Understanding the Collapse of Silicon Valley Bank
The collapse of Silicon Valley Bank, Signature Bank, and Silvergate Bank sent quite a few shockwaves through the market. These collapses made markets volatile as short-term speculators rushed to trade on the news and project these isolated incidents onto the banking sector. Here at TCI, we care much less about daily stock price and much more about what it means for the safety of our client’s assets. As long-term investors, the news of the day and how markets adjust their daily prices are irrelevant to our plan, but certainly the safety of our short-term cash investments is paramount.
To not build suspense, the short answer is that your short-term cash assets are safe and accessible, and we do not have concerns about that remaining the case. For the longer answer, please read on.
All three banks had a similar story prior to failure, so we’ll focus on Silicon Valley Bank (SVB) in this section as it was the largest of the three banks to be taken over by Federal regulators.
In the simplest sense, banks fail because depositors—that is, account holders at these banks—decide to withdraw their money en masse. The core business of banking works by customers making deposits and the bank then turning around and using those deposits to lend out to others. For holding customer cash (and potentially paying those customers some interest), the bank gets access to a significant amount of capital to lend. The bank then pockets the difference between the interest they make on the loans versus the interest they pay their depositors. Modern banks typically do much more than simply turn around and hand out business or personal loans with their capital, but the basic principle of taking depositor money and investing it one way or another is the fundamental model of banking.
For this model to work, however, it assumes that the depositors won’t all demand their money back at the same time. For example, if I’ve given my bank $10,000 to hold for me and they turn around and lend that out to someone else, there’s going to be a problem if I want my $10,000 back. For this reason, banks can’t exist without many depositors which should create some diversification in the sense it’s unlikely that everyone will demand their money back at the same time. This is certainly true for the megabanks like Bank of America and Citibank, but slightly less so for regional banks who will have fewer and less diversified clients. Each of the banks that collapsed were regional banks. Nevertheless, a bank in the Midwest catering to farmers may run into trouble during a drought, for example. I mention this because the lack of diversification amongst the clients of the three failed banks is a vital part of this story that we’ll return to shortly.
So, back to SVB. It is true that SVB did, in fact, make some bad financial decisions on how they were investing client deposits. One of the largest mistakes they made was buying a lot of long-term treasury bonds prior to the rapid interest rate increases of last year.*
*Recall that when interest rates rise, the value of held bonds decreases and longer-term bonds will decrease much more than shorter-term bonds. A quick example: if I hold a 10-year Treasury bond from 2021 that is paying me 2% annually, I will get that 2% coupon for ten years and then I will get my principle back. Unfortunately, starting in 2022 I could go purchase a 10-year Treasury bond that was paying me closer to 4% as the Fed raised interest rates. If I can go buy the same safe asset that pays me nearly double on the open market, what happens to the value of that original bond? It declines because no one would pay me 100 cents on the dollar for that bond. It’s certainly still liquid, but it may only be worth 90 or 85 cents for every dollar of bond that I purchased.
SVB was sitting on a significant portion of these bonds and finally realized that they needed to liquidate and hedge their continued interest rate risk. This action in itself was bad for bank profits, but by no means does this action guarantee a bank failure. A bank that loses money in the short-term is not a bank you’d want to own stock in, but it does not have to portend complete failure. In the case of SVB, though, the news of them liquidating part of their bond portfolio at a loss combined with an attempt to raise capital elsewhere frightened their customers. This is where we come back to the lack of diversification specific to SVB, Signature Bank, and Silvergate Bank.
Each one of these banks was heavily concentrated within the tech and cryptocurrency worlds. This is an interconnected group of people and word spread quickly once a few started pulling their deposits (that word was spread somewhat prominently by large venture capital firms who advise many clients and billions of dollars). The latest news, as I write this, is that depositors attempted to withdraw $42 billion in 10 hours on Friday, March 10, 2023, from SVB alone! SVB couldn’t liquidate their positions fast enough and/or didn’t have enough easily accessible assets and thus, failure.
The bank had made financial mistakes with a bad bet on interest rates, but it was ultimately the demand from a critical mass of depositors to withdraw all at once that made these banks fail.
What appears to be a relatively isolated incident due to the factors mentioned here threatened all banks—particularly regional banks–earlier this week as fears spread. Putting the words “bank run” and “bank stocks crashing” in headlines is always going to create a panic. A substantial response from the Federal Deposit Insurance Corporation (FDIC), the Federal Reserve, and the U.S. Treasury, however, has seemed to calm the panic and decrease the potential of contagion in the banking system.
How Does TCI Protect My Cash?
Cash—in particular what we call “sweep cash”–within your accounts at Schwab or TDAmeritrade is held at a bank and, thus, is FDIC insured up to $250,000 per individual (effectively $500,000 for a Joint or Community Property account). This guarantee is the explicit promise of the FDIC and we have witnessed that system work exactly as intended this week. If a bank fails and the FDIC steps in it may result in a couple of days delay in receiving your funds, but they will be safe.
You should always make sure that cash you hold in your checking or savings accounts is in a bank that is FDIC insured and maintain balances under the $250,000 limit. If you use a Credit Union instead of a bank, they have a similar insurance program called the National Credit Union Administration (NCUA) that has the same $250,000 protection limits through their National Credit Union Share Insurance Fund (NCUSIF).
As evidenced by the actions of the last week, the FDIC has made an implicit promise that deposits above that $250,000 will be made whole as well. Those with accounts that exceeded the explicit $250,000 FDIC limits at SVB and Signature were made whole by the FDIC. That is not something we should count on going forward, but the Feds have sent an important message this week on protecting deposits and trust in the banking system. Note this is not a bailout of the bank executives or stockholders who have seen the value of their investment drop to zero.
How Are Money Markets Protected?
As TCI clients, you may have some short-term investments in purchased money market funds. These are investment products that may look and act like cash but have significant differences. These products typically invest in short-term securities that seek to achieve a higher rate of interest than simply holding FDIC insured cash deposits. Since they are actual investments, these money market funds are NOT subject to FDIC insurance.
Money market funds are different than bank deposits, however. Money markets hold all their funds in securities as opposed to banks which keep a small percentage of their deposits in reserves. Thus, a “run” on a money market where everyone was seeking to pull their money out at the same time wouldn’t have the same effects. It could technically result in a loss in value if the underlying assets had to effectively be sold off in a fire sale. Some money markets approached this point—referred to as “breaking the buck” since all money markets are priced at $1 per share and then pay interest—in the financial crisis of 2008-2009. This was largely because they had gotten too risky in their underlying investments and ended up having significant assets in mortgage-related securities that proved to be worth much less than expected as the housing bubble burst. Even back then, the Federal Reserve and U.S. Treasury took extraordinary measure–including purchasing those distressed securities at full value–to keep money markets intact.
We have a due diligence process at TCI that makes sure any money markets we utilize have ample liquidity to cover these exact situations since they are true investment products—much safer investment products than stocks or bonds, but investment products nonetheless.
In addition, these products are protected by something called the Securities Investor Protection Corporation (SIPC). SIPC protects you from the failure of Schwab or TDAmeritrade in which a federal trustee would step in and make sure the securities you own (the mutual funds, stocks, and ETFs we invest in on your behalf) remain in your possession. In practice, this often happens by having customer accounts of the affected firm transferred to another. SIPC also protects against fraud or errors on the firm’s behalf up to $500,000 per individual.
Finally, Schwab and TDAmeritrade have an extra level of coverage through Lloyd’s of London that can be thought of as “excess SIPC” coverage. This amount extends the coverage limit up to $150 million per client.
Keeping Your Assets Secure
As long-term investors at TCI, we are willing to tolerate short-term price changes in the pursuit of steady, long-term returns with our mutual fund and ETF assets to accomplish our goals. What we do not tolerate is the complete loss of our safer assets due to institutional failure, fraud, or misrepresentation. This is why we work with institutions that have the protections described herein. As we’ve seen this week, they work as intended and are an integral part of our financial system.
As always, we are here for you with any questions or concerns you have. Thank you for your continued trust in TCI!