How Jerome Powell Killed Silicon Valley Bank

Ok. For the record, I like Jerome Powell. He may have underestimated inflation, but so did a lot of people.

Rather, I want to talk about how rising interest rates crippled Silicon Valley Bank — and how this might affect other banks, as well as your portfolio.

What happened to Silicon Valley Bank

With a hat tip to this fine Mint.com explainer, the oversimplified sequence of events is:

1. Silicon Valley Bank’s deposits grew from $61 billion at the end of 2019 to $181 billion at the end of 2021, as its startup customers raised ample VC money.
2. This was too much of a good thing; Silicon Valley Bank couldn’t lend these deposits out quickly enough, so it began looking for something else to do with this money.
3. Unfortunately, a large part of that “something else” happened to be very long-dated (i.e., maturities in excess of 10 years) mortgage-backed securities (MBSes). Silicon Valley Bank put 56% of its assets into fixed-rate securities, which is far higher than most banks.
4. Whether it was fully or semi-deliberate, Silicon Valley Bank was betting heavily on interest rates not rising.
5. As interest rates rose – one-year Treasuries, for instance, went from yielding around 0.05% (on May 31, 2021) to more than 5% these days – the values of those MBSes cratered.
6. Moody’s downgraded Silicon Valley Bank.
7. People worried about Silicon Valley Bank. Peter Thiel and other VCs advised portfolio companies to withdraw their money. Account holders had already been withdrawing deposits in 2022 as funding slowed, so convincing them to withdraw more wasn’t hard.
8. To provide this money, Silicon Valley Bank had to sell already-depressed assets at fire-sale prices.
9. (Silicon Valley Bank also told people “we’re OK” when they were very much not OK, which likely worsened the panic.)
10. Silicon Valley Bank, with $209 billion in assets, became the second-biggest US bank failure ever. FDIC insurance covers $250,000 in deposits, but as Silicon Valley Bank is a business bank, less than 3% of its deposits are covered.
11. Incidentally, with $620 billion in unrealized losses at other US banks, people are worried about a similar fate at other small, undiversified banks, and bank stocks are tanking overall.

So the Silicon Valley Bank story is really a story about interest rates. Jerome Powell didn’t actually kill the bank, at least on purpose. In fact, he was right to raise rates – Silicon Valley Bank just made itself roadkill. As Matt Levine put it, the bank was caught with both assets and customers that were massively sensitive to rising interest rates.

You’re not Silicon Valley Bank, but in this era of rising rates, your portfolio may be more exposed than you think, so now is a good time to talk about interest rates – how they’re set, and how they affect asset prices.

How and why does the Fed adjust interest rates?

An interest rate is the “price” of money. For people, companies or governments borrowing money, it’s a direct price. For companies raising equity, it’s an indirect price, embedded in expected returns.

Like a gas pedal and a brake pedal, central banks like the US Federal Reserve lower and raise interest rates to stimulate or slow down the economy.

The simplest way for the Fed to move interest rates is to buy or sell US government debt on the open market. As Silicon Valley Bank found out, bonds pay fixed payments, so if a big investor (say, one with the sobriquet “JPow”) bids up the price of bonds, those fixed payments now equate to a lower yield, and vice versa.

Technically, JPow’s trading moves rates in whatever government bonds the Fed buys, but US Treasury bonds (bills if maturing in a year or less, although I don’t know why they can’t just call them all bonds) are the world’s baseline for risk-free interest rates, so they affect the interest rate ambience in a way that moving the yields of, say, municipal bonds in Wisconsin wouldn’t.

More in the news is the Federal Funds Rate (which seems increasingly punctuated as “federal (or fed) funds rate,” including by the Fed, so i, james early, will go with that).

The Fed influences, but doesn’t actually set the fed funds rate; it’s a rate between member banks for overnight loans to each other to help top up balances to meet minimum reserve deposit thresholds.

The fed funds rate is even less connected to the broader economy than Treasuries, but the Fed assumes that banks will use it as a floor in their own lending.

How do interest rates affect stock prices?

In theory, higher rates lower the present value of future expected cash flows, and vice versa. This effect is more pronounced with companies whose main cash flows are expected to come far into the future, like many Silicon Valley Bank customers.

One could argue whether it’s more appropriate to be sad that the party is over, or happy that the party persisted as long as it did: Years of low interest rates largely created Silicon Valley Bank’s customers and enriched the investors that funded them (and also pushed up stock prices of tech stocks and biotechs).

Why tech stocks (and Silicon Valley Bank’s customers) are hurting

The big money – that’s at least traditionally determined stock prices – values companies as the present value of their future cash flows. But as the table below shows, with more time and higher discount rates, those values drop precipitously.

The main cash flows of unprofitable early stage companies, probably including many of Silicon Valley Bank’s customers, but also including biotechs and cryptocurrency companies, have always been expected far into the future. Now they have higher discount rates to go with them.

Take a look at the far right column. The same $1 projected to be earned by a company in 20 years is worth 55 cents today at a 3% discount rate, but just 3 cents – almost 95% lower – if the rate rises to 20%.

This boring chart, along with the graph below, tell the story of not just biotech’s rise and fall, not just the tech stock rise and fall, but in a way, also of Silicon Valley Bank’s rise and fall.

Will more banks fail?

Bank failures tend to come in waves. Bank stocks are plummeting as I type. I remember proclaiming on CNN’s Situation Room show in 2008 that we may see hundreds of bank failures over the next few years. I was accidentally right, but after that, the failures slowed to a trickle.

The future is hard to know. Bank failures are like ghosts in your room that appear if you fear them enough – they happen if everybody thinks they’ll happen, and don’t if they don’t. This is the “social” part of the social science of economics.

The broader lesson is that the whole “growth” ecosystem that we’ve gotten used to for 13 years – the VCs, the biotechs, the startups, the unprofitable tech companies, the crypto companies, the banks that lend to all of these – is having its foundation shaken by the change in interest rates.

Those who don’t understand interest rates now will very soon.