Stewart Hotston

Silicon Valley Bank, a regional American bank with a focus on funding venture capitalists and tech start ups.

It took the cash it had to keep as its buffer and invested it in US Government Treasury securities. USTs as they’re known are considered the single goldest of the gold standard of global investments. Absolutely guaranteed to return your money to you when they mature because they’re backed by the US Government.

You would be forgiven for thinking ‘what happened then?’

To understand what went wrong and what’s still going wrong, I need to explain how these instruments work, at least in part.

USTs are tradeable, there’s always someone who wants to buy/sell them. That means they’re what we call liquid instruments. In other words they are considered very much like cash but just in a formalised format that can be shifted between different people (imagine a glorified £10 note being passed around a pub).

Now, different USTs pay the holder a different amount because, they are after all, debt issued by the US Government and you, as the holder, as the lender. As such they US Government pays you an interest rate. That interest rate can vary. Now, assume I have two USTs, one paying 1% and the other paying 5%. The latter is clearly more valuable to me as I earn more from owning it. So I will also pay more to obtain it. This means that the 1% UST is worth less.

On the day the UST was issued it was worth exactly what it said on the front. In other words I could by a £10 note for £10. Think of it like a rare comic or action figure. On the day it’s made I can buy it from the store for the list price but by the time I get it home the resale value has changed. The comic, if kept in good condition might be worth more than the list price. Or, if they print loads more, it might suddenly become worth less (same if I tear the front cover).

All financial investors know the instruments they invest in have values which can change. Most hedge against these changes so they are not exposed to violent changes in value. Why? Well, imagine if I invested in 100bn of these instruments, paying 100bn for them on day 1 only to discover a few weeks later than their value had changed and they were worth just 50bn…that’s a loss of 50bn and, worse still, it’s other people’s money I’ve lost, money which they want back.

All of a sudden I might not have enough money to pay what is owed and, as we all know, when that happens, we go bust.

Now there’s loads of ways of managing this and it’s absolutely a normal part of running an investment book, not least a bank.

Except SVB did none of these things. It behaved like it could never lose money. Except it did and now it doesn’t exist.

The last bit happened because people got wind of what was happening and, worried about SVB not being able to pay its bills, they asked for their money. And when they did that, other people saw them doing that and did the same because if they didn’t they might end up being the ones left owed money by the bank after all the money it did have had been given to others. In other words, there was a run on the bank as all the people with savings there asked for their cash back at the same time.

So much, so It’s A Wonderful Life.

Except I’ve mentioned the cause here and moved on. Let’s circle back.

Why did those USTs change in value so much?

Because the US Federal Reserve raised interest rates. As soon as they did, all new USTs issued by the US Government would be paying that new rate (roughly) meaning that any which were issued before which paid less, were suddenly worth MUCH less. Holders of that older debt were (and are) facing significant losses in the moment. Sure, if they keep them to maturity they get paid every penny and there isn’t a loss. But SVB couldn’t hold on until maturity because people wanted their money back now.

In other words you could say that through a combination of SVBs incompetence and the Red’s raising of interest rates, the US Government bankrupted its own bank. (Regulations are in place to stop this but they weren’t enforced with this bank (and many hundreds of others and guess what, when not policed properly the banks played to the rules they did have to follow not to what prudential risk management required).

There are currently 4200 regional banks in the US. A very large proportion of them are facing something similar.

But it gets worse for us all.

Central Banks around the world have been responding to inflation by raising rates. They have done this despite knowing it’s the wrong economic thing to do because politically they have not choice. They’ve been given one hammer and hence their problems all look like nails.

Those rates rising mean that government securities across the globe are now paying more interest.

2 years ago they were paying nothing. If i invested in an office block in central london it was probably paying me 4%, an amazon warehouse might be paying me 3%, a prime hotel in the west end of London or elite Paris…2%. All these assets are illiquid – that is they can’t just be exchanged between people and their value is contingent not on rock solid governments but on tenants and performance and even the age and location of the building.

Which would you rather own? That’s right – government debt. And that’s now paying 5% in the US and more than 4% in the UK. So why on earth would you own any other asset that relative to government debt is riskier, less liquid and much lumpier. Again, that’s right – you wouldn’t.

In order for those assets to attract your attention they’d need to pay, say 10%. Now if I have an asset paying me 2m a year and that yield is 2% of its value, that implies it’s worth 100m (sorry for the arithmetic here). Now, suddenly I have to pay people 10%. I haven’t got more money coming from my shop or office’s tenants. I still only have 2m a year. So if 2m is suddenly 10% of the asset’s value, not 2%….that implies the value is now worth just 20m. In other words it’s lost 80m of value.

You could dismiss this as paper value. You would be dead wrong. Because the bank who gave me a 60m loan to buy that office is suddenly looking at the value of my asset and panicking that they could face losses of 40m if I sell it – because if I only get 20m back and I owe them 60m – hopefully you see the problem here.

I’ve used real property as an example but this is true for ALL financial instruments.

I’ve been calling 2023 the year of valuation resets. I mean that this is the year that rising interest rates reset the value of all the assets in the economy. And those values are ALL going down. In some cases by a little but there is evidence that commercial property values have fallen by 30% both here and in the US. This is a HUGE problem for investors and their banks.

And for us. Because when a bank faces losses it stops lending. When it stops lending everything grinds to a halt. When companies can’t borrow they can’t expand, they can’t grow and, more often than not, they struggle to continue making a profit.

Inflation is making us all poorer but it’s worse than that. By raising interest rates, Central Banks have created the risk of a slow spiral into a crisis where banks cannot/will not lend.

This isn’t obstinacy by the banks but a desire to protect themselves from further losses. And the secondary issue here is that this drives fear through the markets as people start to look very carefully at banks who maybe haven’t performed well historically and who might be exposed more broadly than others to these assets changing in value so rapidly and by such large amounts. First SVB, then Credit Suisse, today Deutsche Bank. None of these banks are really connected in a financial plumbing sense – they are distinct entities. Yet they are connected in that they are poor performers in a market where Central Banks are deliberately engineering a banking crunch.

I’ve written at length about why raising rates is the worst tool to use when inflation is supply side. I won’t cover those arguments again here.

However, the question remains, where do we go from here.

I refer you back to the point that there are 4200 regional banks in the US. The market probably can’t sustain that. What if they reduce to just 1000? That’s a loss of 3200 banks. Imagining the impact of that on the economy is beyond anyone no matter how smart.

The UK banking system and Europe’s too to a large extent, does not face these laxities in regulation nor the fractured market landscape. We consolidated our banking system after 2008 where the number of building societies dropped from more than 100 to less than 20. Europe did largely the same (although France and Germany in particular are likely to experience more pressure for consolidation).

That means that we may well not see the same issues here in the UK (or in Europe) that are likely to unfold in the US. Except. What happens in the US market is absolutely going to infect us.

I’m going to finish with some questions and answers.

1. Do you need to move your money? No. The UK government’s deposit scheme and our overall banking regulation is pretty solid. I’m happy that there aren’t any UK banks at risk
2. Is it possible this is all a storm in a teacup? Yes. Of course. Yet Bear Stearns collapsed in March 2008 and it was 6 months before Lehman Brothers fell apart. So just because a few days goes by without a disaster don’t assume it’s all over…I currently believe we have much more road to run before we emerge from this.
3. What can I do? Nothing. Well, don’t take your investment advice from reddit.
4. What should I do? All this may well mean nothing to you because, fucking hell, energy prices and food prices and a lack of a wage increase mean the very idea of savings is nonsense. I get it. However. if you have cash? Find high quality places to put it. And perhaps think about looking at how you might support banks who have super strong ESG credentials. I say strongly that this is NOT investment advice! It’s just my personal moral opinion.
5. Will interest rates keep going up. Very unlikely.
6. Will interest rates come down. I’m afraid that’s equally unlikely. The era of ultra low interest rates is over (for now – who knows if this turns from a slow grind of a crisis into something worse).
7. Is all this the result of people gambling in the financial markets? No. it is perhaps the absolute opposite – financial institutions have done what was required to be prudent and, in a shock move, Central Banks using the only tool they have to tackle something that isn’t a nail, have created a situation in which everyone is facing incoming pain.

What is clear to me is that, smart as they are, the complexity of the financial system and its response to rapidly rising interest rates has been missed almost entirely by those responsible for raising those rates. Why? Because they were focused on what classical economics says the economy would do if interest rates rose and never, for a moment, thought about how bank balance sheets would respond. Was this incompetence? I would err on the side of it being an area that no one saw coming but for pity’s sake we need to update economics degrees as a matter of urgency from their ideological capture by people whose theories were discredited by reality 20 years ago (I’m looking at you Friedman and Hayek and all your inglorious acolytes).

In other words I finish as I started – regulators legislate based on the last crisis and 2008 was about badly performing banks and an economy glutted on easy credit. 2023 is about a cash rich economy discovering all the things they’ve invested in are suddenly worth much less than yesterday. We didn’t legislate for this because it seemed inconceivable to us that fighting inflation would precipitate a banking crisis after we spend 15 years shoring up those same banks.