The epic downfall of Silicon Valley Bank was triggered in large part by its portfolio of long-term government bonds.
Bonds with maturities that are decades away tend to pay rates higher than bonds with shorter maturities. That makes sense. After all, the person – or, in this case, the bank – that purchases the longer-terms bonds is agreeing to have their money locked up for longer.
When the bonds can be held all the way until their maturity date – which is ideal for both the bond investor and issuer – the owner of the bond will have received everything they are supposed to. That means they’ll have been paid all the interest payments made along the way, as well as the return of their original principal at maturity.
Are you with me so far?
OK. When investors can hold bonds to maturity, interest-rate risk is not an issue. Interest-rate risk refers to the risk of bond owners losing money if their assets are sold before maturity. More specifically, long-term bonds sold in a climate of rising interest rates will be sold at a loss. That’s because newer bonds that have been issued at the prevailing higher rates have the effect of making “older,” or existing, bonds worth less, because the rates they pay are lower.
After all, why would savers in the market for bonds want to buy “old” bonds paying less than what new bonds are paying?
This means if you’re the person, business or other entity that owns bonds issued before interest rates start rising, you really don’t want to sell them if you can avoid doing so.
Unfortunately, Silicon Valley Bank couldn’t avoid doing so. The venture-capital industry that made up so much of its customer base had fallen on hard times. Depositors were leaving. As with most banks, Silicon Valley didn’t have enough cash on-hand to make good on the mass of withdrawal requests.
Silicon Valley was forced to sell a bunch of their long-term bonds while those assets were underwater – the very thing I just you really don’t want to do. The near-$2 billion loss that resulted sealed the bank’s fate.
Now…the basic mechanics of how bonds work is not the point of this week’s article. However, in order to discuss what I really want to talk about this week, I needed to provide a thumbnail sketch of how Silicon Valley was waylaid.
What I really want to talk about is this: Despite all of the risk-management protocols in place for the banking industry, this most prominent of threats to Silicon Valley Bank – and the one that ultimately flattened it – was either missed or ignored by risk-management professionals at all levels.
And that compelling reality suggests risk is – and likely always will be – an inherent feature of banking.
We obviously know Silicon Valley’s own risk-management team was missing in action. But as we’ll see in this article, there also was no help to be had from regulators. Not only was Silicon Valley Bank not subject to relevant oversight to begin with, but, even if it had been, that oversight was ill-prepared to identify the risk to the bank’s viability from its government bond portfolio.
That’s not all. There also was no heads-up about the bond-portfolio risks provided by Silicon Valley’s outside auditors, who, just 14 days before the collapse, delivered to the bank what the Wall Street Journal calls “a clean bill of health.”
We’re going to look more closely at why even regulators and outside auditors didn’t see the glaring threat the bond portfolio posed. What happened – or, rather, what didn’t happen – is an important reminder that risk management at banks ultimately is performed by people…and people are flawed. And as long as that remains the case, depositors and retirement savers may want to consider making sure their hard-earned nest eggs enjoy all the protections that are reasonably available.
We’ll talk about one of those protection options as we close out this article. But before we get to that, let’s dig in to how the unrealized losses from Silicon Valley’s bond holdings – which eventually turned into actual losses – were missed.
The collapse of Silicon Valley Bank triggered a good deal of political finger-pointing. Why political finger-pointing? On the surface, it seems the bank’s sudden failure gave those opposed to President Trump’s “streamlining” of the Dodd-Frank Act five years ago the first real opportunity to say, “I told you so.”
A brief review: Dodd-Frank was passed in 2010 in the wake of the financial crisis. The purpose of the legislation is to better safeguard the financial system, consumers and taxpayers by improving transparency and accountability in that financial system. In a nutshell, the law instituted a sweeping array of regulatory reforms, including reforms designed to better sniff out potential threats to financial stability.
In the years that followed, the “sting” of the financial crisis began to wear off. Small and mid-sized banks began lobbying for relief from the onerous Dodd-Frank regulations on the basis that the original law placed an undue burden on non-systemically-important institutions. In response, a partial rollback of Dodd-Frank – the Economic Growth, Regulatory Relief, and Consumer Protection Act – was passed by Congress and signed into law in 2018. Among the features of the legislation is that it raised the threshold definition of a “too-big-to-fail” bank from one with at least $50 billion in assets to one with at least $250 billion.
As of the end of 2022, Silicon Valley Bank had just a little more than $200 billion in assets – below the minimum too-big-to-fail standard that was revised in 2018.
Now, back to the finger-pointing. Essentially what the finger-pointers are saying is that if the 2018 Dodd-Frank rollback hadn’t occurred, the Silicon Valley collapse wouldn’t have occurred, either.
Upon scrutiny, however, that claim doesn’t hold up.
As a recent article in the Wall Street Journal points out, even if Silicon Valley had been subject to the same level of oversight as its much larger brethren, it’s likely the eventual outcome for the bank would have been the same. The reason? The Federal Reserve’s “severely adverse” stress-test scenarios did not assume anything close to the onerous interest-rate environment that caused Silicon Valley to buckle.
Wall Street Journal: Fed’s Interest-Rate Stress Test Scenarios “Bore No Relationship to Reality”
The Journal details that the Fed’s “severely adverse scenario” as reflected in its February 2022 Stress Test Scenarios asked banks to consider their risk based on the following rate environment: one in which the three-month Treasury rate hovers near zero and the 10-year Treasury yield sits at just 0.75% throughout most of the first three quarters of 2022.
The problem is that this scenario assumed rates that in no way matched the central bank’s actual expectations for rates over the period used in the scenario. As the Journal says, “Even in December 2021…the Federal Open Market Committee’s Summary of Economic Projections was showing the Fed likely targeting interest rates double those of 2022 in 2023, far higher than what it used for bank stress tests.”
What’s particularly concerning is that even a year later – February 2023 – the Fed’s “severely adverse scenario” by which banks were to assess their level of risk still didn’t reflect the central bank’s actual projections as to where rates were headed.
The Fed’s December 2022 Summary of Economic Projections forecast rates at 5.1% by the end of 2023; yet the February 2023 “severely adverse scenario” pegged the three-month Treasury again near zero by Q3 2023 and the 10-year Treasury yield at 0.5% by the end of Q2 2023, rising to just 1.5% later on in the scenario.
Perhaps even more bizarre is that the February 2023 “severely adverse scenario” didn’t even assume the actual Treasury rates applicable at that time. Two months ago, the three-month Treasury rate was above 4.5% and the 10-year Treasury yield was close to 4%.
In other words, the Fed’s severely adverse scenario banks were assessing their vulnerability against assumed rates so low that they likely wouldn’t have caused much of a problem.
Except those assumptions weren’t at all close to the conditions of the actual rate environment.
As the Journal put it, “The 2023 severely adverse scenario’s assumptions bore no relationship to reality.”
Again, Silicon Valley Bank was not subject to these Stress Test Scenarios thanks to the partial Dodd-Frank rollback. However, even if they had been subject to the scenarios, it’s unlikely the “tests” would have uncovered the problem that played such a big part in the bank’s failure. That’s because the “severely adverse scenario” Silicon Valley would have used to assess its risk was not reflective of the actual rate environment that proved to be such a problem for its bond portfolio.
So, regulatory management of that risk would have been a “fail.” And as we’re about to see, outside-auditor management of that risk actually was a “fail.”
Let’s talk about that next.
Earlier, I alluded to another Wall Street Journal report that revealed Big-Four accounting firm KPMG LLP delivered “a clean bill of health” to Silicon Valley Bank only two weeks before it was shuttered. Although a new audit provision charging accounting firms performing such examinations with identifying “critical audit matters” was introduced in 2017, it seems the elephant-sized interest-rate risk occupying so much of the room went entirely unnoticed.
As defined by the Public Company Accounting Oversight Board that introduced the new disclosure requirement, critical audit matters are those that:
Apparently, the interest-rate risk to Silicon Valley’s sizable long-term bond portfolio did not meet that standard, in the opinion of the KPMG auditors examining the bank.
The Journal notes that SVB Financial Group, the parent company of Silicon Valley Bank, was toting around a particularly ominous level of unrealized losses as of the end of last year. The balance sheet as of December 31, 2022 reflected $91 billion in hold-to-maturity bonds – which actually had a market value of just $76 billion. The bank’s total equity as of the end of 2022 was $16 billion. That means the $15 billion in unrealized losses (the difference between the $91 billion face value and $76 billion actual value) effectively canceled out nearly all of the financial institution’s equity.
Experts say that definitely should have raised a bright red flag as a “critical audit matter,” particularly when you also consider that Silicon Valley’s amount of reported cash was just 8% of total deposits. As the Journal says, such a low ratio of cash to deposits makes the prospect the bank would have to sell off long-term assets in the event of a mass exit of depositors more likely – which, of course, is what happened.
One of those experts is Martin Baumann, the former chief auditor of the Public Company Accounting Oversight Board and one of the architects of the critical-audit-matters criterion. According to Baumann, the circumstances of Silicon Valley’s bond portfolio along with the associated implications seemed to “meet every definition of a possible critical audit matter.”
“I’m not the auditor of the bank and I don’t know if this [bonds issue] should have been included in the auditor’s report,” Baumann added. “But as the lead author of the standard, this certainly is the kind of item that we had in mind for critical audit matters.”
There are multiple lessons here. This may be one of the most important: Despite the presumed best-efforts of whole regimes of risk-management personnel – government regulators, outside auditors, even the bank’s own in-house team – risk in the financial system likely is here to stay.
I’m not suggesting you should avoid doing business with banks altogether in the interest of exposing your money to less risk – not at all. For most people, such an approach would be impractical, to say the least.
But that doesn’t mean you can’t take reasonable steps to reduce your risk exposure where possible. Let’s talk about one possible risk-mitigation strategy as we close out.
One option you might consider to help reduce your vulnerability to banking-system risk is the addition of precious metals to your inventory of assets. Physical precious metals have some rather unique properties that could help lower the impact of turmoil arising from instability in the financial system.
One of those properties is that metals, as an asset class, have no counterparty risk, one of the more prominent risks faced by bank depositors. This means their value and legitimacy do not rely on any person performing any task or living up to any obligation. If you hold a one-ounce gold coin in your hand, you also hold, in an absolute sense, the equivalent dollar-value of the coin at that point in time. There is no one who must “make good” on the asset in any way for its value to be fulfilled.
Precious metals may help to lower risk in other ways, as well. Metals have strengthened throughout numerous historical crises and periods of economic distress. The tendency of gold and silver to respond in this fashion during those troubled times suggests the possibility they could help mitigate the impact of unrest on the value of retirement accounts.
It’s not enough that the banking and the financial system, more generally, is fraught with risk. Depositors and retirement savers must also recognize that management of that risk – to the extent it can be managed – falls to human beings who can be prone to making mistakes and committing errors in judgment.
There may be no foolproof way to eliminate those risks entirely. But while those who are actually responsible for banking oversight are doing what they can – even in their own imperfect way – to help manage financial-system risk at the source, there’s no reason you can’t take steps to additionally manage that risk in your own life and further reduce the potential impact it could have on your financial security.
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