Fears have finally relaxed in the weeks after the collapse of Silicon Valley Bank (SVB). It does seem that the financial system is in balance and the bank-runs were more idiosyncratic rather than systemic.
As it becomes more apparent what led to the collapse of Silicon Valley Bank (SVB), there are a few major takeaways which serve to reinforce an important principle that we believe strongly in: Diversification.
While there is a laundry list of articles and videos explaining the intricacies of SVB’s failure, my aim is to simply focus on the core principle of diversification to help us better understand why poor adherence to this principle may have ultimately led to the demise of the bank.
Many understand the principle of diversification when it comes to an investment portfolio. The wild ride of investing is made less wild when we spread our dollars across multiple companies, sectors, industries, or even countries. If we want to see some more stability in our portfolio, we might deploy 60% of our assets to stock investments while 40% goes towards bonds and/or real estate. We can diversify further by deploying the 60% of stocks to multiple companies, industries, and sectors. We can diversify bonds by choosing bonds of different quality, issuers, or select bonds with varying durations. All of this is meant to reduce the risk associated with too much investment one particular place.
So how does all of this play in with Silicon Valley Bank (SVB)?
SVB remained largely undiversified in two ways:
1. Customer Base
2. Investment Selection
Customer Base: SVB largely operated in the niche of start-ups and high-growth tech companies. These once cash rich tech companies began experiencing a need for cash as profits fell amidst a sharp rise in inflation and interest rates in 2022. Because their customer base was largely undiversified, when economic factors started to plague the tech sector, it led to a sharp increase in withdrawal demand from their entire deposit base, an otherwise very rare occurrence for a bank. SVB's clients were burning cash for the first time in a long time, and they fled to SVB to access it- the only problem was that SVB had tied up large swaths of this cash in long term bond instruments. These weren’t necessarily well diversified investments either, which leads to diversification lesson part two.
Investment Selection: Rather than diversify widely the pool of deposits in a variety of conservative investments, the bank decided to plow billions and billions of cash into long term treasury bonds and other longer term mortgage securities. US treasury bonds and other mortgage-backed securities are not particularly risky investments, however, locking up depositor dollars for the bank’s long-term investment was a major misstep in timing.
The investment bankers at SVB essentially bet on one thing, and one thing only; that interest rates wouldn’t rise. They were obviously wrong. Rates spiked higher in 2022 which made their very safe and conservative US treasury bonds worth almost 30% less than when they purchased them [1]. When rates rise, bond values fall. And when rates rise, bond values on long-term bond investments fall more drastically. This was the case with SVB.
Because so many people wanted to draw out their money from the bank, SVB was forced to “mark-to-market” their bond portfolio. Investments worth $200 billion turned into $140 billion overnight.
When the depositors came to redeem their deposits, SVB would have been forced to sell their investment portfolio at a massive loss, thus realizing the nearly 30% decrease in value. I say “would have been” because they didn’t actually sell the bonds at a loss thanks to the regulators who stepped in and made a deal to make everyone whole. It’s complicated and it’s not the subject of this article so we won’t delve into it to a high degree.
Effectively, the Fed made a deal to take on the long-term debt that the bank owned as collateral and it fronted them money required to safely return deposits back to bank customers. But Silicon Valley Bank is no more.
So how do we tie the two missteps in diversification together?
Well, for one, if their customer base had perhaps been more diversified, made up of businesses and consumers from a variety of industries, then there may not have been such an extreme “run on the bank” that required SVB to redeem such bad investments at precisely the wrong time. The run was largely from businesses and customers in one industry, technology, which really struggled in 2022.
As for their investments, if they hadn't made such a big bet on long term bonds, maybe they could have afforded to stay in the game had their investments been more diversified. Had they invested in shorter term bonds, their “mark-to-market” would not have been as dramatic as it were. Short duration treasuries in 2022 lost about -4% of value [2], a far cry from -27% on long term bonds[3]. Even if they did experience the same demand for deposits from their customer base, they may have escaped with far less harm.
In life, the only certainty is uncertainty, and diversification helps us account for this. We may feel strongly about the tech sector, we may feel that over time the results produced by innovative technology companies outpace many other industries, but if a hurricane of life hits at precisely the wrong time, one might be forced to sell off some investments at just the wrong time.
We don’t necessarily learn something new from the SVB saga, but we ought to take inventory of our approach and feel reaffirmed in our commitment to diversified strategies that help us weather the storms that come from various economic cycles.
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