Opinion:The bankruptcy of Silicon Valley Bank and the beginning of the end

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Rising interest rates will drive more and more banks into insolvency. The way out to avoid this, namely inflation, saves the banks but impoverishes investors.

Familiar images are reaching us from the USA. Familiar, at least, to those who 16 years ago watched the global financial crisis, then triggered by Fed interest rate hikes to puncture the real estate bubble, with the attention of the risk-conscious investor. The closure of Silicon Valley Bank (SVB), the eighth largest bank in the United States, drove savers in droves to bank counters to withdraw their money for safety. This is what is commonly called a bank run, and it has the makings of a systemic shakeup because, in theory, savers’ short-term deposits can be recalled at any time, but the bank has the money tied up for longer periods, either in bonds or in long-dated loans. The resulting mismatch of maturities on the asset and liability sides of the balance sheet creates liquidity risk even when the bank actually has enough assets to satisfy all its creditors’ claims.

And that’s where the rub lay at SVB. Investors didn’t just get up on their left foot in the morning and say to themselves, “I’m going to have a nice bank run today, see if I can scare SVB’s management.” Rather, they had a reason to lose confidence in their ability to repay deposits because SVB had announced a $1.8 billion loss, the cause of which was precisely that investor risk there appears to be somewhat higher than thought.

Bank crash in the USA – Why Silicon Valley Bank crashed
What exactly happened: SVB was hungry for deposits on its tight and aggressive growth trajectory. This growth trajectory was based on the fact that the institution’s customers were primarily startups and ventures from the technology sector, and this segment had experienced an extreme boom in recent decades. SVB supported its clients not only with venture capital, i.e. equity capital, but also – and this really requires an extreme amount of self-confidence in one’s own ability to assess risk – with debt capital, even though it is completely clear to any risk manager familiar with the subject that debt financing is not a suitable instrument for young tech companies because the probability of default, i.e. the probability of bankruptcy and non-repayment of the loan in this segment is far too high for this. The risk-adjusted interest rate on the loan, calculated correctly, would simply not be affordable.
Equity financing, on the other hand, works because, although you have to record quite a few total losses in each portfolio, a single “unicorn”, i.e. a super-profitable startup can more than make up for all the losses in the portfolio.

It was probably this risky business practice that drove up the deposit rates the bank had to pay to depositor customers. The bank paid better, attracting interest-hungry investors in search of “excess returns.” But because it is very difficult to always match the inflow of savings precisely to the needs of the banking business in this way, there is always a temporary excess liquidity in such a model that cannot be invested in short-term money market investments without directly realizing losses, precisely because the interest rate that can be earned there is lower than the interest rate that one pays oneself. “So what to do?” spoke Zeus.

The obvious answer: to invest the excess liquidity in long-term bonds issued by banks, companies and governments, thus earning a higher interest rate via maturity transformation than would have been possible if the money market had been invested at the same maturity. Too bad that this little trick also comes with a risk, namely the interest rate risk of the long-term bonds. If the interest rate in the capital market for these bonds rises, then the old, lower-interest bonds become worth less, and worth so much less until their nominal interest on the fallen value yields a real return equal to the new interest rate level. The longer the remaining maturity, the greater the leverage. Apparently, SVB blew a whopping $1.8 billion using this method. Not pretty.

It is moments like this that make investors, who were previously programmed to be laissez-faire, go from zero to panic mode. How does he know that the 1.8 billion already cover all losses and risks? And anyway, it occurs to us now: They offered higher interest rates than the competition right from the start. There must be a reason for this in the risk of the portfolio relative to the risk-bearing capacity of the existing equity! What could have been known before suddenly becomes the focus of interest and – poof – we are in the queue of concerned savers and withdraw the money. This doesn’t last long without the bank getting into liquidity difficulties.

Then the banking supervisory authority comes along and closes us down, not without wanting to reassure everyone by saying that the problem is isolated and under the control of the supervisory authority. However, anyone who wants to trust such sanctimoniousness must ask themselves where the supervisory authority has been so far, what it has done to identify and prevent the risks, and why its grandiose stress tests did not give it a little hint a long time ago that stress was looming here.
The plain truth, unfortunately, is that the stress tests still don’t work, and that the hundreds of millions invested in them have been completely for naught.

Which brings us to the question of whether what the supervisors are telling us now is true. Because it depends on whether it turns into a systemic problem.
I think the answer to that question is clear: SVB is the tip of the iceberg, and when investors figure it out, the line from a Werner comic applies: “I’m going to count to one, and then it’s roller coaster here!”

Why do I think that? The reason is simple: we have now seen 20 years of zero and negative interest rates that are too low for the market. This cheap money tempts banks, funds, investors, just about everyone, to take risks they wouldn’t take if money cost more in line with the market. The zero interest rate not only makes people addicted to consumption and waste, it also makes them complacent and risk-averse, and it turns otherwise cautious investors into haredevils. It also ensures that bad risks do not materialize for a very long time. Bankrupt companies no longer go bankrupt, but walk around as zombies for years to come. Bad investments still earn enough cash to service interest and redemption payments, even though they are bad. Huge capital flows are diverted to the wrong uses, because there is demand for things that would never be demanded at normal borrowing costs. In short, all kinds of financial insanity are flourishing.
If interest rates then rise again at some point because inflation forces central banks to restrict the drug of cheap money (as they are doing right now), the cold turkey leads to problems. As the saying goes, it’s not until the tide goes out that you notice who’s been skinny dipping, and it’s not until the snow melts that you see the turds in the meadow.

The behavior of excessive risk appetite is most certainly not a characteristic of a lone misguided Silicon Valley bank. It is the logical and compelling consequence of decades of distortion of an economy’s most important price, the interest rate, which should normally include all kinds of risk premia for credit default, liquidity, etc., but no longer does.

When the Fed and the ECB started raising interest rates with their faces distorted in pain, I pointed out exactly that in my publications and the compelling consequence of it. A rising interest rate can only fight inflation, i.e. have a deflationary effect, if the real economic forces of deflation also unfold, i.e. if companies go bankrupt, demand shrinks. This is the whole painful recovery process that such a cold turkey brings with it.

But since the accumulated imbalances are too large for this to happen without the insolvency of large banks and also states (because we have overdone it for too long with Modern Monetary Theory and money printing), the central banks are faced with a dilemma: If they go through with it, there will be bank crashes, state bankruptcies and depression, if they don’t, they will be trampled to death by the apocalyptic horseman of hyperinflation.

My prediction: They would rather have the latter than the depression. Because the latter is the result of the only thing they know and can do: Printing more money to supposedly solve all problems. So what will happen? The banking crisis will spread, not continuously, but in spurts, and there will be bailouts again, first on a small scale, then on a large scale, and finally on a very large scale. Then inflation will set off for the next gallop at 20 percent or at 50 percent, and then the Fed and ECB will again be faced with the challenge of containing inflation, only at higher levels.

Welcome to reality.


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