Over the past weeks the news came fast...a trickle of headlines became a flood - suddenly we've unfolded a banking crisis with echoes of the GFC of 2008-09.
On March 10th the state of California stepped in and took over Silicon Valley Bank (SVB), in what was the second-largest bank failure in history. Soon after, Signature Bank was closed, and several other regional banks are now on the precipice. What happened (and what's it have to do with your portfolios)? To know how we got here, we first have to back to the height of the pandemic.
Money printer goes brrrrr
In the spring of 2020, as the entire world quickly went into lockdown, governments faced a big problem. If they shut everything down and forced people to stay home, the world GDP would effectively go to zero, an unprecedented economic disaster.
The solution was 'helicopter money' policy...aka, they just gave everyone cash! 'Stimmies' were everywhere - zero percent rates, tax breaks, stimulus checks, PPP loans...a fake economy was created to replace the real one that'd been put on hold.
That money had to go somewhere...and asset prices spiked as the world started to reopen. Houses traded at all-time highs, stocks too...crypto made people rich - you could buy a jpeg of a monkey and sell it a week later for double. It was an everywhere, everything asset bubble. By the end of 2021, we had rampant inflation for the first time in decades.
Venture Capital funding was another area with explosive growth...there was too much money and not enough places for it to go. If you were a startup it wasn't hard to find a pile of cash for your company.
Enter Silicon Valley Bank.
Each round of new venture funding was deposited somewhere, likely into Silicon Valley Bank (which also had the 'cool' factor of being the bank of choice in the Silicon community). SVB had cash burning a hole in its pocket and bad decisions would soon follow.
At the same time SVB was sitting on their Scrooge McDuck pile of gold, the Federal Reserve was realizing it had an inflationary mess on its hands.
(a reminder, the Fed has 2 'mandates' - it's responsible for keeping employment levels high and inflation low)
Starting in early 2022, the Fed began to raise interest rates with no mercy, and throughout 2022 they continued raising at the fastest pace in history.
It was pretty obvious to anyone involved in capital markets that the Fed was going to break something...they made it clear early and often that they were going to be aggressive until inflation moderated, and they didn't care if they broke asset prices in the process.
Before we dive into how things did indeed break, we have to cover some finance 101 and basic bond math.
Finance 101 (the bond class)
Bonds are easily understood as loans. When you get a mortgage on your house, they give you the money upfront, you pay interest, and eventually, you pay back the principal amount and the term expires. Bonds work the same; an entity issues debt, and you buy the debt as a bond with the intent to earn interest until the bond expires.
The mechanism to price bonds is a function of the interest rate and the time to maturity. The math is complicated, but the concept is not. When interest rates rise, bond prices fall, and vice versa. A bond's 'duration' measures the price sensitivity to interest rate moves, and without doing any math, finance 101 tells us that the more time until the bond matures, the more sensitive the price will be to rate movements.
When rates are rising you don't want to own long-term bonds because of the above - the price gets crushed!
This brings us back to our friends at SVB.
With their cash pile large and growing larger, they began to buy long-duration bonds to get more return on their cash (generally the longer the term, the higher the interest rate). In our business we call it 'chasing yield,' and it's never a good thing. Here is where some criticism is more than warranted.
SVB held billions of dollars of long-dated bonds. That's fine if you don't need the money... but what if customers withdraw funds? Simply put, SVB made bad investment decisions with presumably little risk management. When customers came knocking to withdraw cash, SVB didn't have it, so they had no choice but to sell these bonds. And because of the Fed moves and bond math mentioned above, they took massive losses on those sales. At that point it was already too late. Customers heard about the losses, more customers showed up to withdraw money, and the death spiral began. It only took a few days for the entire thing to collapse.
I don't run a bank - but I do manage money for a living. I preach to clients constantly that duration risk is the sneakiest killer of portfolio returns that no one talks about. The generally accepted theory in asset allocation is that bonds are safer than stocks. Even with no investment background most people still understand that and invest that way. But the 'safe' part refers only to the underlying credit risk of the issuer, will they pay you or not? The price of the bond? That can and does move every day. And what if, like SVB, you need your money? You may be stuck selling a 'safe' bond at a huge loss.
Don't be like SVB
Here's a chart of a long-term treasury bond fund:
The squiggly line is the daily price from 2020 into 2023...the smooth line I've added as a proxy for the long-term trend. I use trend-following as a risk management tool, and I measure data like the smooth line monthly. I have not owned any long-term bonds in client portfolios since late 2021...and the picture shows you why. After a long-term uptrend, the interest rate environment shifted in 2021, and the line rolled over and became a new downtrend.
If you owned 'safe' treasury bonds and forgot about that position in 2020, imagine your surprise to check the balance in 2023 and find you'd lost almost 50% of your 'safe' money.
The Fed has created a tight situation for all capital markets - that was their goal. Anytime rates move this quickly something is going to break.
SVB is not the only bank in this position, though what's clear now is they were the most egregious offenders of basic bond investing.
If you own bonds in your portfolio, take the extra step to understand their duration. It will save you from any future sticker shock in the portfolio.
And in meantime, you can look a lot smarter than some Silicon Valley bankers!
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