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Silicon Valley Bank, all about the bonds explainer. [1]

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Date: 2023-03-11

Yesterday’s big news story was about the largest bank collapse since the last time that banks were collapsing Here I offer a brief semi-technical explanation of what appears to have happened.

The inciting incident was a run on the bank as depositors began to sorry about the safety of their deposits. Averting runs was why the FDIC was created back in the ‘30s. The total deposits of the bank were on the order of $175 Billion, Since the FDIC only insures deposits up to $250,000, that left around $153 Billion not protected.

(Side commentary. I took a quick look at Google to verify these numbers — svb total assets. alongside the answer was a brief description of SVB starting with, “Silicon Valley Bank was a commercial bank headquartered in Santa Clara, . . .” Note the past tense.)

So, what happened. SVB had a fairly large amount of their deposits stored as bonds, because that’s what responsible and prudent money managers do, it is the way of their people. The actuality of a bond, I think, has been obscured by the presence of bond funds and internet-based investing. A bond is a written promise to repay a certain amount of money at a certain date, plus periodic interest payments during the lifetime of the bond. A bond is issued in return and as security for a loan. They are classically issued for a nice round sum on its face, say a thousand dollars, and a promise to pay a stated interest rate, say 6%. Hence, a $1,000 bond will pay $60 per year, or $15 per quarter.

If you buy the bond at a time when the interest rate in the market is six percent, you will pay one thousand dollars for the bond. But what is the current market rate is only three percent? Well, in that case, you’d be willing to pay $2,000. You’d still get the stated 6% interest on the face amount of $1,000, or $60/year. In that case, you would have paid a premium price over the face amount to get that. In general, as market interest rates go lower, bond prices go higher.

The same is true on the other side. If the market rate is 12%, how much would you be willing to pay to get that 6% bond. In this case, I’d only pay $500. ($500 X 12% = $60) In that case, the bond price is discounted. In general, as market interest rates go higher, bond prices go lower to reflect the needed discount. I have heard this referred to as “getting whipsawed.” Bond yields and prices have an inverse relationship.

(Side note. Finance students are taught that US government bonds are riskless, since the government itself promises repayment. As opposed to corporate bonds, guaranteed by a corporation that can go belly up. They are safe as to the principal repayment, but not from the whipsaw.)

(side note to side note. A Muscovite goes into the Bank of Moscow to open an account, but expresses some concern. The manager assures him of the safety of his deposits. “ . . .since they are backed by the Russian government.” The man hands over his rubles. The manager asks, “So you trust the central government? The reply, “No, but its worth my life savings to see the government collapse.”)

So SVB had a lot of money invested in bonds and the price of those bonds was dropping every time the Fed met and raised rates. Common sense would make me think, “We can just hold these until rates start dropping and the price will come back up.” After all . . .

Alas, no. There is a set of rules in the banking world called “mark to market” As the value of their bonds dropped, SVB had to recognize their loss to the tune of around three billion dollars. This loss, in perspective, was about 19% of their net assets of $16 billion. In response, Moody’s downgraded their credit rating on March 8, the run started on March 9, and the bank was shuttered on the tenth.

This entire story was an oh-so-predictable result of the Fed’s actions in raising rates. it is axiomatic that investment advisors will tell people to put at least part of their assets into the safety of bonds, so I feel pretty sure that a whole lot of little guys are getting burned and cut down by the whipsaw now. The only saving grace is that they (hopefully) have the time to wait out the market until the almost inevitable recession brings down rates, since they don’t have to mark to market

Along with the idea that this should not have been a surprise, I have to wonder why SVB didn’t take action much earlier. I have the feeling that depositor’s email inboxes are jammed this morning with lawyers solicitations for them to join the inevitable class action lawsuit. Along with the news that they may be due money from the Camp Lejeune settlement.

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[1] Url: https://www.dailykos.com/stories/2023/3/11/2157492/-Silicon-Valley-Bank-all-about-the-bonds-explainer

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