What happened to Silicon Valley Bank
Silicon Valley Bank, as the name suggests, serves the San Francisco area, and particularly the startup ecosystem and the resulting wealthy individuals in that space. The amount of money deposited at the bank grew rapidly during the pandemic.
Banks make money by taking depositors’ cash and lending it out. Silicon Valley did the “responsible” thing, and bought high quality government backed bonds, such as US treasuries and mortgage securities. This ensured the bank knew it would get all its money back once the bonds matured. Remember, a bond gives you interest, and pays you back in full at some period in the future. When the bond pays you back all your money is called “maturity.”
Unfortunately, the bank misjudged how soon its customers would want their money back. They purchased bonds that wouldn’t reach maturity for many years, assuming that customers wouldn’t want their money back for many years.
Then interest rates increased rapidly in 2022. This significantly affected the start up ecosystem, making it much more difficult for startups to raise cash. Therefore, startups had to pull their cash out of the bank quicker than they had anticipated. Additionally, new money coming into the bank slowed quickly. This was a big problem for Silicon Valley Bank because their bonds wouldn’t hit maturity for many years, but they needed to give customers their money ASAP. Before we get further in the story we need to understand a simple concept with bonds.
How interest rates affect bonds
The price of bonds generally moves in the opposite direction of interest rates. All else being equal, when interest rates rise, bond prices will fall. When interest rates fall, bond prices will increase. For example, a bond is valued at $100. Interest rates rise 1%, so the bond drops in value by 1%, so now it is worth $99. This relationship isn’t usually 1 to 1.
If an investor holds a bond to maturity, and they are paid back in full, then what happens to interest rates while they hold the bond doesn’t matter. For example, an investor purchases a $100 bond that will pay them back $100 in a year and give them $1 in interest. After a year, they will receive $101 for a return of 1%. However, if interest rates go from 1% to 5% during the year, and they try and sell the bond before it matures, they will have to sell the bond for less than $100. Since they are selling the bond in the investment markets, other investors will only be willing to buy the bond at prevailing interest rates of 5%. Therefore the current bond holder may have to sell their bond at $96.20, and take a $3.80 loss to give the new bond holder at 5% return. The new bond holder who purchased at $96.20, will receive $100 when the bond matures, and get $1 of interest, for a total of $101. That is a gain of about $4.80, which is a return of about 5% on $96.20.
The important points to know is that bonds lose value when interest rates increase. However, bond investors only care about this if they are going to sell bonds before they mature.
Silicon Valley Bank Shuts Down
Silicon Valley Bank is in a pickle because its customers (startups) lost their future source of funding due to rising interest rates, and now need their money back from the bank. Silicon Valley Bank didn’t expect this, invested in bonds that don’t reach maturity in many years, and interest rates increased dramatically. If Silicon Valley Bank has to sell the bonds before maturity they will have to sell them at a large loss due to rising interest rates reducing the prices of their bonds. Silicon Valley Bank had no other choice, and had to absorb the losses, because they promised their customers Silicon Valley Bank will give 100% of customer’s money back. As the news spreads that Silicon Valley Bank is losing money as customers ask for their money back, this causes panic in Silicon Valley Bank customers, and now even more unanticipated customers are asking for their money back, causing Silicon Valley Bank to get into a spiral of losing money on selling bonds trying to get money back to customers. So the government steps in and takes control to halt the panic.
Investors who are relying on their portfolio for income have a similar situation. They should make sure their bonds are aligned with their spending so that they don’t have to sell bonds at a loss to generate needed cash.
Please note, this is a simplified version based on news stories as of 3/10. More information could come out to change this narrative!