SVB, the FDIC, and Are You Really ‘Insured’?

Issue LV

✌️ Welcome to the latest issue of The Informationist, the newsletter that makes you smarter in just a few minutes each week.

🙌 The Informationist takes one current event or complicated concept and simplifies it for you in bullet points and easy to understand text.

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Today’s Bullets:

• SVB in a nutshell

• Bank contagion?

• State of the FDIC

• How to protect yourself

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Inspirational Tweet:

Gabor Gurbacs @gaborgurbacs

There is more than $22 Trillion in the U.S. banking system. The FDIC has $124.5 Billion on its balance sheet and a $100 Billion line of credit from the U.S. Treasury. FDIC assets cover only 1.26% of deposits. About the size of Silicon Valley Bank. One bank. Let that sink in.

Unless you’ve been living completely off-grid or binging on the TV-series Yellowstone (because how can you pay attention to anything when that show is on?!?) the past few days, then you’ve no doubt heard about the drama unfolding in the US banking system.

Silvergate crumbled last week, and this week Silicon Valley Bank imploded.

And this has everyone asking about bank solvencies, the FDIC, and insurance protection on their deposits.

But most importantly, as Gabor implies above, is your money safe?

Well, we are going to unpack this tangled mess, bit by bit, keeping it as short and simple as we can today. So, grab that cup of coffee, saddle up to the fire, and take a deep breath.

This is an important one.

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🥜 SVB in a nutshell

There’s a whole lot of blame-game going around right now, along with tons of confusion about this mess with Silicon Valley Bank (SVB).

But what the heck happened, how did it go down so fast, and what happens now?

Also, can this—will this—happen to other banks?

We will get to all of that, but let’s focus on SVB first.

SVB is (read: was) the 17th largest bank in the United States. Surprising because you’ve likely not heard much about it before this past week, but not so surprising when you consider it was the bank of choice for more than 50%* of all venture-backed tech and life science companies in the U.S. (Source: SVB Investor Relations page).

I’m not going to get into the forensics of the balance sheet and untangle all the assets and liabilities here. That’ll likely take regulators and bankers weeks to do themselves.

Instead, let’s keep it high level today and simplified for everyone to grasp the main issues to understand the risks around us and ahead.

On the face of it, as Gabor points out above, Silicon Valley Bank had $209 billion in assets and over $175 billion in deposits.

Yet, they couldn’t redeem $42 billion to customers who wanted their money back.

Why?

Was it fraud? Poor lending practices?

Actually, it was something much simpler, a mere mismatch between assets and liabilities.

A classic setup for a bank run and hence a bank failure.

If you want to dig in deeper into the overall banking system, or just want a refresher, I wrote a whole article about fractional reserves recently. You can find it for free here:

Is Fractional Reserve Banking Doomed?

For the TL;DR people, it works like this:

Bank takes deposits from customers, both individuals and businesses → Bank then invests most of those deposits in loans or low-risk securities (i.e. Treasuries), keeping some cash on reserve for when a depositor wants their money back

In other words, when you deposit your money in the bank, it is no longer yours. It is a loan to the bank, an IOU that they put on their books. They owe you that money back. But they’ve lent much of it out. Most banks have just 10-15% of the assets (not cash—this is an important distinction, and we will come back to it) that they have borrowed sitting in their own accounts, and a measly amount of actual cash sitting in their vaults.

The beauty and wonder of Fractional Reserves.

Sure, there’s all kinds of fancy terminology and images of vaults and frontier wagons and all, but in reality, you are trusting the bank to pay you back.

You are trusting the system.

Bottom line, if all the customers want their deposits (their ‘money’) back, if they want to withdraw it from their checking or savings accounts, the bank cannot possibly meet all those obligations at once.

They certainly cannot give you actual cold hard cash from their so-called vault.

This is called a run on the bank and it’s how most bank failures happen.

In truth, bank cash management is more complicated and nuanced than this (read the Informationist article above), but it suffices for our purposes today.

Back to SVB. So, what the heck happened?

Remember the whole ‘Bank takes customer deposit → buys US Treasuries (so called risk-free securities) with some cash and lends out the rest’ from the explanation above?

Right.

So, SVB took deposits, lent most of those deposits to other customers, and bought US Treasuries with what was left.

Problem is, they bought a whole bunch of longer dated Treasuries, ones that had a many years to mature, and were still subject to interest rate risk.

OK, let’s back up.

Remember, bond prices are a function of both yield and duration. If interest rates rise, then bond prices fall to compensate for that move in yield. And vice-versa. The longer the duration, the more sensitive the bond is to the interest rate move, i.e., the more it will rise or, as in this case, fall.

So, as the Fed raised rates this past year at breakneck speed, the bonds that SVB bought fell in price. And if SVB was forced to sell them in the open market, the bonds would be worth less than when SVB bought them.

If SVB was able to hold them all the way to maturity, say another 7 to 10 years, then no problem. The bonds mature and the US Treasury gives SVB all the principle (plus interest payments along the way) back.

SVB is made whole on their investment.

But that’s not what happened.

Instead, depositors at SVB started to get worried about the venture capital environment. They began to worry about available liquidity for some of SVB’s customers, the loans that SVB had made to companies. They began to worry that SVB would have some customers unable to make payments. They would fail on those loans.

And customers began to worry that all those Treasuries that SVB owned were worth far less than when SVB had bought them.

So, they then worried that there would be a run on the bank. That other customers would ask for their money back and force SVB to sell those bonds at a loss in order to get paid first. They worried about being one of those left standing in the high stakes game of fractional banking musical chairs.

And so, that is exactly what happened. Worries and fears manifested into an all out run on the bank.

Risk happens fast.

SVB sold Treasuries, tried to sell more equity in the market, tried to secure additional funds, but in the end, sheer customer panic overtook them.

And SVB failed.

The FDIC seized SVB and is now running a wind-down and liquidation process.

What could they have done instead? How could SVB have prevented this?

Well, there are a few ways they could have staved off the herd. First, they could have bought shorter dated paper (i.e., Treasuries or other paper that matured in days, weeks, and months, not years or decades).

Another thing SVB could have done is hedge all that interest rate risk with swaps. We won’t get deep into that here, possibly in a future newsletter, but banks can and often do use swaps and derivatives to minimize interest rate risk.

They are called interest rate swaps, and they are quite common in the financial world. I’ve traded many of them myself over the years.

In any case, SVB didn’t use these, and when the tide went out, SVB was left short-less.

And SVB investors and depositors are now left with a loss.

The logical next question is, are SVB depositors protected by the FDIC, and for how much? Will all investors get $250,000 back? Will they get more?

And what about the FDIC? Reports have been going around that it is insolvent itself. Can it even cover the $250K insurance anymore?

We’ll get to that, but first, let’s talk about the fallout and possible contagion to other banks, as this may impact the answers to those very questions.

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🦠 Bank contagion?

Now that this has happened to SVB, are there other banks that are at risk?