In the wake of the Silicon Valley bank collapse, many terms have been bandied about on CNBC and elsewhere in debates about what went wrong. The key term is “duration risk” along the yield curve in the bond market. We don’t normally go into this level of fixed income at the Club – but in this case it’s important to understand the second largest banking collapse in US history. The bankrupt institution, which has served tech startups and venture capitalists for more than four decades, has become trapped in long-dated US Treasuries. When the bank ran aground late last week, SVB was forced to sell these securities at a significant loss in order to quickly raise funds for its clients. Ultimately, the rush of customers demanding cash from SVB forced US regulators to step in to protect depositors to prevent contagion in the banking sector. Here’s a guide to the dynamics that led to SVB’s demise. How the Bank Works First, let’s get some basics out of the way. Bank deposits are shown as liabilities in the balance sheet. The bank collects the deposits, so when the depositor demands to withdraw the money, it is taken as collateral. The bank also pays interest on these deposits. A bank also aims to make money and must collect at least enough money on these deposits to cover interest. Deposited money does not remain in cash. In order to make a profit and cover more than the interest paid on deposits, the bank takes this money and lends it out at a high rate. Because these loans generate interest that is paid to the bank, they are considered assets. A bank makes money through the spread, or net interest margin (NIM), between the interest rate it pays to depositors and the interest earned on loans and other investments. The money earned is called Net Interest Income (NII). Credit banks can come in many forms – from lines of credit to mortgages to car loans. Another option for a bank that doesn’t have a lot of consumer or business loan applications is to buy securities like US Treasury bills, full trust bonds, and US debt. . That’s what SVB did: they took deposits and bought a lot of Treasury bonds, requiring you to hold the notes for a long time to get your money back or sell them at market value. Treasury prices moving in the opposite direction to this yield can be lower than the purchase price. And in the case of SVB, they were much less. Bond Maturity Risk These Treasury purchases have not been a problem for SVB. A problem arose when depositors came to claim their money and the bank did not have the money. As such, it was forced to sell Treasury bonds that had not yet matured and were priced underwater. That’s because the Federal Reserve’s sustained campaign to raise key rates to fight inflation has pushed bond yields to multiyear highs. (Interestingly, bond yields fell after the banking chaos that drove up bond prices). Deposit can be withdrawn at any time. The deposit has practically no term; cash must be 100% available at all times as it is considered a cash balance. The value of receivables does not change with the market. On the other hand, the market value of the bank’s investments with these deposits can fluctuate significantly between the time of initial investment and the maturity date. Even Treasury bills can see their paper value change significantly before maturity. It is in this discrepancy that the “duration risk” still exists to some extent. Without going into too much detail, a bond’s market value will decrease by a percentage point regardless of duration for every 1% increase in rates. In other words, the percentage change in bond rates is expected to decrease in price over its duration. For example, a bond portfolio with an average duration of five years is expected to decline by 5% for every 1 percentage point increase in rates. If rates were to rise by 2 percentage points, this portfolio would have to decline by 10% given its duration. The 10-year average duration of the portfolio increases by 10% for every 1-point rate increase, and by 20% for every 2-point rate increase, and so on. decreases. These movements are not realistic in the real world and in the timing of cash flows. may affect the duration. But this is a good rough guide. As bond rates and yields rise, the value of deposits (liabilities) remains the same. However, the value of the bank’s investment (assets) may decline dramatically. The nature of deposits means that liability can be called at any time. Assets, on the other hand, take time to recover. They will recover, but how long depends on their duration and the interest rate environment. This is usually not a problem if the plan is to hold the asset until maturity, as any losses before then are only paper losses. Ultimately, on the maturity date, you will receive 100% of your investment and exposure, regardless of the interest rate at the time of purchase. However, if you need to sell those bonds before maturity to meet your liquidity needs—like many depositors who have been knocking on the door asking for their money—you have a real problem. These paper costs must be incurred to cash the bonds and make withdrawals. An experienced risk management team should have hedges in place to protect against this known possibility. This was not the case with SVB. The risk is that the duration of the bank’s investment does not correspond to its potential liquidity needs. A Silicon Valley bank has climbed too far up the yield curve in search of higher returns. In other words, they tied up deposits in bonds for longer than necessary. The bank also did not adequately hedge the risk arising from rising interest rates. This would have allowed SVB to overcome the shortfalls seen on paper between the purchase of these assets and their redemption. In fact, according to SVB’s fourth quarter release, the duration of its fixed income portfolio was 5.6 years and the adjusted duration of the hedge was also 5.6 years. Appropriate packaging will reduce this time. Actually there was no cover. While SVB mismanaged its “duration exposure” to rising rates, the bank miscalculated how much the Fed’s tightening cycle would hurt startups, its client base. The central bank’s fight against relentlessly high inflation has led to a significant slowdown in initial public offerings (IPOs). As a result, SVB’s clients have been forced to use their deposits to run their businesses, unable to raise venture capital funding, which is now more difficult to obtain. Since startups typically don’t make a profit, they burn through cash in hopes of one day going public—the ultimate exit and liquidity event. This final round of IPOs has been postponed for most of these companies. It all started last Wednesday when SVB issued a mid-quarter update to strengthen the bank’s financial position (remember that any conclusion in such a statement comes through rose-colored glasses to some extent). announced a capital increase through the sale of “all” securities available for sale and the sale of common stock and mandatorily convertible preferred stock. As a result of these measures, the bank suffered a one-time loss of approximately $1.8 billion in after-tax profits. Now, maybe that was good. However, one thing that no investor, especially a tech startup that needs cash for trading and payroll, wants to hear is that the bank holding their money is obligated to take action due to the need for “tightening liquidity.” balance”. Any depositor who hears this will naturally want to move their funds to a place where they feel safe. When all securities available for sale were sold, the bank would have to resort to securities it intends to hold to maturity, which of course have longer maturities and therefore more losses on the paper. Meanwhile, according to the mid-quarter update, the average duration of the securities traded was 3.6 years, well below the 5.6-year duration of the overall portfolio. As a result, the market value was insufficient to meet the repayment requirements. The 40-year-old institution collapsed within days, leaving federal regulators scrambling to clean up the mess and stop it from spreading. The Fed and the Treasury Department did just that on Sunday night when they announced that all depositors in SVB (and other signatories in bankruptcy) would be treated. On Monday morning, President Joe Biden talked about bank failures, saying the government’s support for depositors would not cost taxpayers anything. “Instead, the money comes from commissions paid by banks to the Deposit Guarantee Fund.” Biden also explained that “investors in banks are not protected” because of the risk they take. “That’s how capitalism works,” he added. He also said that work to ensure that the entire banking system was healthy and that no bank was too big to fail after the 2008 financial crisis had paid off. (See a complete list of Jim Cramer’s charitable trust holdings here.) As a subscriber to the CNBC Investment Club with Jim Cramer, you’ll receive a trade alert before Jim trades. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust portfolio. If Jim talks about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. 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A man walks past a sign for a bank headquarters in Silicon Valley on March 13, 2023 in Santa Clara, California.
Noah Berger | AFP | Getty Images
In the wake of the Silicon Valley bank collapse, many terms have been bandied about on CNBC and elsewhere in debates about what went wrong. The key term is “duration risk” along the yield curve in the bond market. We don’t normally go into this level of fixed income at the Club – but in this case it’s important to understand the second largest banking collapse in US history.
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