Silicon Valley Bank Broke 2 Simple Investment Rules

Silicon Valley Bank Broke 2 Simple Investment Rules
Silicon Valley Bank customers wait in line at SVBs headquarters in Santa Clara, Calif., on March 13, 2023. (Noah Berger/AFP via Getty Images)
John Moorlach
3/20/2023
Updated:
3/20/2023
0:00
Commentary

The Silicon Valley Bank (SVB) collapse occurred because two simple investment rules were violated. The first is the simple overarching strategy of safety, liquidity, and then yield, with the acronym of SLY. The internal investment team reversed the order. They focused on yield, which requires going out longer on the yield curve and purchasing longer term bonds. This reduces liquidity, as selling these bonds before maturity will result in investment losses if interest rates have risen.

The second rule is to keep enough cash in overnight or extremely short maturities in order to meet depositor requests for their cash.

Since portfolio managers cannot control the direction of interest rates and when depositors chose to withdraw their funds, then they should follow these two fundamental strategies.

A cash portfolio should run like a money market fund, with average weighted maturities of 60 to 90 days—but SVB’s weighted average maturity was about six years! This explains why the bank attracted new clients by offering higher deposit rates.

The bank’s traders were probably praised by management for achieving higher yields, thus higher levels of depositor funds. But higher yields equals higher risks! Or as I said back in 1994 to the media, “If you want to make a killing, you had better be prepared to be killed.” When depositors can earn higher yields elsewhere, they leave. SVB was stuck. They couldn’t sell their long bonds, which were now earning less than short paper. And other banks who were staying within prudent boundaries were now offering higher yields. Of course, depositors would reposition to the other banks—that’s what smart money does.

SVB’s hubris of being the highest yield provider backfired when short-term interest rates rose. The bank played out the famous warning from Warren Buffett: “Only when the tide goes out do you discover who’s been swimming naked.”

With rising interest rates, the value of longer-term bonds declines. When SVB needed to sell their holdings, they had to do so at a significant loss.
The litigation started within hours. Why? Because SVB and its executives failed to disclose how rising interest rates would undermine the bank’s business model.

Local Connection

There are many who are comparing the SVB failure to the 2008 liquidity crisis. But, this recent chapter in investment malpractice has a corollary with what occurred in 1994 when Orange County found itself in a similar predicament. It borrowed funds and paid 3 percent for three-month periods and used the loan proceeds to purchase four-year bonds paying 5 percent. And depositors poured in to participate in the higher yields, including a few borrowing themselves to increase their overall yields.

When then Federal Reserve Board Chairman Alan Greenspan decided to raise interest rates to more than 5 percent, then the county found itself paying more in borrowing costs than it was earning with the four-year bonds. When the proverbial run on the Investment Pool started, selling the longer-term bonds resulted in some $1.7 billion in losses.

For me, it’s déjà vu all over again. Gambling on the direction of interest rates is a dangerous game. In May of 1994, six months before the county’s implosion and filing for Chapter 9 bankruptcy protection, I warned the media, the external auditors, and the Board of Supervisors. To no avail. Here is the pertinent segment of my memo that parallels the current SVB failed strategy:

“The two major concerns about the Pool are as follows:

“Should the borrowing costs, which are set at current market rates about every three months, exceed the income the portfolio generates, which is invested mainly in four-year bonds, the Pool will implode.

“[The] Pool [will] incur serious liquidation problems. Orange County only has about 87 municipalities. But the Pool has over 180 participants. This means that some 100 municipalities have invested in the Pool because it has been generating higher returns than most conservative investment opportunities. Higher returns equal higher risks. And Citron’s Pool is a major gamble that interest rates will continue to decline for the next four years. They are not.

“The Pool’s yield will be decreasing with every incremental increase in short-term interest rates because his cost of borrowing is going up and his return is either fixed or decreasing (in the case of the inverse floaters).

“Accordingly, those municipalities outside of the county can pull out and invest in other investment vehicles at any time.

“If those outside the county pull their funds first with no ’marking to market,' then it will be the Orange County municipalities that will bear the brunt, and at much greater magnitudes.

“Why should our County be subject to so much risk exposure? Can you imagine the lawsuits from other areas because they were not aware of the risks Citron was taking and that our County should make them whole? It happens. It could financially wipe out the most conservative county in this country!”

Paying the Price

After the County of Orange sold its portfolio, lawsuits started flying in both directions. Ironically, one of the targets was the auditing firm of KPMG, which eventually settled for $75 million for defending the portfolio and its audit.
Ironically, KPMG performed the independent audit of SVB. Oops. The posturing has already begun, with a similar response of “KPMG is standing by its audits of SVB and Signature Bank.”

Although Orange County generated national and international headlines for its scheme, no one stepped up to bail out any of the participants. Not the federal government, not the Securities and Exchange Commission, not then Governor Pete Wilson, not then Assembly Speaker Willie Brown, nor then State Treasurer Kathleen Brown. And when the residents were asked to approve a sales tax increase to subsidize the incompetence, they summarily voted the idea down.

To see President Biden jumping in like he’s running a foundation that doles out money willy-nilly, he continues to show his fiscal naivete. First, he forgives student loans without asking parents who underwrote the costs of a college education for their kids if they would like to be reimbursed. Now he wants to bail out banks. No wonder he wants to raise the debt ceiling. Would someone help our President with math lessons, please?

The SVB fiscal malpractice has reverberations. One or two banks with egomaniacal management teams do not make a cause for national enabling. If you want to make a killing and be the biggest bragger in the room, you had better be prepared to pay the price. When all of us have to chip in, it’s dysfunction magnified and wrong.

Views expressed in this article are opinions of the author and do not necessarily reflect the views of The Epoch Times.
John Moorlach is the director of the California Policy Center's Center for Public Accountability. He has served as a California State Senator and Orange County Supervisor and Treasurer-Tax Collector. In 1994, he predicted the County's bankruptcy and participated in restoring and reforming the sixth most populated county in the nation.
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