Liquidity helps
People adjust when the world
Changes in a rush.

Suddenly the United States banking system finds itself under a 2008-like cloud of uncertainty. How did this happen?

From what I’ve read this week, the bird’s-eye view of what befell Silicon Valley Bank (SVB) looks a lot like the same problems I’ve seen in retirement accounts over the past year.

SVB is a regional bank, not a big national bank like JP Morgan Chase, Citi, Bank of America, or Wells Fargo (“The Big Four”). SVB’s customers were mostly venture capital firms and technology startups. If you are a tech startup in San Jose, CA, there’s a good chance that the capital you’ve raised to pay rent, make payroll, and pay employee benefits lived in deposits at Silicon Valley Bank.

By working with firms that exist within a speculative space, SVB could be seen as having more risk than, for example, The University of Kentucky Federal Credit Union. However, what SVB did with their deposits was not, on the surface, risky.

Starting with an $8.3 billion package on March 6, 2020, the United States issued trillions of dollars of economic stimulus. This helped some businesses keep their doors open, their workforce employed, and individuals endure weeks (or more) without work. The result of this Federal largesse was that the US economy was flooded with liquidity. Cash was everywhere.

Individuals paid off debts and saved what was left over. Businesses took the cash and, in some cases, deposited the funds in banks so that they could count on that money being there when it was needed.

Banks are businesses. They take customer deposits and make their own investments. They write loans to people and businesses and charge an interest rate to generate revenue. In March 2020, when the pandemic hit, the Federal Funds rate (the rate set by the Fed and used for overnight loans between the Fed’s member banks) was 0%. That means loans written by any bank during that time would be at historically low interest rates, depending on the credit risk of the borrower.

Prior to March 2020, the Federal Funds rate was near 0% for years:

Dec. 17, 2015: 0.5%

March 22, 2018: 1.75%

October 31, 2019: 1.5%

What does this mean for banks and their customers?

First, it means the amount of liquid money floating around the economy was enormous. Qualified borrowers could access loans for historically low costs. Getting money was easy, (hence “quantitative easing,” or “easy” money policy).

Banks weren’t charging high rates for loans, which means they had to write more loans to generate more revenue. Savings accounts rates were miniscule, and T-Bills (Treasury debt with maturity of 52 weeks or less) were paying, as one of my clients describes it, “zero point nothing.”

Now, imagine you’re Silicon Valley Bank and it is June 2020. Customers are showing up with big stimulus deposits. You need to generate a return on that money to pay savings account yields and make a profit for the bank, but you can only use so much of it to write loans. What do you with the rest? In the case of SVB, they bought a lot – too much by most accounts – of 10 year Treasuries. At that time, 10 year Treasuries were paying better rates than more liquid (shorter maturity) forms of debt.

But 10 years is a long time to wait for a bond to mature. And since interest rates were already low, the only direction for rates to go at that time was up.

We now interrupt this blog for a quick primer on the relationship between bond prices and interest rates.

If I paid $1000 for a 10 year Note paying 1.5%, what is that note going to be worth on the open market when interest rates are over 4%? More, or less, than what I paid for it? Answer: much, much less. If I can buy a new issue of short term debt paying me 4% or more, I will require a deep discount if I’m going to buy someone’s debt paying 1.5%. That way I can make up for the low yield when the bond matures and returns its $1000 issue price, or par.

This is very similar to what happened in Fixed Income (bond) Mutual Funds and ETFs in 2022. Several of the funds I’ve looked at in the past six months hold over 20% of the total fund in bonds with maturities over 10 years. Those funds had double digit price losses last year because as investors withdrew their money, bond managers had to sell those long-duration bonds on the open market at discounts.

Now back to banks.

Last year, when the Federal Reserve started increasing interest rates at, for them, a feverish pace, you wouldn’t be blamed for thinking that they were behaving like Mark Zuckerberg, who has famously said “move fast and break things.”

Over only a few months, banks that were generating revenue based on low interest rate loans and 10 year bond yields were having to compete for depositor’s dollars with short term Treasuries paying 4% or more.

Customers started withdrawing deposits earning a low yield in savings accounts in favor of Treasuries. Treasuries also have the advantage of being backed by the full faith and credit of the United States. Bank accounts are “only” backed up to $250,000 per person, per account registration, by the FDIC. No FDIC insurance is needed when buying Treasuries. Higher yields and safer than a savings account? Treasuries look a lot nicer right now than banks.

How was SVB servicing these withdrawal requests? They had to create liquidity by selling their 10 year bonds at a discount, losing money in the process.

Just like the bond funds in everyone’s 401(k) plans.

As the bank started losing money, its stock price fell, depositors got spooked and wanted their money back, investors sold their shares while they still could, and SVB became a victim of a bank run.

But it all started with an over-allocation to investments with long maturity schedules.

What can we learn from this? What can a bank in California servicing startups and venture capital firms teach the 9-5 investing public about money management?

The lesson to learn is that liquidity matters. “Cash is king” is a cliché for a reason.

Sometimes liquidity may matter as much, or more, than a rate of return. This is certainly the case for your checking account. Very, very few people seek checking accounts paying the highest interest rate. They want one that has access to a lot of ATMs or can easily accept or issue transfers. Checking accounts are all about liquidity.

Liquidity is an important consideration for your investments as well, particularly for the defensive, or safe, portion of a portfolio. Protecting the defensive part of a portfolio with guarantees of principal protection is an excellent idea. But locking money into illiquid investments for years at a time can be its own risk.

2022 gave us a perfect storm of lessons on the importance of liquidity. For the growth side your portfolio, if markets are tumbling by double digits, it may help an investor sleep a lot more peacefully at night knowing that they can move their riskier investments to cash whenever they want to.

For the fixed income side of a portfolio, how can an investor take advantage of interest rates that are increasing every few weeks? If you are able to access money without risk of a big tax bill, or a big penalty, or having to sell a holding at a big discount, you can pivot into instruments that may be optimized for the new environment to keep your money safe, and potentially keep up with inflation.

Earning a 2% yield from a 10 year bond when inflation is over 5% is not keeping your money safe. It’s losing purchasing power at a rate of more than 3%.

The recommendations I was making for client accounts in December 2022 were not at all like the recommendations I was making in December 2021. Having the flexibility to adapt to a changing environment is one of our species’ uniquely superior qualities. Applying that ability to your finances will help them endure markets that are so volatile that even banks – the institutions most associated with financial security – are struggling.

If you want a second set of eyes on your portfolio to make sure you have enough liquidity to take advantage of new opportunities and avoid new risks, we’d love to speak with you. You can schedule time with us by visiting this page on our website.

For more information on the collapse of SVB, I recommend reading this article by Mitch Zacks of Zacks Investment Management.