When Silicon Valley Bank went down, many progressives, and much of the media, immediately pointed to malfeasance, special pleading and regulatory failures—a conditioned response with a strong pedigree. But if those were the real causes, then SVB (and Signature, and First Republic) would have been isolated cases. It’s clear now that they were not. A systemic crisis is unfolding—with a systemic cause.
The business model of SVB consisted of an attractive return on deposits, adventurous loans mainly to young companies in the tech sector, perks for big clients to keep their funds in the bank, and large investments in government bonds and mortgage-backed securities. The safety of the bonds worked to offset the risk of the loans, while the bonds’ return covered the cost of deposits—which grew rapidly as client companies and some cash-rich individuals parked their funds at the bank.
SVB’s growth was indeed rapid, but much of that was back in 2021, the pandemic recovery year. The return on deposits was sweet, and the ad said, in a way that is not now reassuring, that SVB is “fundamentally different from other banks.” It’s also true that SVB lobbied successfully for relief from some regulations on the ground that it did not pose a systemic risk. That looks bad, but SVB wasn’t a systemic risk—its peak deposits of $300 billion were a tiny fraction of US bank deposits.
The bank (I was told by an investor) did not have staff—or possibly, business customers—sufficient to lend out the deposits it attracted to the degree usual for larger banks. Hence much of its balance sheet simply converted short-term deposits into long-term securities, which formed about three-fourths of SVB’s portfolio. This—and not problems with loans—brought SVB to grief. By usual indicators (such as late payments or defaults), the loan book was in very good shape—for the moment.
The problem was not (as Larry Summers declared) that a bank should not convert short deposits into long loans and investments. That is—more or less—what banks do. Loans and bonds are their business. It was also not (as Elizabeth Warren declared, along with other progressives fighting the last war) that the bank took on too much risk. Its loans were risky—because it specialized in start-ups, which are inherently risky. But they were not failing. Its investments, in bonds, were not risky in the usual sense—they were not in danger of default.
In the same vein as Warren, Paul Krugman declared that tougher regulation (of loans) and larger capital requirements or liquidity cushions might have saved the day. Again, fighting the last war. SVB’s loans were all right so far. SVB’s bonds, of course, are liquid! Treasuries and high-quality mortgage-backed securities can be readily sold. SVB’s capital and liquidity would have passed tests until a few days before the crash. This is characteristic of bank failures: Capital looks ample until it disappears. In SVB’s case, the run drained $42 billion in one day—and that was that. The idea that capital requirements provide safety is an economists’ illusion.
The conversion of short deposits to long bonds is a play on the yield curve (the relationship between short- and long-term interest rates). In normal times, longer bonds pay higher interest and the play is modestly profitable—and extremely safe. But when the yield curve inverts—thanks to a tight monetary policy—eventually, one of two things must happen. Either the bank must raise its deposit rates and take the loss, or big deposits will leave for direct investment in short-term Treasury bonds and money market funds. This is the classic disintermediation that doomed the Savings & Loan industry in the 1970s.
As a bank catering primarily to small and medium-sized startups and some wealthy indiviiduals, SVB’s deposit base was unstable. Why did it fail when it did? The destabilizing factor was the Federal Reserve. Once Jerome Powell and his colleagues raised short-term rates above long-term rates, the bank was doomed. We may presume that the CEO knew this, or he would not have dumped stock months and weeks before the end. Others—oligarchs and big players on Wall Street—knew it too, and shorted SVB. SVB was the canary in the coal mine of the inverted yield curve.
Deposits starting flowing out. These deposit outflows prompted the bank to sell bonds, incurring a loss. A Twitter mob sparked the run. A raft of supposedly sympathetic start-up companies with payrolls were caught in the crunch; they were showcased in the news. Larry Summers, among others, then demanded that the Federal Deposit Insurance Corporation issue a full guarantee of all of the uninsured deposits. To the dismay of the sensible former FDIC chair Sheila Bair, SVB was retroactively judged to be a “systemic risk”—allowing big-dollar depositors to exit unscathed.
What would have happened had all deposits not been guaranteed? Businesses with payrolls to meet would have received a dividend from the FDIC for that purpose. Some big depositors would have had to wait for their funds—and would have taken some losses when they got them. Peter Thiel, for instance, had $50 million in the bank when it closed. The overall effect of letting him and others take losses would have been a warning against special treatment for plutocrats. What happened was the opposite. Now, with First Republic, that issue may come up again, on a larger scale.
This brings us to the bigger problem. The US banking system as a whole holds nearly $3 trillions in mortgage-backed securities, largely based on the vast flood of mortgages issued in recent years when interest rates were historically low. Most of them are good mortgages; all of them have lost market value. They can be held without marking to market (writing down their values on the books) only so long as banks class them as hold-to-maturity. Which banks can do only so long as they do not need the funds. Unrealized paper losses on all securities so far are estimated at $620 billion as of year-end 2022. And that is why the Fed announced a new facility to provide cash to needy banks at the par value of their high-quality bonds. A safety net for a systemic crisis—made by the Federal Reserve itself. And the crisis will deepen so long as the Fed keeps raising rates.
So why did the Federal Reserve invert the yield curve? To fight inflation? To kill jobs and stall wages? If so, the stupidity—or the economistic groupthink—is shocking. Most price increases have already faded from the economy (for now). Though job growth is strong, wage increases lag prices: Real wages have fallen. The Fed obviously operates in total disregard of its full-employment mandate—nothing new in that—and indifference even to the textbook logic of labor markets. Why is that? Among specialists, opinions differ on how smart top officers of the Federal Reserve actually are. Personally, I vote for dishonest over stupid.
The Fed works—as a wise Republican monetarist told me many years ago—for the biggest banks. The big banks are not the friends of smaller banks, even if they scramble to help out when the smaller ones are in danger. And the big banks, which operate across the globe, depend on the God-almighty dollar. The Fed raises interest rates, first and foremost, to defend the dollar. Paul Volcker in 1981 raised interest rates to the skies and established a dollar-based world system that is now beginning—just beginning—to unravel. I believe that this, above all, lies at the heart of the inverted yield curve. SVB and the US regional and community banks are only the beginning of the consequences.
What happens next? Obviously, Europe and Japan must match US rate increases and deposit guarantees, and as all those interest rates rise, a global slump will follow. If they don’t follow suit—and perhaps even if they do—hot money will flow massively out of European and other foreign banks, notably Japan, and out of commodities, such as oil and copper. The money will flow into the United States. Into the money market funds and the biggest banks. Enhanced swap lines—to keep dollars available to foreign central banks—were trotted out on Sunday. They signal that the dollar is still boss, and also that the entire global banking system, indeed most of the world economy—outside of China and Russia—is fragile.
Hold on tight.