To minimize risk, plan for the unexpected

On March 10, the Federal Deposit Insurance Corp. (FDIC), an arm of the government, took over Silicon Valley Bank (SVB). The day before, depositors tried to withdraw over $40 bn from the bank – about one quarter of the bank’s deposits – due to fears the bank would collapse.

This is the first significant bank failure since the great recession of 2007-2009.

SVB was the 16th largest bank in the US, measured by assets. With $200 bn, it was small relative to the US’s largest bank, JP Morgan, with 18x the assets. SVB worked closely with America’s early-stage technology companies and venture capitalists. I don’t believe any of our clients had money on deposit at the bank. But there are important lessons for all of us.

There are likely multiple reasons SVB failed. There are useful articles from:

• The Economist
• The Wall Street Journal
• NY Times

To summarize: Two years ago, when interest rates were very low and enthusiasm for tech was at a peak, start-ups raised huge amounts of capital. They could not spend all the capital immediately, so they put it in the bank. SVB, with decades-old relationships, was a popular choice. Their deposits grew by almost 4x in three years. The bank needed to invest this cash. Huge amounts went into long-term investments like US government bonds and 30-year mortgages. SVB profited from the difference between the bond interest and the rate they paid depositors.

In the last year, interest rates have risen dramatically, and start-ups’ access to capital has fallen. When depositors needed some of their money back, and with minimal new deposits coming in, SVB had to sell the bonds they had bought to satisfy withdrawals. But with the rise in interest rates, bond prices had fallen, meaning the bank booked large losses. (Bond prices and interest rates move in opposite directions.) Rumor quickly spread that SVB may run out of money to satisfy depositors, causing a classic bank run.

Here are the lessons – and one important clarification – for those of us not directly impacted as SVB depositors:

• FDIC insurance is valuable. Never keep more cash than the FDIC limits at any one bank. Bank and credit union deposits are guaranteed for $250,000 for individual account owners and $500,000 for jointly held accounts. We urge our clients never to have more than that amount in cash at any one bank. If you need to keep more cash, you should spread it across multiple banks to stay within the limits.
• You are like a bank in one important way: to minimize risk, match assets with liabilities. We suggest to clients that, for short-term needs, they hold cash or money market funds. Those funds will be available immediately with minimal risk of loss. By contrast, if you are investing for retirement spending in 20 or 30 years, you can own stocks. Their value may fluctuate in the short term, but if you don’t plan to sell, you can outlast a bad stock market. SVB made the mistake of using short-term deposits to buy long-term bonds because those bonds paid more than short-term bonds. They paid the ultimate price.
• The key to success as an investor is often the opposite of the key to a success for a company. Investors should diversify – never put too many eggs in one basket. You should own stock in thousands of companies across the globe. You should own bonds issued by governments and hundreds of companies. High net worth investors can further diversify in other types of investments like real estate and private funds. With diversification, the impact of any one company failing is almost nil. By contrast, companies often need to narrow their focus to succeed. They need to find and exploit a niche – otherwise, they usually cannot attract clients or generate an attractive profit. That’s what SVB did successfully for years, focusing narrowly on start-ups and VCs. This is all the more reason an investor should buy broadly diversified mutual funds or exchange-traded funds (ETFs), not individual stocks and bonds. The company often swings for the fences. But you should not take the risk of a strikeout.
• How money market funds fit in. Many of you – including most of our clients – have cash in money market funds, not bank deposits. Money market funds own short-term loans to governments and hundreds of companies. Money market funds are not protected by FDIC insurance. That may sound like they are risky. But we generally prefer money market funds because you are diversifying, spreading your risk across many issuers instead of just one bank. Money market funds are riskier than FDIC-insured deposits because they do not have a US government guarantee. But historically, money market funds have maintained their nominal value the way cash would, with one notable exception in 2008.

The SVB failure may not have directly impacted you. But the lessons are important for anyone who wants to build a solid financial plan.