Over the weekend another big bank made national news for all the wrong reasons. Silicon Valley Bank, the darling of the Bay Area venture capital community and the bank of choice for numerous tech startups, abruptly collapsed. Worried about possible contagion in other small banks, the FDIC quickly stepped in and guaranteed all deposits above the normal insurance limits. But while the immediate financial fallout may appear contained for nervous SVB depositors, the ripple effects are still unfolding in the wider banking system. To put it bluntly, the whole situation is a mess.
I think it’s safe to say that most of you don’t have more than $250k sitting in cash in the bank, so the good news is that you’re probably fine and shouldn’t be too worried. But I do think there’s a larger lesson that attentive investors can learn from the missteps of SVB. So while the talking heads on TV and social media compete for the hottest take on complex banking policy you probably don’t even care about, let’s talk about a few simple takeaways for your own investments.
Why SVB failed
While the full workings of a financial institution can be mind-numbingly complicated, the core issue that caused this particular bank to fail is actually quite straightforward. It’s all about risk management.
The primary functions of banks are to hold customer deposits and offer loans. The spread in interest rates between what they make in loans and what they pay in interest is the primary way that a bank makes money. Pretty simple, right?
Well, imagine managing a bank focused heavily on financing the tech industry the last few years. COVID lockdowns and a rapid transition to work from home situations triggered a massive surge in profits for tech companies offering things like streaming video, home deliveries, and other cloud-based services. In the two years between the beginning of 2020 and 2022, SVB saw their deposits skyrocket from $60 billion to over $200 billion. That certainly sounds like a great problem to have, but if there aren’t enough high-quality loans or investments available to put that money to good use then it’s not so simple.
To make a return on the excess cash deposits, SVB turned to some of the safest investing options that are easily available — US government bonds. And since interest rates at the time were at record historical lows, they bought long-term bonds (mostly in federal agency mortgage-backed securities) that paid higher interest. While risker than they would have liked, the bankers rationalized that by holding the bonds all the way to maturity they were guaranteed to receive the initial principal back along with all of the interest payments along the way to fund the business.
On the surface that all sounds quite reasonable. And it worked just fine up until something unexpected happened — companies wanted their money back. As the economy slowed in 2022 and the shine wore off the tech industry, stock values dropped and they started leaning more heavily on their cash reserves. As they should! It’s why they saved in the first place.
Well, that $200 billion in SVB deposits shrunk to $173 billion by the end of 2022 and continued to fall this year. The big problem with that outflow is a combination of poor risk management and unlucky timing. With interest rates rapidly rising, the market value of those long-term bonds was way below their initial value. And since SVB had very little cash reserves, they were forced to sell the bonds at a substantial loss to return money to customers who needed it today.
SVB announced on Wednesday that they were selling $21 billion in securities to cover their obligations, taking a $1.8 billion loss in the process. Well-heeled customers who understood what was happening attempted to withdraw their money to move it to a bank on more solid footing. SVB didn’t have the level of cash on hand to meet the demand, which precipitated a bank run where customers attempted to withdraw a whopping $42 billion on Thursday alone. SVB quickly ran out of liquid cash, and by Friday the FDIC stepped in to take over. The collapse was swift and brutal.
After a weekend of deliberating options, the FDIC ultimately decided on late Sunday to backstop every depositor for the full amount of their deposits above the normal $250k limit. It’s hard to qualify that as a “happy ending”, though, as the ripple effects of the saga continue to affect many more banks and erode trust in the financial industry as a whole.
The problem with investing other people’s money
While it might be easy to compartmentalize the SVB drama as just a dispute between three unrelatable entities — a big bank, the federal government, and wealthy tech companies — there’s a really important dynamic here that applies to your small-time investing account as well.
The core issue that caused the problem was that SVB invested in risky long-term securities using depositor money that could be demanded back at any time. Do you believe that doesn’t apply to you? Think again. There’s a direct correlation to an increasingly popular investing strategy among normal investors that I’ve been seeing tons of interest in lately.
Investing on margin is the process of getting a loan from your brokerage, investing the balance, and hoping to make a return above and beyond the interest you owe. Sound familiar? Yep — a very similar approach is what ruined Silicon Valley Bank. They were investing customers’ money and you’re investing a brokerage’s money, but in the end the basic concept is the same. You’re both investing money that doesn’t belong to you.
While I’ve already seen several articles attempting to cast blame on the SVB depositors who demanded their money back and questioning whether their worry was justified, in the grand scheme of things it doesn’t matter. Like it or not, it was their money. And like it or not, your margin account almost certainly includes fine print that clearly states that your brokerage can demand their money back at any time and that they can change their terms of that margin call for any reason.
Also keep in mind that for all of the rightful ridicule that SVB asset managers are receiving today, they would likely be considered wildly conservative by your average leveraged investor far more likely to load up on risky stocks than government bonds. And just like SVB, investors often rationalize it by believing that a profit is guaranteed as long as you hang in there long enough to power through any rough spots.
The thing is, that common belief is based on a false assumption that time is always on your side. Once your lender wants their money back ahead of schedule and you realize your real-world investment returns are well below the long-term average you were counting on, all bets are off.
They issue the margin call. All of your securities are forcibly sold at a loss before you even know what’s going on. The floor falls out, and the dark sense of inevitable dread takes over. The only real difference between you and Silicon Valley Bank doing similar things is that the government won’t even consider bailing you out. You’re on your own, and it’s a very lonely place to be.
If you think I’m being dramatic, perhaps the most compelling story about this is a famous Bogleheads thread where an investor shared his personal account of losing everything investing with leverage in 2008. So don’t take my word for it. Read the journey through the words of someone who experienced it first hand with his life savings, and you’ll start to appreciate the risk and emotions involved. He eventually recovered but it was a long and painful road.
Don’t make the same mistake.
Take responsibility for your choices
Read enough stories about Silicon Valley Bank and you’ll find plenty of blame to go around. Regardless of who is at fault, it’s fair to say that it’s another good example of why it’s important to manage counterparty risk by not putting all of your eggs in one basket. From FTX to SVB, there will inevitably be a new industry darling to fail unexpectedly. Plan for that possibility ahead of time and you’ll be a lot better off.
There’s also a lesson here about FDIC limits and not keeping too much money in any one bank. Luckily, brokerage accounts are managed much differently than bank accounts so it’s not something I would stress about in this situation. Still, the major backstops of your investing accounts are something you should take the time to learn about.
But if I’m honest I think both of those things, while certainly important, are relatively low risk compared to the big elephant in the room — you. Investors are often their own worst enemies.
So I would argue that for most normal investors it’s better not to get too lost in the weeds of the Silicon Valley Bank collapse. Not because it’s not important or that you can’t benefit from some extra knowledge, but because doing so has a way of allowing people to compartmentalize the issue as someone else’s mistake. Once that happens, you set yourself up to repeating history.
With that in mind, if you take just one lesson away from this situation I propose that it should be this:
Your risk of ruin drops dramatically when you only invest money that belongs to you.
If you follow SVB’s lead and similarly reach for yield and invest your own savings in long-term bonds to meet your short-term obligations, it could be very painful when your mortgage payment is due and you have to sell a few bonds at a loss. But the good news is there will be no depositors storming your office demanding that you cash out a quarter of your portfolio in a single day to make them whole. Unless, that is, you’re investing someone else’s money.
Margin can be extremely alluring. I get it — who doesn’t want a faster road to success facilitated by some helpful outside capital? But if you ever think you have it all figured out, take a moment to contemplate how the brightest minds at one of the biggest banks in the US just lost everything doing basically the same thing. Are you really that sure it won’t also happen to you?
I came to the conclusion long ago that the potential benefits of a margin account wasn’t worth the risk to my long-term goals. I do understand that not everyone agrees, and if it is worth it for you then I genuinely wish you nothing but growing markets and great profits.
But for those still deciding, I would argue that SVB is a nice case study on the hidden dangers of investing other people’s money to add to your list of datapoints.
You only get one lifetime to save. Manage it wisely.
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