You Should Be Angry, But Don't Be Scared

by Greg Larkin CEO of Punks & Pinstripes

I wasn’t planning on writing this. But here we are.

I spent six years as a bank analyst on #wallstreet, and in 2006 was the first person to publicly predict the 2008 financial crisis. #siliconvalleybank isn’t my first #bank crisis rodeo. I dusted off my bank analysis playbook for this article.

Here’s what I talk about here:

• Why banks blow up

• Why this is bad, but it’s not even a fraction of the 2008 financial crisis

• SVB was a symptom, not a cause. The causes were subprime startups, executive negligence, corporate innovation malpractice, and high interest rates. There will be other (containable) casualties.

Why banks blow up

Banks are different animals than other companies. Here’s how they’re different and why they blow up.

1. You are what you finance - a bank is a reflection of the people, industries, companies, and countries it provides credit, capital and services to. If your customers are startups and the startup bubble bursts then it will hurt you. If your customers are subprime borrowers who default on their loans then it will hurt you. This is what happened to Silicon Valley Bank. Its customers were startups and #vcs who were more dependent on their deposits for funding as high interest rates decreased VC funding.

2. Greed is not good - Banks are not like software companies where exponential growth is a good thing. Whenever a bank grows exponentially it never ends well. (JPMorgan Chase & Co. and Capital One might be the only two exceptions in history). Because growth in a bank is always accompanied by a commensurate increase in risk. If you triple your loan volume you also increase the risk that those new borrowers will default. If you triple your deposits you triple the possibility that your depositors will all flee at the same time, leading to a run on the bank. Rapid expansion looks great in the short term, but as soon as good times turn bad it blows up. (They always turn bad).

3. Speak to me like I’m 12, part 1. WTF is liquidity risk? - Great question. Liquidity in banking is a fancy way of saying how quickly your money can be converted into cash. Your deposits in your checking account are highly liquid, you can withdraw them at any time and you always know how much they’re worth. Your house, on the other hand, is not as liquid; in order to convert your home into cash you have to first sell it. And, importantly for SVB, your startup is highly illiquid, its valuation fluctuates and shouldn't be treated as cash-equivalent. You can come up with a good guess of how much your startup or home is worth, but you won’t really know until it’s sold. And in times of economic turbulence your guess will be less accurate. Highly illiquid assets are ‘marked to model’ meaning their values aren’t really known, so people estimate what they’re worth.

Many illiquid, marked to model assets are ‘held to maturity’ meaning the bank has no intention of selling them for a long time. And many regional banks like SVB successfully lobbied for a law that enabled them to avoid recalculating the value of held to maturity assets. Silicon Valley Bank had tons of startup depositors pulling their liquid deposits out, but SVB’s own assets were highly illiquid and were supposed to be held to maturity. When they started selling these assets (long term bonds) their value cratered.

4. Explain that last part like I’m 10. Sure. When there is a huge mismatch between the liquidity of a bank’s clients and the bank’s own money, bad $hit starts to go down. The bank might have to prematurely sell assets that weren’t supposed to be sold for a long time at a huge loss because their customers need their money NOW. Like right now. THAT’s why liquidity risk matters.

5. Speak to me like I’m 12, part 2. WTF is credit and interest rate risk? Credit risk is the risk that a borrower defaults on their loan (This was a huge problem in the 2008 credit crisis, not so much right now) and interest rate risk is the risk that interest rates will fluctuate. Interest rate risk is a big problem right now. When interest rates increase loans are more expensive and the bonds that a bank invests in decline in value. Silicon Valley Bank had to prematurely sell long term bonds at a huge loss while their startup depositors were pulling their funds.

While we're here I should also mention market and headline/reputation risk. Market risk is the risk that you hold your assets in markets that fluctuate and potentially decline in value (for SVB that was 10-30 year bonds and mortgage backed securities). Headline/ reputational risk is the risk that headlines scare your depositors into pulling all their assets. Last thing: operational risk - the risk that your technological systems and operating procedures are so antiquated and bad that you get hacked, or you lose track of important customer data. Last, last thing - geopolitical risk, self explanatory and not a factor with SVB.

6. You should be pissed off, but don’t be scared. The autopsy report of SVB’s collapse will invariably find that many people inside the bank knew exactly how dangerous the business model was and were told to shut up and let the grown ups drive when they raised their concerns. I was lucky to work for a completely punkrock investment research startup when I analyzed banks, which encouraged me to shout from the rooftops about my early prediction that Lehman, Bear Stearns, Countrywide, and WaMu would collapse. But once we were acquired and I moved into the mainstream of Wall Street, I quickly saw that obstructionism was rampant and dissenting opinions were unwelcome - even if they were essential. That infuriated me at the time. And it bothered me that the culture of obstructionism on #wallstreet was never addressed post 2008.

So, you have every right to be pissed off. What was SVB’s board of directors doing? Who inside SVB warned that the business model was dangerous, and who shut them down? Where were the regulators? Images will surface of self-righteous politicians going out of their way to defang regulations. All of these revelations should make you angry.

But you don’t need to be too scared, I don’t think. I lived through the insanity of 2008 and this is nowhere close to it. To be specific this is no more than 1/20th as bad as the global financial crisis of 2008. 2008 was caused by approximately $7.3 TRILLION dollars of toxic assets underpinned by $700 billion dollars of subprime mortgages that defaulted. In 2023 we’re looking at no more than $300.3 billion of capital at risk, the total invested in startups in 2021. Equally there’s no 2023 equivalent to 2008 mortgage backed securities to make this a huge issue of contagion. We’re nowhere near that level of calamity, Thank God.

7. Silicon Valley Bank was a symptom not a cause. There were four underlying causes to SVB and they will claim more victims:

• Subprime startups - NINJA borrowers (no income, no jobs, no assets) were the homeowners whose defaults triggered the 2008 financial crisis. There is a startup equivalent to the NINJA borrower. Too many startups with no revenue, no business model, and inadequate financial oversight raised too much capital from Silicon Valley. Valuations became disconnected from value. But they were able to swap their paper valuations for actual fiat currency at real banks. That bubble hasn't yet fully deflated. And it should have never been allowed to inflate in the first place.

• High interest rates - As long as inflation remains elevated interest rates will remain high, driving down bond values, and weakening some bank balance sheets. IMHO this is healthy and overdue, but it's not without casualties.

• Obstructionism and Negligence - During a bull market like the one we’re coming out of, corporate boards are more like golf retreats than executive oversight committees. Put simply, too much risk was indulged by too many boards. That wasn't limited to SVB. That needs to change.

• Innovation Malpractice - Too many companies became so seduced by Silicon Valley's tech utopianism that they neglected their basic (boring) obligation to safeguard investors' capital, manage risk, and pressure test their earnings. Silicon Valley Bank, can sit alongside GE, and ARK Investment Management LLC in the Innovation Malpractice trophy collection. The 'thought leaders' and consultants which espoused this version of tech utopianism deserve some of the blame. I'm doing my best to offer a better alternative for companies who need to innovate and transform.

Lisa Wardlaw, former #CFO of Munich Re, Matt Moscardi a bank analyst and governance expert, Ariel Serber, a financial advisor for startups and small businesses, and I will be talking about the #svbcollapse on Friday at 11am Eastern Time on LinkedIn Live.