HENWYs high earners, not wealthy yet, are in their mid mid 30s to mid 40s. Their retirements are not going to be for another 20 to 30 years. So you want to try to manage those with assets that are similar in nature and sometimes and many times in the case that's owning businesses. While they have a lot of short term risk over the long term. They've had a history of getting you good returns. So again, this whole concept of asset liability matching is a very important topic and something that the Silicon Valley management team did not do properly.
Now, the third, and it seems that everyone's finally waking up to this, even though I always try to point this out to clients, is FDIC insurance. When you put your money in a bank, right now, if it's an individual account, you only have $250,000 of FDIC insurance, meaning that up to the first $250,000 in cash in your account, you are insured by the Federal Deposit Insurance Corporation, FDIC, if you have $250,001, or more, that $1 plus is no longer insurance is at risk in case of a bank failure, if it's a joint account, husband and wife. So that's $250K each goes up to 500,000. But the whole point is people, we have to understand that these insurances exist. And if you have deposits that are higher, you are taking on risk, there is risk in everything in life. If you don't want to keep your money in a bank, you can keep your money in cash in your house, which has a risk to the bank of storing your money. So we have to understand that in everything we do in life, there's certain risks, and we have to understand what those risks are. And if you do not understand what those risks are, find someone that can help you out.
The fourth important key point here is something I stressed all the time and talked about on previous shows is that boring, is beautiful. A lot of people poopoo, the fact that you can have diversification in your client base and your asset base in your investments. Silicon Valley Bank had minimal diversification. A lot of their banks, a lot of their clients were all in the same sector and had all the same makeup. Maybe they were giving loans to 1000s of different people or deposits from 1000s of different people. But they were all the same person. At the end of the day. They all worked in venture capital tech, life sciences, similar types of business models where they're not really making money, and you have to hope they make money. These are sexy industries, but they have risk again, understand your risk and understand that boring a lot of times is beautiful. When you have a bank that simply takes in a loan, sorry, takes in deposits and makes loans. It might be boring, it might not go to the moon. But you shouldn't also wake up the next day and be worried that you're not going to get your money out. Same thing with investing, focusing on the most profitable businesses. It's not rocket science, it's definitely not sexy. But if a bunch of the most profitable businesses go down, are we really worried that every single profitable business in the world is going to go on there? Probably not. So this is probably more of an opportunity to then buy more versus if you buy a business that makes no money, or has high concentration, or makes or has a weird business model. If it goes down, what are you going to do? You're not You're stuck? Are you really going to put more money into that? No, because you'd have no clue what they're doing, and they're not making any money. So again, boring is beautiful.
Those four key points:
stretching for yield, understanding the concept of duration and asset liability matching,
understand about FDIC insurance, and understand that boring is beautiful.
So with that said, I'm gonna wrap up episode 15 of The Big Bo $how. I hope you liked it, hoped you understood and got some knowledge from the show.
And I will wrap up this show as I do every show, saying to live a life of integrity. Always obtaining knowledge. And always live a life that you're passionate about.
Until next time, all the best. Thank you for tuning into The Big Bo $how.
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