SV BANK - V.2

15 March 2023

SIilicon Valley Bank bought long-dated US treasuries with its customers deposits. This is recommended practise, it should a safe,no-risk investment, no one would expect the US government to default. It bought when interest rates were at historic lows. But the Fed has increased interest rates since then, in order to combat inflation, and the price of these bonds has fallen, taking SVB with it.

1. The trouble is the banks' customers were tech startups with big loans and small revenues.

Then rising loan int charges and many of these still-low-revenue startups had trouble repaying their loans.

So some had to draw cash out of their current account.

The bank didn't have enough current assets to reimburse and so it had to sell some of its bonds ... very safe but long-term government bonds 

But because interest rates have been rising, these Bonds were worth less than par value ie the balance sheet was potentially having liabilities exceed assets.

Once other customers got a whiff of trouble at the bank, that their deposits may not be safe, they wanted to withdraw their money as well.

If so many customers turn up at the bank asking for their money and the bank can't give it to them because it doesn't have it, well then this is called a bank run !!!

I do not understand why SVB hadn't hedged against this risk of default with a Credit Default Swap. 

Normally, when you own a bond, issued by govt or corporate, you can expect to receive regular interest payments - the "coupon" - but there is always the risk the borrower can't make repayments ie defaults. 

A corporate treasurer or anyone owning bonds should insure against this risk - "hedge" against the risk of default - by swapping the risk of default on the expected fixed income stream with another investor, who agrees to reimburse them if the borrower defaults.

These CDS, Credit Default Swaps, contracts would commonly be maintained by regular payments of a premium - much like the regular premiums due on an insurance policy. 

Why wasn't SVB worried about the borrowers who issued the bond (the loan) defaulting? Why didn't SVB buy CDS to offset or swap that risk? They borrowed short, in effect, from their depositors; and invested long in government treasuries; but didn't take out a hedge against a fall in the value of their assets, presumably because they are expected to hold the asset to maturity and thus the par value would be returned.

What they didn't expect was to have to sell these treasuries before maturity in a market where are rising interest rates had reduced the value you of the asset and thus they were forced to crystallise a loss on their balance sheet.

Now, liabilities exceeded assets and SVB became insolvent. There would be a run on the bank because depositors couldn't get their money out and the fed had to take over to reassure markets even though this was only a medium-sized bank.

2. To avoid a bank run and the contagion to other banks, the US Fed (the BFTP) decided to guarantee the value of those government bonds *at Par*, even if the bank had to sell them at below par they would still get full par value from this govt top-up (bailout) 

And this stemmed the tide of customers and prevented a bank run ... in any case, the bank has shut its doors, taken over by the Fed ... it's the shareholders and unsecured Bond holders who will pay pay this time and not the taxpayer like in 2008.

3. Of course, the worry now is there are many companies with government and corporate bonds on their balance sheets 

And because of this problem that risk is being repriced, we can see it in the share price 

For example legal and general LGEN.L is down to 230 GBp. Where its value before was around 260 maybe even 300.

Many big companies have seen their share price fall by five percent today and more.

4. My question is : will the Fed step in to protect the value of corporate bonds as well as government bonds? and will the Bank of England follow suit ?

In which case legal and general for example is an absolute bargain at the moment at 230 GBp.