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Is My Money Safe? Lessons Learned As Banks Collapse

March 14, 2023 | FERS PensionGeneral Financial PlanningThrift Savings Plan (TSP)

The Federal Reserve’s actions intended as a wrecking ball towards inflation has finally hit something else: Silicon Valley Bank (SVB). By now, you’ve likely heard of this bank’s collapse. Last week and over the weekend, Silvergate Bank also collapsed and regulators took over New York’s Signature Bank as well.

HSBC has wasted no time in engulfing SVB’s UK arm. They purchased the UK division for just £1; the price of a cup of tea. Doing so helps prevent a systemic issue from forming.

This is the biggest story in the markets this week, and it brings us eerily familiar vibes of the trauma we experienced from the financial crisis 15 years ago.

Understandably, people are worried, and loaded with questions. So, we’re going to discuss the high-level details about how this happened, answer some frequently asked questions, and most importantly, discuss lessons to be learned. We’ll deal lightly in principles of economics to help you understand the greater issues at hand.

Silicon Valley Bank – What Happened?

In short, this was a case of tremendous mismanagement from this financial institution. More on this after we discuss the details.

SVB had been around for around four decades and was the choice bank for many technology firms. SVB was in the top 20 banks in the U.S. by scale. They grew fast given the low rates environment, since many of their technology clients had a lot of cash to park in the bank.

How do bank’s make money? They lend and invest the deposits that people give to them. This is the core business model of banks. They were flush with cash from account holders and began to invest the capital.

The investment of choice was 10-year Treasury bonds yielding around 1.5% on average. With a rise of interest rates by nearly 5% (greater than a triple), bonds immediately began to lose value extremely fast. Remember, rising rates means falling bond prices— it’s an inverse relationship, like a seesaw.

Simultaneously, many of their institutional banking clients began to utilize their cash reserves to run their businesses instead of borrowing money (as mentioned, interest rates have increased so the price to borrow become too expensive for them, and they began to withdraw their own cash deposits.)

The problem: with their clients now requesting larger amounts of withdrawals, SVB was forced to begin to sell out of the Treasury bonds in which it had invested. But with the fast rise of rates, they were forced to sell at massive losses to generate the cash. They also announced that they were doing a capital raise (looking for more investor money).

As such, many venture capitalists and other investors warned their clients to move their money, which set off a chain reaction that led to the classic run on the bank (everyone wanted their money). SVB lost around $40 Billion in market capitalization very quickly, and financial regulators took over the bank shortly after.

Interestingly, as recently as a couple of weeks ago, the CEO of SVB was asked about the risk of their long-term bond positions, given the rise in interest rates. His response indicated that he didn’t see a risk.

Many argue they couldn’t control interest rates (which they can’t) and shouldn’t be faulted. Personally, I disagree. This was a case of risk management failure of their portfolio. Every portfolio requires parts of it that counterbalance each other. This is what makes a properly diversified pile of capital.

Lessons For Federal Employees

First, it’s important to take pause and think about your own risk management. No investment is considered “safe”. SVB was invested in Treasury bonds. This is as “safe” as you can get. For every investment, there is an equal and opposite force in economics that can cause it harm. For bonds, one of these is interest rate risk, which SVB failed to address, and it ultimately became its kryptonite.

Secondly, be sure to speak with your bank to understand how much of their FDIC insurance covers your accounts over the limits. Make sure you understand the FDIC insurance. The $250,000 insurance covers accounts in cash, not investments. Some banks can increase the amount by having agreements with other financial institutions. With high cash balances in accounts these days, you should use caution in how you structure your wealth. You should also have a high-level understanding of their balance sheet and the types of practices in which they’re engaging.

Most importantly, choose your financial institutions carefully. Have a good understanding of how they operate their businesses and the safeguards in place, particularly the custodians of your investment accounts.

One of the things we do for our retirement clients is implementing a robust due diligence process for the custodian of their assets. Over the years, something that has come up many times as a deal breaker is how these institutions treat the assets, including cash positions, of their account holders.

Very few custodians are federally regulated as a limited-purpose savings trust. Private trust companies are completely unique in that they do not commingle client assets with their own—one of the main reasons SVB has collapsed.

Traditional financial firms lend money and securities in an effort to make more money and use their client assets as collateral for their own borrowing. It sounds heinous, but it’s standard practice for larger financial organizations. It’s important that you understand how these firms operate prior to using them.

Private trust companies adhere to extensive federally mandated controls designed to prevent fraudulent and unsafe activities. They’re subject to independent audits and examination by the Office of the Comptroller of the Currency (OCC). They cannot participate in lending, so your money cannot be used as collateral for the custodian or bank’s activities. By design, they can’t pledge, lend, or margin client assets that are held in its custody.

Client assets are also never commingled with corporate balance sheets. As a result, they are not subject to the same risks of a traditional bank or brokerage like a Silicon Valley Bank, Merrill, Schwab, Fidelity, etc. This distinct custody relationship keeps your assets set aside, in trust, in your name, to protect you from just this kind of issue.

More and more, the private wealth space has migrated towards this type of custodian for their clients’ asset given their structure. I encourage federal employees to do similar due diligence and consider the same factors when planning their retirements.

Some private trusts, like the one we use for our clients, do not allow custody of client assets by any of the investment firms that clients are invested in either. This means if an index fund goes bust, your assets aren’t subject to creditors or malpractice (not to be confused with an index fund crashing in value—there is always market risk). Investment firms are granted access to the custodian’s assets, but never take possession.

They also have fidelity bond coverage for protection again employee dishonesty, forgery, alternations, errors, technology issues, etc. Again, all of this to help protect your wealth.

Federal employees should not be complacent about where they choose to custody their assets. What you have in your portfolio needs be protected and last for the remainder of your life. A careful, well curated choice in custodianship for those assets is imperative.

What’s Next? 

Regulators have taken over the bank and will begin to liquidate assets to attempt to pay out its debt. FDIC insurance will kick in for anything less than $250,000. Federal intervention is tricky; changes made after the financial crisis in 2008 limits oversight to the broad market, not one institution. Certain rules are reserved for systemic issues, not individualized ones such as this. It’s more likely that other big banks will attempt to pick up the pieces of SVB. We may see the government take action if it because systemic.

Federal employee should understand that this is not a bailout as we know it. Taxpayer funded bailouts are different, as is this situation compared to 2008. The depositors are being made whole from the insurance, but SVB has essentially vaporized.

We can almost certainly see that there will be regulation coming down the pipe. What will that do to bank profits? How will they pass this on to consumers?

Will Other Banks Be Affected? 

Yes, in varying degrees. Any other banks that had a similar demographic of clientele will likely see collateral damage. The larger, global banks will likely be able to meet the demands for cash, but their stock prices will most certainly take a hit. Schwab shares, for instance, are down nearly 37%* in 2023, and First Republic bank shares were down 62%* yesterday. The Federal Reserve will likely be keeping a close watch for spillover. Currently, systemic issues don’t appear to be present, but it’s early to tell.

The banking system is based on faith. If Americans lose their faith and confidence in the banking system, this wouldn’t just be an SVB problem. It would transition to a systemic issue and pour over into different banks and have a widespread impact to our economy.

If regional banks begin to receive flak from this situation, it could mean that its clientele does a similar run and wipes them out as well. This is why the President had to say what he did, to help keep society calm.

If only larger banks remain, only the upper echelon of society can expect any kind of service as they won’t be able to work with everyone with less.

Will This Bleed into Other Area?

Possibly. It’s still early and difficult to tell whether this will have a ripple effect. Notably, commercial real estate has faced a somewhat similar issue with capacity since the beginning of COVID and corporations’ willingness to move to remote telework.

I think the big question is less about the contagion towards other large banks, but whether this has the potential to spread to other asset classes. The Federal Reserve is watching extremely closely to make sure they don’t tip the economy.

Should We Be Worried? 

There is likely not a reason to be concerned unless you were directly impacted by having assets with SVB. Right now, there is no apparent risk of this individual occurrence causing a larger systemic issue, but news like this is always taken roughly given the permanent trauma from 2008. You should use this as a learning moment to gain perspective and a greater understanding of the financial markets and institutions work.

A circumstance like this reminds us once again of the importance of planning. Our clients tell us one of the factors they value most is having the sense of confidence about their financial future, so that they can live their lives without the worry of their safety.

Be proactive about your planning and take care to perform good due diligence. After all it’s not just your money, it’s your future.

*Price quotes form Y Charts.