SVB: Damned by Duration

Richard Kramer:

Welcome to Bubble Trouble conversations between the independent analyst, Richard Kramer, that's me and the economist and author, Will Page, that's him, and he's actually in Austin, Texas this week. We're going to do what we do best, lay out the inconvenient truths about how financial markets really work. In recent episodes, we've been saying that if there's a bubble that burst, we pricked it first. But events at SVB, Silicon Valley Bank and many others have caught us off guard. This bubble burst before our eyes, and now the one word on the market's lips is contagion. We've been here before, and we'll certainly be here again, banks getting bailed out and central banks scrambling to respond, and that's what Bubble Trouble is all about. So this week we're going to talk about it. More in a moment.

Will Page:

Thank you, Richard. Great to be podcasting from Austin, Texas at SXSW. Again, we'll come back to what we've learned at the conference in the future episode, but this episode is all hands on deck with Silicon Valley Bank. It's incredible. With the purpose of this podcast, when I first met you, Richard, was to cite that children's story of The Boy Who Cried Wolf. 15 years ago, banks were being bailed out at ACOs to the taxpayer and we were told, "That's it. It will never happen again." here we are in March 2023 and what has happened? The boy cried wolf again.

I want to take this podcast down a path of just joining the dots from all of our episodes in the past. So I think what Silicon Valley Bank has done has brought Bubble Trouble to life in a way that we didn't expect, we didn't want, but we're going to have to dissect. Now, Richard, one of our very first podcasts was the S and S words. That is you introduced us, our audience to sycophants offense and stenographers. So let's hear it out. You have a bug in your basement about the sycophants and stenographers on Wall Street and in the financial sector. What were these sycophants and stenographers saying about Silicon Valley Bank in the years and the months and the weeks before the collapse?

Richard Kramer:

Will, that is one of my favorite catchphrases, sycophants and stenographers. I know it doesn't roll off everyone's tongue, certainly with a Scottish accent, it doesn't sound quite the same, but they are the folks who say, "Congratulations on a great quarter." Then ask managements, "How should we think about, i.e., fill in the blank "about what we're supposed to tell people?"

Will Page:

They praise as opposed to appraise.

Richard Kramer:

That is your tagline and it's a fantastic one. So many banks were still recommending SVB stock literally days before it collapsed-

Will Page:

Days?

Richard Kramer:

... but this is really ... days. So Goldman Sachs was recommending SVB stock and maintained its buy rating and actually raised their price target six days before it went bust.

Will Page:

No.

Richard Kramer:

Yep. This is part and parcel of VC boom that just left a lot of money sitting around and a lot of conflicted parties that had to figure out what to do with it. Now what you really need to understand is that everyone has skin in the game here. The banks recommending SVB stock want SVB to keep funding risky companies that they hope one day they're going to get a role taking public. The VCs want someone to help them borrow and fund those companies that doesn't ask all the pesky questions about risk that bigger and better organized banks might. There was a huge surge in U.S. venture-backed investment activity that took place in the last couple of years. A lot of that money ended up on the balance sheet of Silicon Valley Bank. So it's natural that you have Goldman Sachs, but also Wells Fargo and many other banks recommending their stock because they wanted to see them succeed.

Will Page:

Incredible. I've just come up with a new strap line for our sycophants and stenographers perennial rent, which is you have independent analysts like yourself, but then you have dependent analysts. The interdependencies in this business really have come to the fore here. I want to ask a dumb kid in the classroom question, which I'm sure is on the lips of many of our listeners, which is Silicon Valley Bank, I follow financial markets, I follow your work, Richard, but wasn't a household name to me when this whole thing went belly up, how big was it? Was I just off the radar here or is it a relatively small bank in a wider scheme of things?

Richard Kramer:

Well, you weren't off the radar in the sense of you weren't in California where Silicon Valley Bank is primarily located and has branches in a presence, but it did have a $200 billion balance sheet. Indeed, their management lobbied regulators to get the levels at which you would have to perform what's called a stress test lifted from 50 billion to 250 billion so they could stay under it and stay under the radar. But they still had quietly built up a huge business becoming the bank of choice to all of those VC-funded startups that we've had funds skewering on Bubble Trouble.

Will Page:

So that stress test, just to be clear, that in layman's language is like a shock absorber the bank has to have should the times get tough? Is that a fair comment?

Richard Kramer:

Well, since the 2008 financial crisis, the central banks and securities regulators of the world have asked banks to consider what would happen in a worst case scenario because they want to avoid the privatization of profits and socialization of losses situation we had to go through in 2008 [inaudible 00:05:16] Obviously that led to a decade of difficult decisions and austerity and all sorts of other terrible things. So they force banks to consider the worst case scenario and make sure those banks have sufficient resources to withstand the 100-year flood that everyone thinks these recurring financial crises always represent.

Will Page:

Got it. Very clear. Of all the jokes that you've never laughed at on this podcast, Richard, my favorite one is when you ask an investment banker about the moral hazard. An investment banker's response goes like this, "Well, I understand what the second word means, but you need to explain to me what the first word stands for," that is morals. Now there's got to be some dialogue where you need to tease out here on the moral hazard with Silicon Valley Bank. But I noticed in the press Bill Ackman was arguing for bailouts, whereas, Ken Griffin from the Citadel Group was arguing not to bail out because it would undermine capitalism like, "This bank behaved badly. It deserves to fail, it deserves to get punished." If you save a failing bank, then you encourage other banks to behave badly, other banks to fail and other banks to be bailed out by the taxpayer. So let's get into this moral hazard question for our audience here. How do you see, firstly the debate playing out to bail out or not to bail out? Secondly, what position would you take yourself?

Richard Kramer:

Well, let's sketch out if I can, some of the aspects of bailouts because in this case, the Federal Deposit Insurance Corporation that is making depositors whole is actually funded by the banks. Now, we can debate over time whether the banks will be forced to raise the fees that they charge to consumers so indeed, this will end up hitting the average person. But this is not a government or taxpayer bailout the way it was 15 years ago. The problem is in a transactional system, there are always going to be counterparties who benefit, someone loses and someone wins. In a way, there's never going to be unanimous opposition to bailouts because someone is going to be on the other side of them saying, "We need help! Help! Bail us out!" What's the solution?

You could have perpetual bailouts and guarantees, in which case the moral hazard would go crazy because anytime you had losses you would run screaming to the government and say, "Please, can you make me whole?" Or you could have a perpetual, "Let them fail," policy. As long as that was the case, you could have a lot worse outcomes that might cause systemic risk in the system. So part of the problem here is that the government, and indeed the banks with their instruments like the FDIC are picking winners and losers, and they're deciding which banks to help out and which to let go of the wall. That makes it an interesting debate between two billionaires, Ken Griffin and Bill Ackman, as to what the right course of action is in every one of these situations.

Will Page:

Let's just take the views, when you hear Ackman argue for bailouts, do you think he has a point or do you think, "Hold on a second. He would see that anyway?"

Richard Kramer:

So Ken Griffin and Bill Ackman both have a point in the sense that Bill Ackman's point was, "Geez, if we let this bank go under and the depositors have 200 billion of cash," which is frozen in the process, which has just kicked off, which is that Silicon Valley Bank has turned the last page of Chapter 10 and they've started on Chapter 11, which means technically they've admitted that they're bankrupt, so Bill Ackman's point of view is, "We can't afford to have 200 billion frozen and everyone else is going to freak out and pull their cash out of everywhere else where they fear it might be the same situation."

Will Page:

He's coming on contagion-

Richard Kramer:

He's fearful of contagion, whereas, Ken Griffin coming from his own very self-interested view, says, "Well, that's capitalism, red and tooth and claw. If there are companies that don't measure up or don't manage their business as well, we should let them go to the wall." As many of them as we have to have go bust, that is the purgatory corrective, if you will, of the excesses of the last 10 plus years where we've effectively had free money.

Will Page:

Wow. Very clear. I know a lot of our audience is on your side of the pond currently that is Britain and a lot of them are in America. But in Britain, a quick word on what happened in the UK over the period of a weekend, HSBC snapped up the SVB arm for one pound or a Scottish Putin as we call it.

Richard Kramer:

So Silicon Valley Bank had a very small portion of its business sitting in the UK and indeed, you would've had loans to UK startups or cash the UK startups had raised and kept deposited in UK banks frozen had there not been some sort of rescue. Now we can debate what the real value of that loan book was and whether in the course of a weekend HSBC or any of the other bidders over the course of a weekend would've been able to go through the entire loan book and ascertain its quality and see whether they were getting a fantastic deal or they were taking on liabilities for that one pound. But it was really the opportunity cost of them jumping into an area where, let's face it, you wouldn't associate old line UK banks like HSBC with loaning money to tech startups.

Will Page:

Got it. Thanks to a Netflix documentary, you're more likely to associate an old-style HSBC bank with Mexican drugs cartels. But we'll leave that for another show.

Richard Kramer:

Yes.

Will Page:

That brings it to close for the first part of this podcast. It's been a brilliant layman's explanation of what went wrong. In the second part, I think we want to go deep on this term duration and actually get to grips of the mechanics of what brought this bank down. But just closing out, I do really feel passionately that 80 episodes of Bubble Trouble out on the shelf now, so many episodes are coming to life. You talked about the FDIC being financed by the banks. It reminds me of another earlier episode we did called Purer Standards where you explained the merry-go-round charade of the standard ratings agencies. Just really quickly before we close out Part One, is there a parallel there between how the rating agencies, another referee that's governed by the players, and the FDIC, another referee that's governed by the players that play the game, is there a parable there that we could tease out?

Richard Kramer:

Well, I wouldn't look as much at the rating agencies because I haven't looked in detail as to what they were rating the bonds from Silicon Valley Bank or how much they looked into the risk that was embedded on its balance sheet. What I would look at in detail is the U.S. regulator, the SEC, and whether they were asleep at the switch, whether they allowed too many of these banks to lobby in their own self-interest to avoid the onerous costs of having stress tests to raise the capital threshold that stress tests should be applied at, to have limited disclosure, which allowed them to the unrealized losses on their books out of the public eye.

Indeed, the more transparency in the financial markets because the financial markets are very good at finding things out for themselves if you provide the data, the more transparency we would've had going into this, the easier it would've been to spot that Silicon Valley Bank had made some colossal missteps in how it was running itself. We can get into that in Part Two. But really, this is a failure again of light touch regulation where the idea that the foxes should just be allowed to hang out and keep an eye on the henhouse really didn't work out so well.

Will Page:

It does feel to me like the causes and consequences of Bubble Trouble. The name of this podcast come down to either A, marking your own homework or B, having overly influenced those who are marking it for you. We'll be back in Part Two to get into the mechanics of what brought us back down. My thanks to Richard Kramer. You'll be with Bubble Trouble more in a moment. Back with Part Two of Bubble Trouble. This time we're dissecting the collapse of Silicon Valley Bank with Richard Kramer who's putting it all into layman's terms for us, keeping it jargon free as he does best. Now we're going to turn to a technical concept.

Just to stress, I'm economically trained, but I am jet-lagged out of all control, so I'm on par with a lot of our audience who might not have the economic training. We're going to understand a term called duration. So speaking to experts who understand why this bank went to the wall, they come up with this one word explanation called duration. I want you to tease that out for our audience in a simple terminology as possible. Treat us as the dumb kids in the classroom as you walk through this. If duration is the cause of the bank collapsing, what is duration?

Richard Kramer:

So duration refers to a mismatch of how long you might be locked into assets and the much shorter timeframe where you might have to make good on liabilities. In this case, SVB made a very bad bet on interest rates and the speed in which interest rates rose caught banks like SVB off guard. One of the things we'll come back to a little later is how important risk management and matching those assets and liabilities on the similar timescale is to big banks. Now-

Will Page:

Just quickly on there and how important it is to have a chief risk officer, which SVB didn't have for, I think, nine months running up to the collapse.

Richard Kramer:

Nine months, indeed. So let me give you a real-world example, which is going to be close to home for you, Will, literally and figuratively. So imagine you have a lovely new house and let's say it's worth 2 million pounds, and on this you have a million pound mortgage. So you have a 2 million pound asset and a million of a 10-year mortgage debt, and you get builders in to do a loft conversion and a back garden extension and a bunch of work. When that's all done, your house is going to be worth 3 million, but you need to pay those builders 500K to get the work done.

As you pay the builders for materials and the work, and you still have 100,000 a year in your mortgage payments, so you have all this long duration asset, your house, which you hope is going to rise from 2 million to 3 million when the work is done, but your short duration liability just went from 100K to 600K. Now, you gross that up to 200 billion of deposits and assets with a lot of those assets being long-dated and locked in to lower interest rates while the liabilities were rising with the speed of inflation. Hopefully, that gets across the mismatch of duration where the-

Will Page:

Love it.

Richard Kramer:

... assets had a very long life and were locked in, but the liabilities were things that needed to be addressed, especially when people started pulling their money out. Of course, giving people their deposits back is one form of liability.

Will Page:

I'm sure a lot of our listeners who are buying doer uppers around London Town are quickly rechecking their mathematics now as well.

Richard Kramer:

Well, and again, it's the reality of cash costs going out the door versus the duration or the timescale of realizing the upside on assets, and usually, asset growth is slow. You have a house and it appreciates a little bit every year. What we've seen in many parts of the economy and many bubbles have formed because of this, is when you had free money, you had assets which appreciated very quickly because there was no cost to borrow. What we've gone through is the fastest ever tightening cycle by the U.S. Federal Reserve. Within less than 12 months, interest rates effectively went from zero to four to 5%, and that caught lots of banks and lots of financial institutions and lots of companies off guard because they were proceeding on the basis that the cost of capital would be effectively free in perpetuity.

Will Page:

Just on that, there's a much more self-macroeconomic question I want to ask, which is about getting back to a new normal. You're right to flag that interest rates have gone up, but so too as inflation. I think we are now at the point where somebody, a 16-year-old kid could study GCSE economics are never lived in a time where interest rates were above the rate of inflation. That's crazy, right? When I studied economics, there was this obscure moment called signerage, which happened in history but would never happen again. All we've had for 15 years is this process where putting money in a bank account loses you money. Now, let's assume that inflation comes down. We're seeing energy prices fall to record lows. Fingers crossed, we're going to see progress on that front too. Let's assume that interest rates stay reasonably high. Do you see a position where interest rates are at last above the rate of inflation? And B, what would that new normal that recognize normal the stable capitalist model do for markets? Is it going to prevent more bubbles or could it stoke more bubbles?

Richard Kramer:

So there's so many things to unpick in that question, and it's not a simple one, and I'm certainly no expert on macro policy. I can tell you there's a major moral hazard problem for policymakers about how they want to approach this. When you look at a 5% interest rate in the U.S. you have to realize that on a nominal level, when inflation's at six or seven or 8%, actually interest rates are still negative. So it still makes sense to borrow money at 5% if you think your costs are going to go up six, 7%, and that's crazy. Now, policy makers never want to take the hard decisions and tackle the hard stuff like inflation because doing so requires keeping rates higher for longer, which kills things like the housing market or the investment market.

A lot of times those policy makers are frankly more sensitive to the donor class with a lot of money than the working class who's suffering 15% food price inflation in the UK right now. I think as to the contagion issue, what is undoubtedly making the policy makers fearful today is that we've got another bank, First Republic, that got a 30 billion capital injection. You have Credit Swiss, which got a 50 billion Swiss Franc facility from the Swish National Bank. You've got lots of other banks that the largest one in Japan lost about 20% of its value in two days.

Will Page:

Wow.

Richard Kramer:

So everywhere the policy makers are looking, they have to be fearful that there are more SVBs looming. When the head of the U.S. Treasury says the banking sector is sound, well, that to me sounds a little like if you're having a beer with a friend of yours and they volunteer to you over a beer that, "Hey, you know what? Really, my marriage is in great shape," you have to wonder when the divorce is coming. So all of this protest from the policymakers rings a bit hollow right now because you're seeing this duration mismatch play out in lots of other banks that equally were not as efficient in their risk management as they should have been when interest rates were absolutely roofing it.

Will Page:

Wow. It does make me think, again, bringing the past 80 odd episodes of Bubble Trouble to life, we've done so many around central banks, around quantitative easing. You had a colleague from the Wall Street Journal talking about Central Bank independence. Maybe that's going to be the biggest stress test of them all is, can central banks remain independent during the political cycle, or are we going to see politicians influence monetary policy to get themselves reelected? So let's bring it to smoke signals. Now because we're moving in real time on this one, Richard, you have to appreciate the smoke signals you're going to give us and our audience here, you got about 48 hours before they go live. A lot can happen in 48 hours just like what happened last weekend. So give us a couple of smoke signals so our audience can spot the next Silicon Valley Bank.

Richard Kramer:

Yeah. Look, one of the things we decided when we started Bubble Trouble we weren't going to do is provide these hot takes on the news, "Hey, this is what was in the headlines yesterday and this is what we think about it."

Will Page:

Clickbait.

Richard Kramer:

We didn't want to do that because we wanted to have the smoke signals in particular as a part of the podcast be something that had lasting value, duration value, if you will.

Will Page:

Yeah.

Richard Kramer:

So I've come up with two smoke signals I want to lay out, which I'll be proud to look back on in a year or two year or five years' time and say, "Well, they're still valid." Now I think the first one is Silicon Valley Bank is a classic example where for all the talk of disruption, you cannot just disrupt a sector with different behavior when the laws of financial gravity still apply. So one very wise commentator said to me in a private email, he said, "This is exposed a relative lack of traditional banking sophistication at the company." In other words, they stayed a Silicon Valley bank and a Silicon Valley culture instead of upgrading their banking and treasury and asset liability management and capital management and risk management personnel like they should have when their balance sheet absolutely ballooned.

The CEO of Silicon Valley Bank talked about, "Hey, they were the coolest bank," and the higher risk clients that they took on were just the new rock stars, even if they could be mercurial. I think this is going to be a classic lesson that you can't avoid these laws of gravity that if you're going to build a giant bank, even if it's going to be a challenger bank or a digital bank or whatever you want to call it, these laws of gravity still apply. You cannot have assets which are locked up long duration at low income levels and bring on liabilities which are going to be as volatile as these people surely should have known these VC investments that they were chock-full of would be.

Will Page:

Got it. Got it. Smoke signal number one, take another draw, inhale deeply and blow out smoke, signal number two.

Richard Kramer:

Okay. Well, today's markets are really a classic echo chamber in that they are really very liquidity driven. It is crazy to think that the Fed fund's rate is still negative with inflation, and you've got all of these unacknowledged financial problems building up in some of these former boom areas. So for example, private equity or private capital, private lending, we don't get to see the same visibility in those areas that we do on the big bank balance sheets to the extent that they give any real disclosure. I think one of the big issues for SVB was they were tied up in that private capital echo chamber. They were in the business of supplying banking services to all of that private capital flowing through VC funds to private companies without the discipline and checks and balances of the scrutiny of the public markets.

It was very easy to come up with the great concept startup that would get valued at $10 billion, but you knew that the asset base underneath those valuations was never stable. It was a castle built on sand. So the second smoke signal is really that you need to be aware of the echo chamber. When you have a bunch of different parties telling you everything's going to be all right, that's all the more reason to doubt or question, especially in areas where you don't have good disclosure what the underlying situation really looks like. If the answer is, "Well, we can't tell you because we're private," or, "It would be a competitive disadvantage," or, "We don't want to reveal too much," well there should be a discount for those sort of companies instead of the crazy premium we've seen people pay in the last three to five years.

Will Page:

Well, so don't get hobbled by the herds, and the currency of the contrarian can only appreciate and value in times like these. Richard, I want to thank you for-

Richard Kramer:

Well, before we go back, I want to go back because one year ago you were at SXSW. You were the one who called out to me and everyone, and we had one of our most popular episodes, NFTs, Not For Me, the bubble in these strange digital renderings that someone was so excited to show you on their phone that they just paid five or 10 grand for. Isn't that exactly the kind of private capital application where you never really had a way to check what the underlying asset was worth?

Will Page:

Yeah.

Richard Kramer:

Isn't that another example of where we were commenting a year ago that you were unable to understand how the Echo Chamber worked? What was was that underlying value of those NFTs you were proudly having people show you you on their phones from SXSW, and that was just one year ago? What does that make you think about the echo chamber?

Will Page:

Yeah, I think you've got copyright under the words wash trade 'cause you introduce them to a much broader audience just at the right time as well? But yeah, I just think the currency of the contrarian has to appreciate and value during times like these. I mentioned at the very start this podcast, the difference between an independent analyst like yourself and a dependent analyst like so many others. I think we're beginning to see a gulf appear between the two schools of thought you could say. I got to say Lauren Jarvis, who kickstarted Spotify's podcast campaign said the number one purpose of a podcast was to impress your friends at dinner parties.

Richard Kramer:

No.

Will Page:

One thing you've done in part to you at this podcast has allowed me and many others to explain duration at dinner parties. Hopefully we're all a lot better off for this 30 minutes of Bubble Trouble.

Richard Kramer:

There is one good moral of this story, and that is the folks who didn't do their due diligence, the equity holders of SVB, they got wiped out. They went to zero. So if you were buying that stock on faith or on the recommendation of one of those great investment banks that told you it was still a strong buy, or you didn't do your homework looking at their balance sheet, well, you got what's coming to you. In that sense, the Ken Griffin style of capitalism worked. We can debate whether Bill Ackman was right in calling for all depositors to be made whole, but unfortunately, that ship has already sailed because that decision was taken for the benefit of the wider economy. I think in this case, looking at SVB stock capitalism did work because it's today trading at a zero.

Will Page:

Fantastic. Well, my thanks to Richard Kramer, a real-time podcast for a real-time development. I feel like we should say back next week, but we could be back in 48 hours with a new story about a bank going to the wall. But this has been Bubble Trouble dissecting silicon, Silicon Valley Bank. We'll see you this time next week.

Richard Kramer:

If you're new to Bubble Trouble, we hope you'll follow the show wherever you listen to podcasts. Bubble Trouble is produced by Eric Nuzum, Jesse Baker and Julia Natt at Magnificent Noise. You can learn more at bubbletroublepodcast.com. Will Page, and I will see you next time.