Silicon Valley Bank just failed. Will contagion spread across the financial system? Let’s take a deep dive

Wednesday - Silvergate announced it’s ceasing operations Thursday - Silicon Valley Bank stock crashes 60% as the bank scrambles to shore up liquidity Friday - SVB fails, taken over by FDIC. It’s been a horrible week for banks.

Silicon Valley Bank just failed, and FDIC is taking over The bank attempted to raise capital, and couldn’t. Then they tried to sell to a larger bank, and couldn’t. Now, SVB has failed and the FDIC will attempt to salvage customer assets.

Is this just the tip of the iceberg? And how intertwined are all these banks?

Many banks are facing the same problem: Their bond portfolios were locked in at low rates. As depositors withdraw money, banks may have to sell their bonds at huge losses to come up with the money. If too many customers withdraw at once, the bank’s losses could be massive.

Silicon Valley Bank’s problems started with a $1.8 billion loss on the sale of its AFS (available for sale) bond portfolio. Rumors swirled that SVB was facing huge interest rate risks on its $91 billion portfolio.

This panic caused some customers to withdraw money (it’s unclear how much at this point). Withdrawals feed the vicious cycle of selling bonds at a loss to cover the outgoing deposits.

SVB theoretically had the assets to cover deposits (which they are legally obligated to do) BUT, the real question was: how liquid are those assets? And can they be liquidated without causing massive losses? Turns out, the answer to the last question was ‘no’.

Are other banks facing this problem? Absolutely. Take First Republic Bank. Its stock was down as much as 50% today on similar fears, but has since recovered a bit. twitter.com/Schuldensuehne…

But the word ‘contagion’ doesn’t necessarily apply to the issues with bond portfolios. This issue has little to do with its relationship with other banks - it would be a problem regardless of SVB’s dealings with any other banks.

Interest rate risk is an inherent challenge of running a bank. However, a contagion could still be playing out. The potential failure of one bank can lead to many others failing just because of fear.

Naturally, people are looking at what other banks have a potential weakness. First Republic and many others were identified earlier today. Now many customers of those banks are fearful and withdrawing money. twitter.com/Grit_Capital/s…

Many are pointing out that banks with bad business practices are the only ones in danger here. Banks that have responsibly managed deposits and investments should (in theory) be safe.

Many are also comparing this to 2008 with Lehman Brothers and Bear Stearns One thing to keep in mind is that those institutions were investment banks, and we’re talking about commercial banks that take in deposits.

While a commercial bank can certainly get into trouble, they can’t have anywhere near the 31x leverage that Lehman had when it collapsed But, commercial banks can certainly fail. Selling bonds at losses and realizing losses on bad loans are two big problems banks are having now

So the contagion could be a bevy of problems that hit many banks at once: Interest rate risk and losses on bad mortgage and consumer loans, for example. So if the economy gets worse, these banks could be in more trouble.

But Silvergate and SVB did business with FTX, plus many other formerly overvalued tech companies that are now crashing back to Earth. twitter.com/GRDecter/statu…

Are big banks like Wells Fargo and JP Morgan in danger? Michael Barr, the Fed’s vice chair for supervision, spoke on that yesterday:

What’s next? The markets will quickly identify the banks with large interest rate risk and too much leverage. And those banks will either shore up liquidity quickly, or meet a similar fate as Silvergate.

I’ll keep you up to date here: gritcapital.substack.com