14 Mar Investment Markets Update – Silicon Valley
14th March 2023
Silicon Valley Bank
Who are Silicon Valley Bank?
Silicon Valley Bank (SVB) was the 16th largest bank in the United States. It was based in California and specialised in taking deposits from, and lending to, technology based companies. Although it has been in existence since the 1980’s, SVB grew particularly quickly during the Covid pandemic, as technology services boomed.
Why did SVB go bust?
I’m afraid this was down to our old friend, Bonds, and his close relative, Inflation, again.
As business boomed for SVB, they received significant sums of customer money to hold on deposit. But instead of holding this cash in the money markets, they chose to invest a significant amount of the cash in long-dated US Government Bonds. Government Bonds are generally low risk, particularly when the government is of a developed nation such as the US. However, there is a significant difference between low risk and no risk. Furthermore, long-dated Bonds (i.e., those that mature many years from now) are generally more volatile that short-duration Bonds (because there is more time for things to go wrong).
All was well until 2022 when inflation began to cut into the US economy and the Federal Reserve reacted by ratcheting up interest rates rapidly and heavily. The effect of this was that newly issued Government Bonds were then paying a much higher rate of interest than the Bonds that were already owned by SVB. This meant that the value of their Bonds – should they choose to sell them on the open market – would be less than they had paid for them.
Had SVB held the bonds for the next 10 or 20 years or more, until they matured, then they would indeed have received their capital back from the US government. However, technology companies have been particularly affected by the inflationary economy and the economic downturn, and many of the bank’s customers started requesting their deposits back.
SVB didn’t have enough cash to hand so they had to sell some of the Bonds at significant losses. This crystallisation of their paper losses caused SVB a big problem and they tried to tap up some of their investors and Venture Capital funds, by way of a share’s Rights Issue, in order to plug their capital shortfall. Unfortunately, their request had the complete opposite reaction to what was hoped for. Instead of receiving a cash injection, their customers panicked, and the Venture Capital funds told their clients to withdraw their money immediately and so a classic run on the bank situation developed. With everybody queuing up for their money back, and insufficient funds available to repay them all, SVB was bust.
What has this got to do with the UK?
SVB had a UK banking arm, based in London. Like its parent company, it specialised in taking deposits from, and lending to, technology companies. So far as I know, the UK arm had not been placing client deposits into long term Government Bonds, but nevertheless, they were doomed to suffer the same fate as their parent company, as investors here heard the news from the United States and rushed to request their money back. On Friday evening SVB UK was closed down by the UK authorities.
Although SVB UK is a small bank within this country, it was a significant for our technology industry. Many hundreds of small tech companies – some of which hopefully will become successful and big companies in the future – faced ruin. Overnight, it appeared that they would no longer be able to access their own cash. Bills and wages etc. would remain unpaid and these early stage technology companies would be lost forever. The UK authorities and Government worked extremely hard over the weekend and were able to facilitate a sale of SVB UK to HSBC bank. This was a neat and swift solution meaning that from Monday morning, SVB UK customers were able to continue with their financial transactions without interruption. The markets rather liked the deal from an HSBC perspective and it could well turn out that they end up a winner from this debacle.
So, what are the other ramifications?
It is still very early days in this “fast moving situation” as they say. It is not yet possible to draw an analysis of what the long-term effects might be. However, a couple of things are already appearing to shine through. Banking stock generally throughout the developed world has been sold off in the last few days, in particular regional banks in the United States similar to those of SVB. It cannot be ruled out at all that other such banks in the US might suffer the same fate as they did. Rather extraordinarily, the US Government has effectively announced a complete unlimited insurance of deposits lost by customers. Not only could this be rather expensive, but it also brings the risk of moral hazard. Why would people worry that their banks are taking risks if they know that they will gain if the banks bets win and they will be compensated in full if their banks bets lose?
On more immediate level, the markets have also decided that interest rates are likely to go up far less quickly than they had previously expected, and peak at a lower level. The Federal Reserve was expected to increase interest rates by another 0.75% at its next interest rate meeting. This is almost certainly now not going to happen, indeed, there may be no rise at all. Back home, the Bank of England has raised interest rates up from 0.1% to 4% in the last 15 months. There is now a large question mark at how many more rises they will vote for, given the uncertainty of the banking market (although they are keen to state that the UK banking system as a whole is extremely strong).
In short, central banks are faced with an even more tricky balancing act between pushing down on inflation, with higher interest rates, and not breaking part of the banking system by raising interest rates too aggressively, too quickly.
The other noticeable immediate effect has been on the Government Bond and Corporate Bond markets. With interest rate rise expectations now greatly lowered, the value of existing Bonds has gone up. UK 10 year Government Bonds (Gilts) have had a great leap forward in the last few days, as have Index-linked Bonds. Ordinary Corporate Bond have also seen their values rise, for the same reasons.
What might happen next?
Well, policymakers are hoping – not very much. They hope that the sale of SVB UK bank here, deals with the matter so far as the UK is concerned. In the US, President Biden has gone full Mario Draghi (the former head of the European Central Bank during the Greek financial crises), and Biden has promised to “do whatever is needed” to maintain a solid banking system in the US. For Draghi, the markets accepted his word and stopped shorting Greek Government Bonds, and market calm was restored. Whether Biden can pull of the same trick – time will tell.
The nightmare scenario would be contagion throughout similar US Banks – First Republic bank saw a 60% fall in its share value in the last few days. A banking crisis in the US would certainly affect world stock markets greatly. At the time of writing, this looks a less likely outcome – but we shall need to keep our fingers crossed for a little while yet I think.
An Ironic Twist
This crisis began due to SVB Bank in California making huge losses on US Government Bonds, which had fallen over the last year, and now was needed to be cashed, to repay depositors who wanted their money back. As a result of this bank failing, US interest rates are no longer expected to rise as much – and US Government Bonds have therefore risen in value. SVB have solved their own problem – but unfortunately just a bit too late!
A diversified portfolio
I shall finish this note with my old mantra of having a diversified spread of assets. I have attached a graph showing a selection of some common investments we hold in our portfolios, and how they have performed over the last week.
You will see those funds investing in Shares – Artemis Income, CT American have fallen. Those invested in Corporate Bonds – Invesco Corporate Bond, M&G Strategic Corporate Bond have gone up. I-shares Physical Gold has gained, which is typical in a period of financial crises and Vanguard UK Inflation-linked Gilts has gained over 5% in a week.
Client portfolios with an equity base will have seen an overall fall in values this week, but those falls would be greatly cushioned by their exposure to other assets, such as those mentioned above.
Please note these are the views of Christopher Charles Financial Services Ltd, and are for background information only. They do not constitute advice, nor should action be taken without specific advice, pertaining to individual circumstances. Investments can fall as well as rise in value, and you may not get back as much as you invested, particularly in the short term. E & O E – figures are produced with great care, but no liability whatsoever can be accepted for any errors of information within this document. Past performance is not a guide to the future. Christopher Charles Financial Services Ltd is authorised and regulated by the Financial Conduct Authority.
CCFS Ltd, The Dolls House, Teeton Road, Guilsborough, Northampton, NN6 8RB Phone: 01604 740022