The Moral Hazard of Federal Intervention at SVB

In the famous words of Mark Twain, "history never repeats itself, but it often rhymes." Recent events, including the demise of Silicon Valley Bank and subsequent regulator response, are a painful reminder of policy mistakes made in the past.

 The first of these: Amid the panic during the Great Recession in late 2008 and early 2009, regulators essentially bailed out Wall Street traders of Credit Default Swaps (CDS). Credit Default Swaps are complex, opaque financial instruments. Traders had made tens of millions in salary and bonuses with these products. The unwinding of some of these instruments ultimately led to the demise of several large investment banks.

 This bailout left a very sour taste in my mouth. "Joe Lunch-bucket" taxpayer was bailing out fat-cat centi-millionaire Wall Street traders who walked off into the sunset without consequences. All this with the approval of Fed/Treasury officials. 

 I described my frustration in a memorable discussion with an uncle who had worked his entire successful career as a broker for Merrill Lynch. My take: we have created an economic environment where if you take huge bets and win – you get rewarded, but if you take those same bets and lose – you walk away with no consequences. The taxpayer? Not so lucky. In other words, regulators gave and a nod to capitalizing the gains and socialized the losses – creating a moral hazard.  

The second mistake started as a reasonable response to the carnage of the recent Great Recession: low-interest rates: The mistake was keeping rates really low for really long.  

This tactic aimed to pull the economy out of a deep recession. It encouraged home purchases and business formation. My family directly benefitted from the policy boondoggle – with a monthly mortgage payment less than many married college students pay for rent. In such an environment, is it any wonder real estate prices and demand skyrocketed? In a world where debt was close to free - a worldwide debt orgy ensued. 

 While you can argue that growing the economy initially with low rates was prudent – Fed policymakers kept rates low for close to ten years before considering a rate increase. However, the onset of COVID-19 not only changed the Fed's flirtation with higher rates - they also doubled down on lower rates, while congress added TRILLIONS to a world already awash in cash. The inevitable result? A nasty bout of inflation. 

 The Fed noticed the problem only after it was painfully obvious that their policy had generated persistent (NOT transitory) inflation. With almost $30 trillion of outstanding debt which will need to be refinanced – the FED scrambled this year to kill inflation quickly – to avoid the pain of financing the debt at much higher rates. However, the Fed was late to the game and, as a result, had to raise rates at unprecedented speed and magnitude. Government policies have unintended consequences, which are now coming home to roost.

 Why did Silicon Valley Bank fail? Here are a couple of reasons. Their deposit base was primarily venture capital and private equity companies. These companies took in enormous amounts of money that they deposited in 2021. Silicon Valley Bank management/treasury department made some awful decisions (incompetently bad) on how to invest these deposits. Instead of buying low-duration, short-maturity treasuries, they reached for minuscule additional yield by buying treasuries with ten to thirty-year maturities and slightly higher yields (bad idea).

 These long-dated treasuries fell precipitously in value as rates went from .5% to around 4.5% in less than a year. Recently, with the economy slowing down, these same VC/PE companies needed access to that cash for critical operational needs like making payroll. The result? Silicon Valley Bank had to sell these "risk-free" treasuries, which were on their books with significant, reported losses. When Wall Street analysts and depositors caught wind of these losses, the run on the bank began.    

 Let's be clear on the uniqueness of SVB. These VC/PE customers are some of the world's most financially sophisticated, wealthy banking clients. They are very desirable banking clients – and it just so happened that SVB had a LOT of them. In addition, most of their deposits in SVB were significantly above the FDIC deposit insurance limits of $250k. 

 The VC/PE industry has been a critical global economic growth and innovation driver. Their demise would have been a disaster – at least for the companies and the potential economic growth they represent. Hence, when it became evident that SVB was about to fail, the Fed stepped in and closed the bank and back-stopped all deposits – including those greater than $250k – again (like in 2009) for many customers who happened to be Wall Street fat cats.

 I find myself conflicted. Do we bail out a critical industry (at the cost of higher fees for "Joe Lunch-bucket" depositors for decades to come), or do we let capital markets experience "creative destruction"? After serious reflection, I am inclined to be a "capitalism purist," and believe the long-term consequence of allowing depositors with greater than $250k to lose their deposits is better than the moral hazard of bailing them out. Policymaker action has clearly and permanently reinforced the notion that the FED/FDIC/Treasury will always come to the rescue if you have the right name, profession or resume, which carries incredibly problematic consequences. 

 So, what should the average investor do? Stay calm, invest in quality stocks and bonds (keep maturities short), own some alternative assets like gold or silver and don't find yourself with over $250k at any bank.