The problem with Bonds, or why Silicon Valley Bank was screwed by interest rates.

Suppose you buy a 30 year treasury.

Now the way treasuries work is that when you buy one, you buy it so that, 30 years from now, it will be worth the face value on the bond.

Now back in March of 2020, 30 year treasuries were going for 1.42%. Using the simplified formula that the value of a treasury 30 years form now is :

(1 + R/100)30,

this means you’re buying that $100 treasury for $65.50.

(1+1.42/100)30 = 1.014230 = 1.52654, and $100/1.52654 = $65.50.

For $65.50, you’ve bought a promise that in March of 2050, the treasury you have in your possession will be worth $100.

(Yes, I know; treasuries are not compounded annually. But this “back-of-the-envelop” calculation is close enough to illustrate the problem.)

Now, suppose you want to sell that treasury.

What happens next?

Well, think about it: what you’re selling is the promise that in 2050, the person who buys this treasury will receive $100. What should the person buying that treasury pay for it?

That’s a surprisingly simple formula: basically, at today’s interest rates, how much should I pay for a bond that matures in March of 2050 that pays out $100 in 27 years.

Well, today’s interest rates are 3.71%. Plugging in those numbers into our formula above, we get $37.40.

(1+3.71/100)27 = 1.037127 = 2.67397, and $100/2.67397 = $37.40.

So if you’re selling me a treasury from March of 2020, a fair price I would spend on that treasury is $28.11 less than you paid for it three years ago.

Net loss: 43%.

What’s Going on With Silicon Valley Bank?

How did we get here?

SVB Financial is the parent company of Silicon Valley Bank, which counts many startups and venture-capital firms as clients. During the pandemic, those clients generated a ton of cash that led to a surge in deposits. SVB ended the first quarter of 2020 with just over $60 billion in total deposits. That skyrocketed to just shy of $200 billion by the end of the first quarter of 2022.

What did the bank do?

SVB Financial bought tens of billions of dollars of seemingly safe assets, primarily longer-term U.S. Treasurys and government-backed mortgage securities. SVB’s securities portfolio rose from about $27 billion in the first quarter of 2020 to around $128 billion by the end of 2021.

Why is that a problem?

These securities are at virtually no risk of defaulting. But they pay fixed interest rates for many years. That isn’t necessarily a problem, unless the bank suddenly needs to sell the securities. Because market interest rates have moved so much higher, those securities are suddenly worth less on the open market than they are valued at on the bank’s books. As a result, they could only be sold at a loss.

SVB’s unrealized losses on its securities portfolio at the end of 2022—or the gap between the cost of the investments and their fair value—jumped to more than $17 billion.

Essentially SVB bought a bunch of treasuries–undoubtedly a wide variety of them, spread across a lot of time–back around the time when 30 year treasuries were quoting between 1.5% and 2.5%:

Fredgraph

And thanks to a recession of VC money, they were forced to sell when 30 year treasuries were quoting nearly 4%.

Even in the best case scenario that means the value of those treasuries–the amount they can get for them today with interest rates significantly higher–is at least 25% less than what they paid for them back in 2021.

Here’s the problem: a lot of banks own treasuries. Until the Federal Reserve started ratcheting up interest rates to fight inflation, treasuries were seen as the single most secure investment instrument out there–because you know 30 years from now they’ll return a fixed interest rate that on average is above the inflation rate.

So this is not an SVB problem.

This isn’t even a “deregulation” problem.

This is a combination of people pulling down their assets from banks who may be overexposed to treasuries which, thanks to rising interest rates, are dropping in value like a stone.

And this potentially affects all banks, especially now as the stock market is repeatedly hammered by high inflation and high interest rates.

SVB just happened to be overexposed to more high-value asset holders in their commercial banking sector; companies with millions in their checking account needing to make payroll, which are only insured to $250k.

The problem, of course, is not with you or me. If you have less than $250k in your checking account and less than $500k in an SIPC insured investment–such as a mutual fund–then you’re fine.

Note: If you own shares in a place like E-Trade, you are the beneficiary owner–and the “customer name securities” rule applies: the shares revert directly to you, even though they are held on your behalf by the brokerage. (So, for example, if you own a million dollars in Apple stock, you get the full million dollars worth of Apple stock returned to you if E-Trade goes bankrupt.)

The problem, however, does lie with corporations who may have a huge amount of money in a checking account which is used to pay out their payroll. A company with 100 people working for it may have a burn rate of $1 million a month in salaries, payroll taxes, rent, maintenance and the like. And if that company suddenly has the $3 million it has on hand to cover 3 months burn rate frozen–there are 100 people who ain’t getting their payroll checks.

And I suspect someone at the Federal Reserve and at the Treasury Department is waking up to the fact that these high interest rates along with the massive burndown in savings means a lot of banks may find themselves in hot water.