There’s a lesson to be learned from Silicon Valley Bank’s downfall

Well, it has been a surprising March so far. No, not the pool-busting upsets at the NCAA’s March Madness. But the announcement that Silicon Valley Bank (SVB) had failed and was being taken over by the banking regulators, followed by the failure of Signature Bank and the bailout of First Republic Bank. And, over the last weekend, the 166-year-old Credit Suisse disappeared in a shotgun wedding to UBS, forced by markets and regulators. So, what happened? And what does it mean for Canadian investors?

SVB banked startups and venture capital firms, primarily in the U.S., but also through their Canadian branch. Plenty has been written, and will be written, about the root causes of SVB’s failure, the largest such US failure since the demise of Washington Mutual in 2008. One contributing factor was SVB’s decision not to hedge interest-rate risk. SVB had a large portfolio of long-duration bonds on their balance sheet. But, as interest rates rose dramatically over the last 12 months, the portfolio had losses. These losses, and the slowdown in tech funding for VC-backed startups, prompted depositors to withdraw vast amounts of money until SVB’s capital position eroded. A sound hedging policy, together with a more diversified loan book, would likely have prevented this collapse. Such a hedge, like all insurance, comes at a cost. No doubt, in good times, the SVB Board thought that this was a cost that could be avoided. Today, not so much.

And here lies the lesson for all of us. Already homebuyers are facing higher mortgage rates if they look to purchase a new home. Those with an existing variable rate mortgage are seeing the impact on their monthly payments; come renewal time, those with fixed mortgages will face the same music. Investors can also learn what SVB learned – change is unpredictable, comes quickly and often with devastating consequences. The same lesson was painfully learned by Credit Suisse bondholders. A special class of bonds, Contingent Write-down Capital Notes, a form of convertible bond used to shore up the bank’ s capital structure, was obliterated overnight. Bondholders holding $17-billion were wiped out. Caveat emptor or buyer beware is always good advice. Unfortunately, today, there are very few “no risk” investments. It simply comes down to the question: what likelihood do you attribute to a certain risk materializing, and is potentially higher return you get for that worth the risk? Prudent and even-keeled risk management is what is needed – by firms and by investors. In the Credit Suisse case, presumably, the buyers of these bonds, and the issuer, didn’t put much weight on the risk of a shotgun wedding at bargain basement prices.

One of the few solutions to this reality comes down to what grandma used to say – don’t put all your eggs in one basket. What does this mean? Diversify. Plan for things not to go your way. Things that you don’t expect, can’t predict. But, no matter, you still have to live with the consequences.

Canadians have been reminded repeatedly of the wisdom of grandma’s advice. We all know about Nortel – the onetime darling of the Canadian stock market. Everybody owned it; employees, pensioners, even institutional fund managers owned it. At its peak, Nortel was trading for $124 a share and the company was worth almost $400-billion. In fact, Nortel alone accounted for more than a third of the value of all companies represented in the index of the 300 largest public firms in Canada. But what happened next? Within two years, Nortel’s value plummeted to $5-billion, taking with it the life savings of many investors, emptying the coffers of many pension funds and leaving 60,000 employees without jobs. Especially if you were a Nortel employee, you lacked diversification: salary, bonus, pension and investments all had significant exposure to the stock.

Will other banks follow? We don’t know. Will it impact other stocks in other sectors? We already see the impact on the banking sector, but what else, we don’t know. This isn’t a failure of imagination, but the realization that financial markets are complex dynamic systems. If a thousand people were asked to hold a ball in front of them and then drop it, a thousand times it will fall. This is a natural system and little that people do can affect the outcome. But if a thousand people were asked whether they think a particular stock was going to go up or not, the answer and behaviour of the thousand people could, in fact, impact the stock. If enough people believe it will go up and if they act on that belief, the stock will go up. This is why bubbles form (enough people believe the price will go higher) and why bubbles burst (suddenly people realize there are no fundamentals supporting the share price).

Humility is a great tool for all investors – amateur and professionals. Warren Buffett put it this way, “Diversification is protection against ignorance, but if you don’t feel ignorant, the need for it goes down drastically.”