It’s Not the Bus’s Fault When You Step in Front of It: SVB Chapter I

I’ve been chewing on the SVB collapse for a bit now and I have a lot of thoughts on what went on in the Valley and now in DC and Wall Street. There is a lot of time to think about what happened at the bank and I will get to that later. However, for now, let’s focus on what this isn’t about.

I have seen both in straight news coverage and the unmediated dumpster fire of the vanities[1] that this is a result of Fed rate hikes. Now sure, is this rate hike a proximate cause for SVB’s implosion? Sure, I guess. In the same way that a bus driver choosing to operate her bus at 35mph[2] on a public street is a proximate cause for you getting hit by same bus because you didn’t see a bus in that exact spot yesterday even though it’s a bus lane. You should have seen it coming; you could have seen it coming. You walked in front of a bus. You know how to cross the street and you aren’t even a professional street crosser with a head of street crossing risk management. Just as motor vehicle traffic is one of the biggest risks you have to manage when crossing the street—rate risk is one of the biggest risks in banking.[3] OK, let’s depart from the metaphor.

At the heart of modern[4] banking is the principle of short borrowing to finance long lending. I give my 10 florins to Piero at 5% on the understanding I can get those florins whenever I want, and Piero turns around and lends out those 10 florins to Paolo on the understanding that he gets 12 back in a year. Groovy, Piero is up 1.5 florins and I don’t have to hide my florins in my boot—a true win-win. This is of course a simplification along many axes and we won’t complicate it too much except for one way. As the prevailing market rates change, the values of my deposit and Paolo’s loan change and debts with longer maturities will change in value more than those with shorter. But my deposit value doesn’t change at all because I have an unlimited call provision on my loan to Paolo—which is to say I can go to him and say “give me my 10 florins” and he has to give them to me—and if he doesn’t have 10 florins he will have to sell something to raise that money. Except if rates have gone up and his future 12 florins from Paolo is worth much less, so he has to sell that loan to Cosimo for 7 florins. Oops, now Paolo is up il ruscello di merda. And that is duration mismatch.[5]

Luckily along the road people have put a lot of effort into developing bond math so you can predict how the value of debt will change as rates change and then you can use that to manage exposure to the risk of rate changes. You can even run stress tests to see what happens to your portfolio when rates change. You can even develop a department and several disciplines devoted to this practice[6]. Now you won’t eliminate this risk because then you won’t earn any money on the spread between the short term rates you pay and the long term rates you earn, but you have to understand it and limit it. Unluckily[7] for SVB, it seems like they didn’t manage this risk in any meaningful way. The bond math is in many ways immutable—the timing and scale of rate movements may not be fully knowable, but their effects on the values of debt securities is pretty effing knowable. And either through complacency or avarice,[8] the folks at SVB took the ¯\_(ツ)_/¯ approach to risk management.

SVB had a tonne of deposits[9] funding a huge position in long dated bonds—amounting to a bet that rates would not go up. Either they chose to take that bet or wandered into it—but at the end of they day they positioned their bank on the assumption that rates would not increase despite all evidence to the contrary. They were so accustomed to operating in the ZIRP[10] times that they were simply not prepared for anything else. So yeah, they kind of walked into the bus. A lot of really strange market behaviour has ensued during the years post-GFC and a lot of people have made an awful lot of money at a time when it was easy to do so and accordingly have not prepared themselves to do business under a different paradigm. Now, they probably should have prepared themselves for a time when things were different—and this is true for everyone. But people running a bank should not have forgotten or decided to just skip the fundamental risk management that being a credible bank is built upon. SVB did just that when they built this position for themselves and their depositors. There is a lot more to be said and to develop in this crisis. But I just wanted to get started by clearing my throat a bit and saying: this isn’t because rates went up—it is because SVB was completely unprepared for when they did.

It is on them, not Jay Powell.[11]      

[1] Twitter Dot Com

[2] 56.33 kph for the metrically minded.

[3] Maybe the biggest risk.

[4] I mean modern in classical historical sense—i.e. the banking system as it has developed since Italian guys issued loans and took deposits at their benches (banchi) in Venice and Florence.

[5] I realize this a very profound simplification of fractional banking. But hey, I feel I have covered what needs covering.

[6] As has happened

[7] Or very stupidly

[8] Or a toxic combo

[9] Most of which were highly concentrated in size and in one very insular industry, more on this later

[10] Zero Interest Rate Paradigm

[11] It’s on a few other people too, but that is for later