Due to losses on its bond portfolio, Silicon Valley Bank collapsed in March. What happened? Bonds are safer than stocks, but not perfectly safe. Bonds carry two risks: default risk and interest rate risk.
A bond is a loan; the bond buyer is giving a loan to the bond seller that is repaid with interest. Default risk means the borrower might stop making these payments. This is what occurred during the 2008-09 financial crisis when the housing market crashed, homebuyers stopped making mortgage payments, and thus those who bought mortgage-backed securities never recovered their money. Ratings agencies estimate a bond’s default risk, though these ratings were flawed during the financial crisis.
Interest rate risk is perhaps less well-known. Suppose someone buys a $1,000 ten-year bond that pays a fixed 2% interest rate over the life of the bond. If the buyer holds the bond until maturity, they get their $1,000 back at year ten and the 2% interest earned every year before then. If the buyer wanted their money back early, they could sell the bond in the bond market. Assuming the interest rate on ten-year bonds remained at 2%, they could sell the bond for $1,000 as the new buyer would be indifferent between buying this bond or a newly issued bond as both are paying the same interest rate.
The original bond buyer is in trouble if interest rates rise. Suppose the interest rate rises to 4%. Now, the buyer is trying to sell a bond paying 2% interest while newly issued bonds are paying 4% interest. The only way he can now sell is if he offers a discount on the price. In this example, he would have to cut the price on his bond to $866 so that the new buyer is indifferent between buying this bond paying 2% interest and a new $1,000 bond paying 4% interest. The original buyer thus takes a $134 loss.
This explains what happened to Silicon Valley Bank. The bank used customer deposits to purchase bonds – in particular, mortgage-backed securities – during the pandemic when interest rates were low. When mortgage rates rose following Federal Reserve tightening, the value of these mortgage-backed securities plummeted. There are hedging strategies banks use to guard against interest rate risk. The Silicon Valley Bank did not employ them as they aren’t required for bonds the bank is planning to hold to maturity.
If the value of a bank’s assets falls, the bank becomes less able to repay depositors. Silicon Valley Bank’s depositors noticed and since many of them are active on Twitter, quickly raised the alarm that the bank was in trouble. Depositors raced to the bank to withdraw their funds and given the loss on its bonds, the bank was unable to sell them to raise the cash needed to meet this withdrawal demand. It remains to be seen how many more Silicon Valley Banks are out there if the Federal Reserve continues raising interest rates.
