[Updated Sections 3 and 4 and added Section 6 on 2023.03.14, 8:41PM]

Blaming rising rates takes the focus off other systemic and firm-specific issues.

WHY IT MATTERS: Understanding the full context of Silicon Valley Bank’s (SVB) failure provides perspective on financial system operations and stability.

By now we all have heard about Silicon Valley Bank’s collapse: HTML.  In this post I look at five contributors to SVB’s collapse:

1. Balance sheet imbalance.
2. Rising rates.
3. Mismanagement.
4. Where were the regulators?
5. Crypto contagion.
6. Cut-off the nose to spite the face panic.

1. Balance sheet imbalance

Table 1 shows differences between Bank and industrial company balance sheets.

Entity	Assets	Liabilities	Equity
Bank	Loans. Treasury securities. Other marketable securities (HTML).	Deposits. Short-term borrowings.	Assets – Liabilities.
Industrials	Operating: Manufacturing equipment. Non-operating: Investment securities.	Long-term and short term debt.	Assets – Liabilities.

As I tell my students, the “balance” in balance sheets comes from beer, specifically ALE:

Assets = Liabilities + Equity

Commercial banks like SVB provide an asset transformation service. Many short-term highly liquid deposit accounts are transformed into fewer long-term income generating assets such as Treasury securities (HTML), home loans, and loans to businesses. As liabilities are reduced (depositors withdraw) the balance must be maintained through the sale of assets.

In theory, Equity > 0 because the bank operates profitably within the economic environment in such a way that Assets > Liabilities. However, SVB got to the point of having Assets < Liabilities. To “balance” the balance sheet they planned a sale of $2.25 billion in new shares.

That proposed sale sparked a panic in both equity markets (stock plummeting) and with SVB’s own customers (depositors rushed to withdraw money). If you have $72 in assets and $100 in depositors wanting their money, what do you do when you can’t raise > $28 through stock issuance? Collapse.

But let’s move on to how SVB got to this $72 in Assets and $100 in Liabilities situation (by the way, I just pulled $72 and $100 out of the air for illustrative purposes).

2. Rising rates

Rising rates reduce asset values – it’s just math

Presume a $500,000 home loan was issued last year at 3.5% interest. Today, home loan rates are twice that at around 7.0% (Bankrate.com: HTML). So, if the originating bank wants to sell that loan today, it needs to earn 7%. how does a $500,000 loan paying 3.5% interest earn 7%? If that loan sells (banks and investors buy and sell loans) for $337,474, with the payments unchanged, it will earn 7%.

So, the increase in mortgage rates from 3.5%to 7% resulted in the value of this bank asset dropping from $500,000 to $337,474 (a 32.5% reduction in value) – in just one year. The same algebra applies to other fixed-rate assets held by the bank such as Treasuries.

Rising rates make raising capital more costly

Many of Silicon Valley Bank’s customers (depositors and borrowers) are startup companies. Startup companies tend to have less (dare I say negative) cash flow. As such they need to raise capital periodically to sustain operations, R&D, etc. Capital is raised either in equity markets (share issuances be it IPO or SEO) or debt markets (borrowing). Well, with rising rates the appetite for risk in both markets declined.

So what does a startup do that needs cash flow for operations do when it can’t raise more capital, or at least not efficiently? They burn through cash. From SVB’s perspective, that means withdraw deposits. But again, as more and more of SVB’s depositors do this, SVB has to come up with the cash by selling assets. As I described in the previous section, the value of those assets decline during a rising rate environment.

3. Mismanagement

Sacramento State University launched a Masters of Science in Finance this past Fall: HTML. I teach FIN210, Financial Institutions Management. In fact, I taught it just this past October. I last taught the course in 2008 at the University of Memphis. So, every time I teach this course we are staring at financial system calamity. But it’s not my fault.

Financial Institutions Management boils down to a simple goal: measure and manage risk. I won’t go into SVB’s financial details here (full disclosure: I haven’t looked at them. I’ll make it an assignment for this coming October’s cohort!). However, something clearly went awry with the measurement and management of risk.

One thing the management did seem to do, and it was a very human thing to do – protect their interests. See 2023.03.10 Bloomberg, SVB CEO Sold $3.6 Million in Stock Days Before Bank’s Failure: HTML. Also, to further vilify executives, check out this 2013 post of mine on corporate bailouts: HTML.

2023.03.14 update: However, concentrating your customer base to startups only, and forcing those startups to sign exclusivity agreements, clearly did not help: HTML.

4. Where were the regulators?

Again, I haven’t looked at SVB’s financial details. However, as taught in FIN210 at Sac State’s MSF program (yes, that is a shameless plug for the program), banks should comply with numerous U.S. and international regulatory capital metrics (e.g., Tier 1 capital ratio, Tier 1 Common Equity / Risk-Weighted Asset ratio, etc.). Was SVB compliant with all capital adequacy ratios? If so, perhaps regulators need to rethink the adequacy of their capital adequacy ratios.

2023.03.14 update: It turns out the regulators were called off by the previous United States President’s Administration: HTML. As such, I do not believe you can fully blame the regulators which were not allowed to apply stricter standards on SVB as a result of the 2018 deregulation move. Although, there is certainly a cased for shared blame: HTML.

5. Crypto contagion

Silicon Valley Bank and Crypto are understandably intertwined. Silicon Valley is a global center of startups. Crypto startups need financing. SVB is there. However, with collapses of crypto exchanges like FTX (HTML), Crypto lenders like Silvergate (HTML), destabilization of so-called stable coins (HTML), crypto wallet thefts (HTML), and general “rat poison squared” nature of crypto as espoused by Warren Buffett (HTML), I question the prudence of intermingling regulated commercial bank operations with unregulated crypto so-called currency operations.

DISCLAIMER: I have JOMO (joy of missing out) with regard to crypto. Never have been a fan. Never “invested” a penny in crypto “assets.” One fundamental problem I have with crypto fanatics is when they say “the USD has no value, it isn’t backed by anything.”[1] Well, then why do you quote the price of your crypto so-called currency in “worthless” USD?

Moving on, SVB was in the business of providing banking services to not just startups, but even some crypto-related startups. A deeper dive into their financials will be an ongoing case study.

6. Panic induced from within startup ecosystem

2023.03.14 update: A former MBA student asked me “What about Peter Thiel inducing this panic.” At present, I have only two things to say about this:

1. “Feelings are an unreliable guide to reality.” -some Buddhist-related quote.
2. It is ironic that the very bank, or at least type of bank, that financed Thiel’s companies is one that Thiel served as a downfall catalyst. Human greed and selfishness were on full display.

Conclusion

Something went awry at SVB. Risk was not properly measured and managed. One risk to be measured and managed is interest rate risk. Specific details on SVB’s missteps in this regard require further analysis. I look forward to pushing that off onto FIN210 students in October. For instance, how does SVB’s capital adequacy ratios and interest rate risk measures look over time and vs. other banks.

In regards to other banks, I do think (and hope) that SVB’s collapse is not a widespread issue. However, I do not think SVB will be the last bank failure, especially of those intertwined with unregulated crypto businesses. Keeping my fingers crossed that my credit union has avoided crypto and measured and managed risk wisely.

-Dr. Moore

Update (2023.03.12 4:15PM)

A joint statement by Treasury, Federal Reserve, and FDIC says all depositors (even those with more than the $250,000 FDIC limit) will be made whole – at no expense to taxpayers: HTML. Who pays the expense: “Any losses to the Deposit Insurance Fund to support uninsured depositors will be recovered by a special assessment on banks, as required by law.”

Footnotes

[1] The notion that the USD “isn’t backed by anything” is false. The USD is backed by a government that can tax a productive population. The population is productive because we have resources. We have resources because we have a military that can protect and take more. We also have resources due to good ‘ol American ingenuity. However, I won’t go into the role of slavery in the initial capital and resource accumulation of this country. In a similar vain, banks don’t “create money out of thin air” either. When you get a home loan for $500,000, the bank does create a corresponding deposit (liability) of $500,000. However, that $500,000 is backed by the bank’s ability to collect principal and interest from you over the years. The bank has a claim to the future fruits of your labor. Hence, “the borrower is servant to the lender.” I will stop here before I go on another Dr. Moore tangent.

[*] Thanks to CB for editorial suggestions.

Just when you thought you heard the last of Wells Fargo malfeasance and fines, here comes another one. A quote from the article:

“Wells was ordered to repay $2 billion to consumers by the Consumer Financial Protection Bureau, which also enacted a $1.7 billion penalty against the San Francisco bank Tuesday. It’s the largest fine ever leveled against a bank by the CFPB and the largest yet against Wells, which has spent years trying to rehabilitate its image after a series of scandals tied to its sales practices.”

Followed up by this funny but sad quote:

“Put simply: Wells Fargo is a corporate recidivist that puts one out of three Americans at risk for potential harm,” said CFPB Director Rohit Chopra, in a call with reporters.

Not sure why they didn’t come through, but, if you visit the post on the website you will see the figures: HTML.

-Dr. Moore

On rental “investment” property

I found this an interesting read from seeking alpha. I have had many discussions with folks regarding real estate, particularly rental real estate. From my observations, real estate is an overly-emotional transaction. The seeking alpha article below takes a step back and examines some of the facts of purchasing Real Estate Investment Trusts (REITs) vs. rental property. I say “some” of the facts because the article omits the following critical costs of rental property ownership:

1. Property taxes.
2. That depreciation expense you take every year ultimately translates into repairs. “The chickens will come home to roost” so to speak. You depreciate $10,000 this year, eventually an AC or roof or fence or whatever needs to be repaired. And those expenses persist once you have exhausted all of your deprecation allowance.
3. Insurance costs for rentals is higher than owner-occupied homes. Take a look at this 2022.10.14 article from Benzinga (via yahoo finance) titled “Insurance Costs Are Rising, But Real Estate Investors Could Lose More By Not Being Honest About Their Property”: HTML.
4. What about vacancies? Many rental property owners assume properties will be rented 365 days year. That is simply untrue. And with turnover comes costs.

Myth: home prices always go up

While I am at it, let me share a couple charts to address the myth that “home prices always go up.” First, the S&P CoreLogic Case-Shiller home price index from 1986.01.01 to 2022.07.31:

Figure 1: S&P CoreLogic Case-Shiller US Home price index from 1986.01.01 to 2022.07.31. Source: Bloomberg.

We are all familiar with the Great Recession and subprime mortgage crisis around 2008. Figure 1 shows home prices dropped 26.76% from the 2006.06.30 peak to the 2011.12.30 low. Also note the incredible spike in prices towards the end of the data sample. This is not sustainable.

So how long did it take for home prices to reach their 2006.06.30 peak? Over ten years:

Figure 2: S&P CoreLogic Case-Shiller US Home price index from 2006.06.30 to 2016.12.31. Source: Bloomberg.

On home affordability

A recent NPR article titled “With mortgage rates near 7%, the housing party is over. Now it’s hangover time” (HTML) provides examples of folks stretching their budgets to overpay for a home they truly can not afford.  This relates to emotions involved in home purchases (be it rental or for your primary residence). Dave Ramsey has three simple criteria to assess whether or not you can truly afford the home you wish to purchase (HTML):

1. 15 year fixed rate mortgage.
2. 20% down payment.
3. All-in monthly home payment less than 25% of take-home pay.

How many actually go through those calculations? How many disregard the results even if they did do the calculation? How many changed the 15 year term to 30, 40, or more years just so they could “afford” a more expensive house?

In conclusion, be careful when describing your real estate purchase as an “investment.” If you do the math, which means including ALL costs (insurance, vacancies, repairs, property taxes, real estate commissions when you sell, closing costs when you buy, etc.) you may see: (1) you couldn’t afford the home in the first place, (2) it was a poor investment, and (3) there are many better alternatives.

-Dr. Moore

https://seekingalpha.com/article/4546221-why-i-stopped-buying-rental-properties-to-buy-reits-instead-part-2

This is a long article but rich in content. Early in the article the author highlights the wide wealth gap: “The wealthiest 1 percent of Americans hold more than half the stocks owned by households; the bottom 90 percent hold just 11 percent.” Think of the simple math behind that: The wealthiest 10 percent of the US population owns 89% of equities.

How did we get here? The author notes this entrenched position is enabled by policies that favor the wealthy (entrench wealth):

“Start with the tax code. Income gained from selling stock in a company is taxed at a lower rate than income gained from actually working at that business. A second transfer from poor to rich: A homeowner may deduct mortgage interest on a first and second home, while the less wealthy pay nondeductible rent.”

I mention often in class that there are only two professions in life. Either you own the means of production (bourgeois or ownership class) or you do not and therefore you are the means of production (proletariat or working class). I’ll offer a third example of wealth transfer from poor to rich. If you have sufficient wealth, you drop $50,000 on solar panels and batteries for your expensive home. Then, although the person with solar panels and batteries in their expensive home can afford electricity, they actually generate their own and even sell some back to the grid. Now, who’s buying that electricity off the grid? The poor people who are renting or who own a home where $50,000 solar panels/batteries approaches the value of the home!

Moving on through the article, I really like the term “name inflation” coined by the author:

“The name inflation of the Big Tech CEO class corresponds to its wage inflation: Eight of the 10 wealthiest people in the world are current or former chief executives of American technology companies, and their wealth consists almost entirely of shareholdings in those companies”

What does he mean by “name inflation.” The author points out how many times CEO names are mentioned in S-1 filings (filings to go public) over time:

1980, Apple, Steve Jobs mentioned 8 times.

1986, Microsoft, Bill Gates mentioned 23 times

2019, WeWork, Adam Neumann mentioned 169 times.

2021, Affirm, Max Levchin mentioned 131 times.

2021, Robinhood, Vladimir Tenev mentioned 109 times.

I came to a conclusion during one of my book club meetings: Wealthy insecure alphas (or insecure alphas that come from wealth), who know they are not alphas, use their wealth to create a narrative of their greatness to mask their shortcomings. By using the phrase “False Idols” in the article title, the author tells us that many Americans are not seeing clearly. Rather, many Americans are buying the paid-for narratives and making these insecure alphas false idols.

As further evidence of broader idolatry, the author further notes how valuations have gotten way out of hand:

“three electric-vehicle firms—Tesla, Lucid, and Rivian—were together worth more than the rest of the auto and the airline industries combined.”

Towards the end, the author points out how what was supposed to be distributed ownership and decision-making (via going public) is, in practice, concentrated control in the hands of a few. And, speaking to the insecure alpha funding idolatry narratives, you often hear founders justify dual-class shares by stating “the dual-class share structure ensures this company remains founder-led.”

But wait a second. Who said the founder of a private company is the best person to lead a large public company? Different skill sets? Are we to just buy the “I’m an all-knowing tech god” narrative, buy non-voting shares, and transfer more ownership and control to the few? As an aside, please know that Elon Musk is not the founder of Tesla: HTML. If this is a surprise, may the fact that Elon Musk did not found Tesla liberate you from big tech founder (and he wasn’t even the founder) idolatry.

I’ll end here because it is late. But also because this Atlantic article, as I said, is rich in content. Please take the time to read it. I believe it is worthy of the time.

-Dr. Moore

https://www.theatlantic.com/ideas/archive/2022/09/big-tech-founders-gates-neumann-jobs/671519/

Let me begin by quoting the last paragraph (beginning with the end in mind):

“Taking climate risk as investment risk is just good business,” says Henisz of the Wharton School. “Now, we can argue about how we do it and who does it well and who does it poorly. That’s a legitimate argument. [But] the idea that ESG is ideological and not economics is a political argument.”

The article, in my opinion, does a great job describing what ESG is and how it connects to investment decisions. It is yet another example of where politics should be set aside in order to clearly see the facts of the matter. Speaking of facts, it sure was hot in Sacramento last week…

Stay cool my friends,

-Dr. Moore

https://www.npr.org/2022/09/12/1121976216/esg-explained

Then, this NPR article pops up on my news feed. It has some good tips above and beyond bringing your HP12C (even though bringing your HP12C on the belt clip holster will really settle down salespeople). Of note is this quote:

“Earlier this summer, the FTC proposed new rules aimed at combating the graft and skulduggery found at many dealerships.”

Skulduggery? I must admit, I had to look that up (underhanded or unscrupulous behavior; trickery). Nevertheless, I think the best advice now is to have patience. Sooner or later this short supply of cars will normalize. Hold off participating in the skulduggery if you can. But if you must, here are a few considerations:

1. Don’t trade your car in. As the article says: “One study found that dealerships tend to treat a buyer’s decision to trade in their used car like a neon sign on their foreheads, flashing, `Charge me more!’” If you need to unload your car, consider selling it directly to Carmax (I’ve done this twice) or shift.com (I almost did this to capture peak price for my car, but then had no idea what I would buy to replace it). There’s also Autotrader.com, your local newspaper, craigslist, etc.
2. Narrow down what car you want and be patient.
3. Get pre-approved at your credit union for an auto loan if you must have a loan. “Stealerships” will play around with rates and number of months to trick you into a monthly payment “that you can afford.” That should not be the case at your credit union. This is especially true if you follow #2.

Good luck…

-Dr. Moore

https://www.npr.org/sections/money/2022/08/30/1119715886/inside-the-rise-of-stealerships-and-the-shady-economics-of-car-buying

First, let me begin with a meme I received this morning:

At first I thought the news headline was fake. So I googled it. Much to my surprise, it is real. I find quotes from the article even more disturbing:

• “Applicants do not have to be Black or Hispanic to qualify for the product, a bank representative said.” So, at first glance, one would say of course, discriminatory lending practices are illegal. But…
• “Bank of America’s Countrywide Financial, a subprime lender it purchased in 2008, was fined $335 million in 2011 over claims that it charged Black and Hispanic homebuyers higher interest rates than white applicants.” And
• “In 2012, Wells Fargo agreed to pay $175 million to settle claims that it targeted people of color with risky home loans that were more expensive.”

So, to say something is fishy here is an understatement. We have a looming recession, inflated asset prices (stocks, bonds, real estate, used cars, you name it), supply chain issues, natural disasters, etc. So this is the perfect environment to ramp up sub-prime lending like the 2008 financial crisis?

Another thought comes to mind: Just who are the sellers of the homes in the neighborhoods BofA is targeting? Remember, if someone is buying a home, then someone (or some business entity) is selling. Is there anyway to trace that ownership to Bank of America and the alleged hedge fund friends of the meme? I will leave that research to the readers. If you find something, post a comment.

Regards,

-Dr. Moore

https://www.nbcnews.com/business/consumer/bank-america-zero-down-payment-mortgage-first-time-buyers-details-rcna45662

For all those with JOMO (joy of missing out), this long soap opera of a read is entertaining. Massachusetts, Singapore, New York, Dubai, Cayman Islands, super yacht, the mafia, greed, deception, hubris, arrogance, it’s all in there.

May this story serve as a reminder: if something seems to good to be true, it probably is.

-Dr. Moore

https://nymag.com/intelligencer/article/three-arrows-capital-kyle-davies-su-zhu-crash.html

Many students know I never “drank the Tesla Kool-Aid.” However, occasionally students get tired of listening to me. So, perhaps hearing this Tesla perspective from Time Magazine may help. The Time Magazine piece, in my opinion, does a great job explaining the big picture surrounding electric vehicles (EVs). For example:

“A much more sustainable alternative to mass ownership of electric vehicles is to get people out of cars altogether—that entails making serious investments to create more reliable public transit networks, building out cycling infrastructure so people can safely ride a bike, and revitalizing the rail network after decades of underinvestment.”

I teach finance. I am not a psychologist. But I have wondered why “cults” seem to form more frequently. E.g., crypto so-called currency cults, meme-stock cults, Tesla/Elon cult, former president cult leading to the January 6 incident (e.g.: HTML), etc.. In all these cases, a person, thing, or idea is treated as a God. When clear evidence showing these are not Gods and are far from perfect (even detrimental to the individual in the cult and society as a whole) is presented, people double-down on their flawed beliefs. I don’t get it.

Nevertheless, may all read the Time article with an open mind and gain broader perspective on the electric vehicle space.

-Dr. Moore

https://time.com/6203815/elon-musk-flaws-billionaire-visions/