This post chronicles SVB’s fall from grace through poorly drawn doodles.
Before we talk about the present, let’s talk about what SVB’s fund allocators did a few years ago:
To balance their portfolio, they purchased low-yield, long-term bonds.
Now, back to the present: interest rates have risen from 0 - 0.25% to 4.5-4.75% pushing down the value of those bonds. Why?
Let me explain it using chickens, eggs and a chicken coop.
Let’s say that a chicken coop represents your cash. You own it. You can use it whichever way you like. A chicken is a debt product such as bonds, securities etc. You can give your chicken coop (money) to it, and, in return, it’ll generate eggs, aka interest.
Now let’s say that a few years ago, chickens were laying one egg per year. That was the standard, acceptable rent. At the same time, you had an empty coop, not generating any eggs. So you reached out to a chicken, signed a 5-year lease at a fixed one egg per year rent, and were happy that your chicken coop would generate predictable, stable returns.
Fast forward to today, and now the world has changed. Interest rates have increased, meaning chickens, aka debt products, generate more eggs per year than they did a couple of years ago. So, instead of giving you one egg per year, contemporary chickens give two eggs yearly.
You’re in year two of your five-year lease. If you continue to let the current tenant chicken live in your coop for the next three years, you’ll essentially lose three eggs because your coop could be housing today’s chickens who pay two eggs per year as rent vs one egg.
And the market is aware of your conundrum. So it deducts the opportunity cost from the value of your coop. In other words, it values the same chicken coop that generates two eggs yearly much higher than a chicken coop stuck with one yearly egg lease.
So the rapidly rising interest rate (eggs per year) is why SVB’s debt holdings value (chicken + coop) is significantly lower than it was.
Meanwhile, SVB’s primary customers, i.e. high tech startups, are cash-strapped. They’re closing fewer funding rounds, at a lower valuation, and depositing less money in their accounts than a couple of years ago, which is why SVB was running low on cash.
So, to shore up their reserves, they devised a simple plan:
- Sell medium/long-term debt holdings and eat the loss (they sold $21B worth of long-term debt at a $1.25B loss)
- Reinvest the freed-up cash in short-term debt and recoup the loss in the next 2-3 years.
- To be extra sure that they don’t run out of cash, raise capital by selling equity ($1.75B in common stock, $500 million in convertible preferred shares)
- Write a press release letting everyone know about their plan.
- Continue to exist as one of the top 20 banks in the US.
We all know they never reached step 5 - so where did things go wrong?
Step 4!
Why?
Because of these guys:
They’re startup founders and investors who have gone through a lot in the past year. They have seen their valuations slashed, laid off their employees, and had many sleepless nights over their deteriorating balance sheets.
When they read an ambiguous press release saying their bank was selling equity to generate cash, they got spooked.
They wanted to clear out their accounts as soon as possible. In their minds, it’ll be a first come, first serve situation until the bank runs out of cash. That’s called a bank run.
If your bank holds your cash deposit as actual cash, bank runs would be no big deal. The bankers would simply open their lockers and hand over your money. But, alas, that’s not how things work.
Your bank puts your cash to work to fund its operations and generate profit for its shareholders. So, it takes your money and invests it elsewhere. Your account dashboard still shows the expected balance, but that money might not be there as physical cash.
This is why bank runs are so devastating. They’re like a self-fulfilling prophecy: the more customers panic and withdraw cash, the higher the likelihood of the bank fully depleting its cash reserves. When that happens, they can't sell the remaining assets fast enough to keep up with the rate of withdrawals and become illiquid.
That’s precisely what was happening to SVB last week. But then, the situation went from bad to worse, and finally, the feds called:
FDIC stands for Federal Deposit Insurance Corporation. They’re a government corporation with a mandate of ensuring that the US taxpayers don’t lose their hard-earned money due to either fraud or the incompetence of big banks. So they’ve taken over SVB.
What happens next?
- If you’re an SVB customer and your deposits are insured, you’ll get your money back as soon as possible.
- If you're not insured, things might get tricky. FDIC will create a cash pool by liquidating SVB’s assets. Your total amount will be returned if that pool is large enough to cover everyone’s deposits. If not, then you might lose a certain percentage of your assets.
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SVB defaulting could have severe repercussions for the tech world. Thousands of people might lose their jobs. If you’re a CEO, Founder or Co-founder of a US startup, please consider signing this petition: Y Combinator petition.
#siliconvalleybank #svb