Silicon Valley Bank: what went wrong & what lies ahead for the US economy
At the end of 2022, Silicon Valley Bank (SVB) was the 16th largest bank in the US by consolidated assets.
It’s now the second largest bank to collapse in US history.
The rise and fall of SVB: a microcosm for the US economy
Tailored towards US venture-backed technology companies, SVB was at the forefront of the huge malinvestment that was generated from QE, ZIRP and enormous money printing. Its rise and fall thus serves as an important microcosm for the wider US economy.
The extraordinarily loose financial conditions fostered during much of the COVID era, created an environment that fostered vast speculatory activity, and huge demand for anything growth and tech related. The flurry of IPOs and private VC funding that found its way into the tech sector, meant that SVB saw astounding deposit growth over the past three years, with deposits rising from an average of $55bn in 2019, to $186bn in 2022 — an increase of 3.4x in just three years!
Though with QE reverting to QT, the Fed raising rates aggressively, and the M2 money supply now declining, the environment has shifted decisively. The Nasdaq has fallen over 30% from its all-time closing high in November 2021, while tech IPOs and private fundraising has dried up.
With many of SVB’s tech customers having become reliant on simply raising additional capital in order to chase more and more topline growth (or perhaps even just active customer growth), as opposed to generating profits, SVB has continued to see its clients record large operating cash outflows.
This meant that the enormous growth that SVB saw in deposits, has quickly reverted to outflows.
After peaking at $192bn in Q2 2022, average client deposits fell to $175bn in Q4 2022. At the end of February, deposits had fallen to $165bn.
As customers continued to draw on their deposits in order to sustain their large rates of cash burn, SVB needed to move to shore up its liquidity position.
For while many think that their savings are simply sitting in a vault, locked away and ready for them to access when needed, this isn’t the case.
Banks use customer deposits to make loans. They also invest customer deposits in items like fixed income securities. Only a small portion of customer deposits are actually held as cash reserves by a bank.
In the case of SVB, during Q4 2022, its cash & cash equivalents averaged 6.3% of its total assets. This was equal to $13.6bn, down from $22.1bn in the year ago period, and a fraction of the average Q4 2022 customer deposits of $175bn.
During Q4 2022, the remainder of SVB’s assets were primarily held in fixed income securities, including Treasuries and agency RMBS (56.6% of assets), and loans (34.3% of assets).
With only a fraction of its total assets held in cash, in order to continue to fund its customers deposit withdrawals, SVB sold $21bn of US Treasuries and agency securities, which had an average duration of 3.6 years, which it planned to re-invest into short-duration US Treasuries.
By doing so, SVB would improve its liquidity, improving its ability to process its customer deposit liabilities. The problem was, interest rates have risen significantly over the past year, and SVB had bought these securities at much higher prices than their current levels. As a result of not being sufficiently hedged against higher rates, SVB made an estimated $1.8bn after-tax loss on the sale of these securities.
In order to bolster its capital position after incurring this loss, SVB announced that it intended to raise $2.25bn of new capital — here lies the cascade of events that led to its quick downfall.
Confidence evaporates & the end arrives quickly
Remember, banks only hold a small portion of their deposit liabilities as cash. Ordinarily, this is OK, as banks know that most of the time, only a small fraction of customers will seek to withdraw their deposits at any given time. In order to meet demand for customer withdrawals, banks therefore generally only need to hold a fraction of customer deposits as liquid cash reserves.
Though when confidence sours, the situation can change VERY quickly — which is exactly what happened with SVB.
Upon hearing of its latest update, which detailed its realised losses on fixed income securities, and its plans to raise additional capital, SVB’s stock price CRASHED, falling over 60% on Thursday 9 March.
With confidence in the bank disappearing, a bank run was now underway, with deposit holders rushing to withdraw their money as quickly as possible, for fear of a collapse. Ultimately, $42bn of deposits were withdrawn on 9 March and SVB ended the day with a negative cash balance of $958m.
On 10 March, the Californian Commissioner of Financial Protection and Innovation deemed SVB insolvent, and took possession of the bank.
The ramifications for the US economy: a lot depends on confidence
In terms of the direct ramifications, there’s tens of billions of dollars of deposits that SVB’s customers no longer have access to, which will hamper the liquidity and solvency of the customers impacted. This will further hit a tech sector that was already reeling from the reversal of conditions that encouraged its prior boom.
More broadly, the likely greatest risk from the collapse of SVB is that of consumer and business confidence, in their deposits at other financial institutions. Remember, it was the loss of investor and customer confidence that saw SVB’s situation spiral out of control.
With other regional bank share prices seeing major falls in light of the SVB news, how will customers of such banks respond? For instance, PacWest Bancorp, Signature Bank, and First Republic Bank, all suffered major falls on Friday, falling 37.9%, 22.9% and 14.8% respectively.
Will there be a sudden rush from customers of these banks to withdraw their deposits? It’s not as if they don’t have good alternatives — despite yields falling on Friday, 1-month to 1-year Treasuries continue to all yield upwards of 4.7%. 4- and 6-month Treasuries are currently yielding more than 5%.
Indeed, further declines in deposits would just be the continuation of a trend that has already been underway: total US commercial bank deposits are now DOWN 2.3% YoY — the largest decline in the history of the Fed’s current time series, which dates back to 1973.
Don’t ignore the lessons of history: aggressive hikes and a falling money supply puts the US economy in a very dangerous position
More broadly, the Fed’s aggressive tightening has resulted in the M2 money supply seeing YoY declines.
The M2 money supply hasn’t seen YoY declines for at least 60+ years (the furthest that monthly Fed data goes back).
On an annual average basis, we can go back further, with M2 last declining on an annual average basis in 1938.
The last time that the Fed raised interest rates while M2 was declining? The Great Depression.
What happened around/during previous instances of the M2 money supply falling?
The Long Depression (1873-79), The Panic of 1893, the Panic of 1896, the Panic of 1907, the Depression of 1920-21, and the Great Depression (1929-39).
What’s the lesson? An inflationary, credit driven system does NOT function well with a falling money supply. In order to promote the artificial expansion of economic activity via credit growth, interest rates need to fall over time, whilst inflation from money supply growth is needed to encourage debt by eroding its real value. Given that this is EXACTLY what has been occurring for decades, flipping the script risks a major deflationary bust.
As I recently wrote on Twitter:
“For the first time in 40 years, the Fed raised rates above the peak of the previous cycle.
The M2 money supply is FALLING - not since the Great Depression has the Fed raised rates while M2 is falling.
History is clear: it's not if there will be a bust, but when.
An inflationary, debt based system encourages growth via lower interest rates and an expanding money supply. In order to support more & more leverage, rates need to fall over time to reduce debt burdens.
With this cycle having played out for decades, the amount of leverage in the system is now at extreme levels.
Trillions of dollars of QE and extended periods of ZIRP, culminating with an extreme wave of money printing that HUGE government deficits unleashed during COVID, has created an economy that is rife with malinvestment and built on sand.
Relatively suddenly, the tide has now gone out. QE has reverted to QT. Rates have been raised aggressively. HUGE growth in the M2 money supply has reverted to outright declines.
For an inflationary, debt based system, this concoction is akin to starvation.
Instead of encouraging more leverage & debt fuelled growth, the rug has been pulled.
Major debt deleveraging is now being encouraged, which given the amount of leverage in the system, risks a MAJOR deflationary bust.
Though just as there is a lag between money printing and inflation, there too is a lag before the impacts of tightening are fully felt.
Given that the economy usually appears strong just before the end of a business cycle, this lag leads many into a false sense of security - "this time is different", they say.
Yet history shows that time & time again, this time is not different.
Whether it's tech, real estate, crypto, or supply chains moving to meet an artificial surge in durable goods demand, one does not need to look far, to find examples of the enormous speculation & malinvestment that vast money printing, and long periods of ZIRP & QE, encouraged.
An economy that is built on sand, will be washed away when the tide goes out.
Aggressive rate hikes amidst an already falling M2 money supply, means that the tide is moving out quickly and aggressively.
A dangerous period for the economy lies ahead.”
With the money supply falling, the concern over high inflation needs to be replaced with the risk of a deflationary bust. SVB has provided an important early lesson into the dangers that have built up in an economy that has grown accustomed to QE and ZIRP, and which was additionally heavily stimulated by the largest surge in the M2 money supply since WWII. With economic distortions and malinvestment widely spread, SVB provides an early warning sign for the economic dangers that lie ahead.
By ignoring the lessons of history, and continuing to tighten while the M2 money supply is falling, the odds of a severe recession being on the horizon are significant. The great irony is, that the Fed’s aggressive tightening is designed to clamp down on high inflation, but causing a severe recession in the process, is the very thing that is most likely to cause another spike in inflation down the road, as the Fed and federal government would both be likely to respond with aggressive stimulus, resulting in another sharp increase in the money supply.
An extreme surge in the money supply, followed by aggressive Fed tightening, would be expected to cause a recession. As tightening continues in spite of the M2 money supply already falling, the real question now, is likely a matter of how severe that recession will be. With the Fed’s aggressive tightening working with a major lag, it’s time for the Fed to reassess its strategy, before the US economy is pushed firmly off the cliff. Time is running out.
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Perfect
Easiest move would be for the fed to say new inflation target is 4%. We only got super low inflation due to globalization anyways. Not sure why we are so married to 2%. If it’s about credibility, they have none after the transitory inflation bs.