Extinction Level Event in Silicon Valley

The collapse of Silicon Valley Bank at the end of last week might be a milestone for the exuberant tech sector but there is also a strong likelihood of contagion across the broader financial sector. 

Silicon Valley Bank

Gary Tan, the President of Y Combinator, described the demise of Silicon Valley Bank as a potential ‘extinction level event’ for start ups. Y Combinator is the pre-eminent accelerator in early stage companies in Silicon Valley and lent widely across the country, so it most certainly has a grasp of what’s happening on the ground. Some investors have described Silicon Valley Bank as the left ventricle at the heart of Silicon Valley, given its importance in lending alongside venture capital firms. Y Combinator are worried that 30% of their companies won’t be able to make payrolls in 30 days’ time as their deposits evaporate and only 5% of it is guaranteed by the government.

As I have written elsewhere, we have witnessed the mother of all bubbles in the last decade: driven by near zero interest rates, central bank money printing and huge fiscal spending by Western governments during Covid. Silicon Valley has been one beneficiary of all this extra money sloshing around. Assets of SVB rose 300% in the last 3 years whilst capital was invested into start-ups and was then deposited. Deposits massively outstripped SVB’s lending portfolio, so in order to generate a return they put a lot of their capital into long-maturity bonds particularly 10 year fixed-rate mortgage bonds. And when interest rates rose, the market value of the bonds fell. Instead of just selling the bonds last year and taking a hit, they tried to muddle through but unfortunately – as I forecast in a previous article with Horasis – rates spiked again causing more losses, Furthermore, SVB’s deposits had been dropping for four quarters as tech stocks and valuations have seen a significant fall. 

In the last week, there seemed to have been a lot of speculation over SVB’s financial situation. At first a sort of social contract held amongst VCs and startups: as long as we don’t withdraw money then SVB should weather the storm. But eventually more and more VCs saw the writing on the wall and panicked, messaging their startups to withdraw their capital and hence a bank run ensued. What happens next will partly be determined by whether the US government will intervene beyond the deposit guarantees.

 This will be made more difficult by very unpopular bank bailouts of the GFC and also the fact that senior management seemed to have all sold significant amounts of personal stocks in the last 10 days. But there have been desperate calls from major investors and influencers, such as Bill Ackman who said that “the government has about 48 hours to fix a-soon-to-be-irreversible mistake”.  Personally, I would not want to be in the Biden White House at this moment. 

Contagion

Whenever a significant event transpires in the financial sector, investors quickly strive to ascertain whether it is a one-off or whether there might be contagion. A one off event might be when there has been a very poor operating or investment decision by a company or perhaps something like fraud which has nothing to do with other institutions. 

Contagion will happen when investors find that there are direct counterparties which will be affected or when there are other institutions facing similar circumstances. Because most investors are not trained in systems thinking, they initially overlook the larger ecosystems in which organisations operate. Eventually they realise that a failed institution has many lessons to reveal and often there are many organisations which are facing similar challenges: the failure is merely a symptom. I have witnessed this countless times over my career observing markets around the world. The failure of the Bear Stearns hedge funds in May 2007 was a perfect example of this, highlighting the systemic risk which ultimately led to the collapse of the financial system in late 2008. 

Silicon Valley Bank might well be a unique institution but it is clearly embedded in the tech sector.  This event perhaps marks the end of an era of free money to the tech sector and more challenging times to come. Certainly there were hedge funds which had shorted it on the basis of this hypothesis. 

Also, to state the obvious it is also a bank. Many banks around the world have sizable bond portfolios and whilst they might not have mismanaged them to the degree of SVB, they are susceptible to these large movements in the bond markets. I have consistently taken the view that the 2020s would witness a sea change in economies and financial markets as the background music became more inflationary. After 40 years of low inflation this will clearly take younger – probably most – investors by surprise. As risk assets rose this year and markets began to brush off inflation risks, I wrote an article at Horasis reiterating the tectonic forces which are pushing in the direction of inflation (https://horasis.org/economics-and-finance-outlook-the-background-music-has-changed/) 

Confirmation of My Inflation Outlook

Whilst I frequently take a different view than central bankers about future prospects – that was actually my full time job for some time – I thought that it was interesting that the former Chief Economist of the Bank of England, Andy Haldane concurred with me over future inflationary pressures. Or I with him, as I have a lot of respect for him. I have long been aware of his views because he seemed to be one of the few central bankers who were cognisant of modern scientific thinking: whereas economics was long stuck in a previous century, he was looking at complexity science and systems thinking. Now he is doing some great work as Chief Executive of the Royal Society of Arts (RSA) which has been a bastion of innovative thinking in the UK for 250 years and I am proud to be a Fellow. The RSA has been promoting a more systems view towards everything. 

Recently he acknowledged in an op-ed in the Financial Times article – interestingly calling for more imagination –  that inflationary forces are coming from the supply side and put central bankers in the ‘horns of a dilemma’. 

“What the world has experienced is an upward shift in the level of global prices. This has arisen from dislocations in global supply chains, buffeted by geopolitical crosswinds. As these supply chains have become both more fragmented and more fragile, prices have been pushed higher ….This shift upward in the equilibrium global price level is the mirror image of the golden age of globalisation that occurred after the second world war, when global supply chains lengthened and deepened, contributing to inflation persistently undershooting its target in many countries, including Japan, the US and eurozone. That golden era is now over, because supply chains take time to repair and reconfigure, particularly for people and their skills. The resulting reflation seems set to persist for a period measured in years not quarters. Large and lasting global supply shocks of this type put monetary policymakers on the horns of a dilemma.”

The fortunes of Silicon Valley Bank and its depositors are now very much in the hands of the US government. We will know more on Monday morning and markets will respond accordingly.. However, even if there is a bailout, this will merely be treating the symptoms and not the disease. The Western world has yet to face the hangover of an extreme bubble and there are tectonic forces pushing towards higher inflation (including debt, demographics, geopolitics and war). Expect more trouble to come.