There's no metric for stupid

Note: One could argue I oversimplified some things in this post. I did so for the sake of clarity. I think it gets to the point, but apologies, dear reader, if you feel I went too far astray.

Banking is a funny thing.

In one sense, it is the simplest business in the world. You buy and sell money. No friction in that.

In another sense, it is the hardest business in the world to invest in. Because it looks so much easier than it is!!!

John Maxfield is an encyclopedia on banks. Everything he says about them is smart. You should go have a listen to his chat on The Smattering podcast right now.

One thing John likes to talk about (and this is me paraphrasing) is that it isn’t the smartest bankers who make good investments, but the most humble. That played out in the story of what happened to Silicon Valley Bank.

In 1999, I was invited to participate in a summer program put on by the American Bankers Association called the Stonier School of Banking. It was basically banking 101. The first thing we learned was about the concept of duration risk. We played games to simulate scenarios. We spent a lot of time on it.

Duration risk is one of the most fundamental things to understand in banking. Every banker knows what it is. And yet, nine out of ten times when a bank fails it is due at least in part to duration risk. Silicon Valley Bank (SVB) failed due to duration risk.

A few years ago, Silicon Valley Bank faced a tough choice. It had plenty of deposits coming in, but no clear, sensible thing to do with all of the money. Some of it could be lent out, but SVB’s core customer is not a huge borrower. The most straightforward thing to do is to buy bonds or other securities to fill the gap.

But remember, these deposits that are coming in can be withdrawn at any time. These startup tech companies aren’t buying a lot of certificates of deposit. Presumably, in normal course of business all of the deposits won’t be withdrawn at once. But in theory, it could happen.

Here’s the basic choice the bank faced (and yes, I am watering this down):

1. Buy short-term securities. This is the conservative option, because it matches the duration of the assets (short) to the duration of the deposits (can be withdrawn at any time). The problem is, in the last few years with interest rates near zero short-term securities were paying next to nothing. Fill your portfolio with these and you are protected from a bad spell, but you are going to report lackluster earnings until rates rise. You have to beg your shareholders to be patient.

2. Buy longer-dated securities. This solves your earnings problem, because you can earn a better rate of return on these assets. So, you do get to report robust earnings. But in doing this, you have duration risk. Your assets aren’t lined up with your deposit base. You are ill-prepared for that rainy day.

SVB went with option B, and indeed for years reported robust earnings. (I’m willing to bet a lot of bonuses were paid out as well, but that’s a separate discussion.) It worked, until it didn’t.

Worth noting that things are not as black and white as I make them out to be in those options. The bank can exit out of their long-dated securities if they need cash. But they would have to take a huge loss to do so.

Recall that bond prices and bond yields have an inverse relationship. When rates are low, bond prices are high. It is all about the total return at maturity. Because Silicon Valley Bank was buying these securities at a time of record low rates, they were paying a full price for them. But in the last year rates have risen dramatically. That in turn means buyers today will pay a lot less for those securities than what SVB paid for them a few years ago. To sell them now would mean taking a massive loss.

Throw in a few more variables: SVB’s core clients aren’t doing so well. Rising rates have hit tech companies hard. Crypto has blown up. There is reason to think SVB’s core customers need their deposits back more than a typical bank’s customers do. At the risk of calling it a perfect storm, it was pretty much a perfect storm. And it sank the ship.

Silicon Valley Bank needed the cash. It sold those securities for a huge loss. It tried to go to the market to raise more cash to offset those losses. Customers got nervous and started withdrawing more and more cash.

The bank plotted out its own demise years ago, hoping the scenario would never play out. This week, it did.

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So what can we learn from this?

This is, and isn’t, a reflection of bigger issues going on in banking. A lot of banks out there are feeling the same pressures. SVB might have been ill-advised to chase returns in a low-rate environment, but to some extent many, perhaps nearly everyone, did. People have been asking me a lot about some of my favorite banks I’ve talked about on Twitter and elsewhere. I’d bet they are feeling the same stresses that brought SVB down. But I am hopeful that they better managed risk, and I also suspect their customers have seen much steadier cash flows through the downturn. I’m not selling. But I am watching carefully.

This is, and isn’t, a reflection of bigger issues going on in the economy. The rising rate cycle has created a lot of disruption. Not so much because rate hikes are rare, but coming off of a zero base for a long time is really rare. Tech startups are likely more pinched for cash than your average business, but a lot of businesses (and households) are feeling pinched for cash. I believe in many ways Silicon Valley Bank is the exception, but they are not alone in what they saw in the economy. Let this be a lesson to us all: There is dangerous out there.

You can’t buy banks based on the usual metrics. Back to what we said at the start. Let’s call it Maxfield’s Principle.

Banking is a relatively straightforward business. You buy and sell money. If you can buy it for 25 cents per $1 and sell it for 50 cents per $1, you do really really well.

But the economy is complicated. And it isn’t always possible to buy low, sell high. Especially not really low and really high to make your investors go WOW. That is fundamental to the business. Two banks operating in the same town, same state, or same country don’t get to deal with separate economies. The economy is what it is.

Silicon Valley Bank was always an outlier. They were the bank that rode the wave of the last 20 years better than anyone. Yet, one of the reasons they were so successful is their core customer, early-stage tech companies, are not really ideal bank customers because they don’t have a lot of cash flow, and lending to them is risky. Other banks wanted in on those relationships, but never wanted to fill their book with that business.

They were also an outlier in terms of performance because they focused on performance. It worked, until it didn’t.

There is no business where management quality is more important than in banking. That’s the real takeaway here. It has to be tempting to hit quarterly targets, to show investors you are so smart you can grow throughout the business cycle. But that requires a reality distortion field. I’d much rather a banker wise enough to look at the environment, look at the risks, and tell me honestly, “it isn’t worth the risk to grow right now.”

Those bankers tend not to make the cover of Barron’s. They aren’t invited on CNBC much. But they are out there. And they are silent superstars.

Silicon Valley is the land of outrageous ideas. That’s a culture. A mindset. But if we learn nothing else from the rise and fall of this bank, it should be this: Look for bankers who aren’t trying to defy the laws of physics.

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