The Black Swan Season
It’s raining Black Swans.
They are everywhere.
By now, I don’t think I need to explain what a Black Swan event even means. Because we all have done a Masters in Black Swan Theory (MBS) over the last 3 years. In case you have forgotten it, let me quickly jog your memory. The black swan theory is a metaphor to describe an event that comes as a surprise, has a major effect, and is often rationalized after the fact as if we always knew it.
One of the benefits (in the context of investing) of these black swan events is that we manage to improve our vocabulary a lot by learning new alphabets and words. During COVID-19, we learned L, K, W, and the different types of recoveries. We also learned about AAA, AA, A, B, C…. ratings of bonds thanks to the credit risk crisis. While we learn new alphabets, and words during such events, we never ever learn the basics of investing.
In this post, I intend to get the spotlight back on the basics of investing and risk management through the lens of the latest Black Swan event. Haven’t you heard about the event already? Unless you are living in an alternate universe, you wouldn’t have missed the circus of the implosion of Silicon Valley Bank.
Last week, Silicon Valley Bank (SVB) went bust. By the way this has nothing to do with our Shamrao Vithal Co-operative Bank (SVC Bank). While Shakespeare wrote, “What’s in a Name”, in the world that we live in, it seems there is all (and everything) in a name. Over the weekend, India’s SVC Bank, issued a statement and sent text messages in English and local Marathi language to its customers in Mumbai saying it has no relation to the U. S. Lender SVB.
With $209 billion in assets and a market capitalization of $16 billion as recently as last week, SVB is by far the biggest bank failure in the US since the global financial crisis (second only to Washington Mutual). However, there are some interesting things to note about this bank.
SVB gained its fame as the banker to venture capital and private equity firms, specializing in technology and health-care clients. Thus, SVB has an attractive client base of tech firms and wealthy founders, which also led to it having a concentrated depositor base (a likely candidate for a bank run). The best part is that this was not a loss-making bank. SVB had posted profits every year before its rapid downfall.
So, what really happened?
At the start of the first quarter of 2020, SVB had just over $60 billion in total deposits. In the last few years though, its deposits boomed to $189 billion dollars with the phenomenal rise of the startup ecosystem, peaking closer to $200 billion.
The bank then invested the majority of these billions of dollars of customer deposits in the safest bonds in the world. The United States Treasury bonds backed by the full faith and credit of the United States government. The equivalent of these bonds in India are our Government Securities G-Secs or Gilts as they are known. It seemed like nothing could go wrong. But the executives ignored the basics of risk management (It’s another issue that the bank did not have a Chief Risk Officer between April 2022 and January 2023).
In pursuit of higher returns (a common human mistake), they invested bulk of these deposits in long term bonds or in bond parlance, long-duration bonds with more than 10 years to maturity leading to a clear mismatch of their assets and liability. A bank’s liability is the amount they have to pay back the depositors.
While depositors can demand their money any time, most of the bank’s money was invested in these long duration bonds. SVB’s mistake was investing short term money in longer duration bonds. Even though the US Treasuries did not have any credit risk or default risk, these longer duration bonds carried a lot of interest rate risk (or duration risk). The longer the duration, the higher this risk. This means that if the interest rates rise swiftly (or even slowly), the market values of these bonds will go down significantly. This is exactly what happened with SVB. When interest rates rose last year, the market value of their investments slumped, leaving the bank with losses that on paper stood at $15 billion.
The bank could have sold the bonds and taken a hit on the portfolio, but SVB decided to hold its low yielding bond portfolio to maturity earning lower net interest margins along the way. This would have been fine too.
But while all of this is happening, its customers tried to withdraw $42 billion – about a quarter of the bank’s total deposits last Thursday alone. This flood of withdrawals destroyed the bank’s finances and at the close of business Thursday, the bank had a negative cash balance of $958 million and couldn’t cover its outgoing payments to the Federal Reserve. According to the regulator, SVB was in sound financial condition on Wednesday. A day later, it was insolvent.
As I mentioned previously (above), SVB had a very concentrated customer base. The reality of this depositor base is that they are full of trend chasers. According to Bloomberg, Peter Thiel, the influential tech venture capitalist, withdrew his Founders Fund’s entire account worth millions from the bank by Thursday and encouraged its portfolio companies to do the same. Despite seeming sophisticated and intelligent, they all behave like lemmings (someone who blindly follows the crowd – even toward catastrophe). As Nick Murray wrote “Human Behavior is a Failed Investor.” And this is exactly the type of clientele that is hardwired to act in a way that perfectly facilitates bank runs.
In short, SVB was undone by ignoring the principles of risk management – the heart of investment management.
What should we then learn from this Black Swan?
Part -II Coming Soon – will have the answers.