The failure of Silicon Valley Bank might be one of those coal mine canaries. Keep reading for a simplified, high-level explanation of why many banks may be feeling the heat, in language that you can use when talking to friends and family. If you want a more technical read, click over to 20 banks that are sitting on huge potential securities losses—as was SVB.
Financial institutions looking for safe places to invest assets frequently park money in various types of bonds. Bonds issued by governments (especially the US Treasury) and large stable companies are considered as good as cash, and they pay interest.
How Bonds Work
A bond is essentially a loan. If a company or government wants to do a project, but don’t want to save up money to pay for it or take money out of savings, they might create and sell bonds. Originally these were physical pieces of paper that stated the interest rate the borrower would pay, and how long before they gave the lender back their money (maturity).
Let’s say a city (Anytown) wanted to build out a new park, and the cost is estimated to be $50,000. The city creates 50 bonds, each having a value of $1,000. When they sell all 50 bonds, they have their $50,000, and city leaders put on their suits and head to the site to grab shovels from staff and pretend to start digging for the cameras.
To convince people to buy their bonds Anytown has to pay interest to the bondholder. How much interest? That depends on a lot of factors, but a big part of the calculation is what the federal government is currently paying. Before the Biden disaster, interest rates were ridiculously low, which means that a well-run and financially stable city could sell bonds at a very low interest rate and still be paying more than customers could earn in a bank.
People who bought these bonds were promised a certain interest rate for a fixed time period. Let’s say that Anytown was able to offer a 2% interest rate for ten years. You give the city $1,000, the city gives you a bond. They will then pay you $20 every year for ten years (2% is really low), at which point they will give you back your $1,000.
The Key Point – And Why Banks are Nervous
Banks like bonds, especially government bonds, because they are a safe place to park your money. Let’s say Joe Smith deposits $20,000 in a savings account at a bank. The bank sees that Anytown has just started selling ten year bonds that pay 2%, so it takes $10,000 of Joe’s money and buys 10 of these bonds. The bank’s saving account is paying Joe 1%, so they take the $200 in interest each year from Anytown and give Joe $100. Sweet deal for the bank. Until Joe comes in five years later and wants his $20,000 back.
If interest rates are generally the same as they were five years ago when the bank bought the bonds, no big deal. They find someone who wants to buy $10,000 worth of bonds paying 2% and sell them as, essentially, five-year bonds. BUT – if interest rates have gone up substantially (as they have over the last two years) there is a big problem. Nobody wants to buy five-year bonds that only pay 2% when they can easily buy the same quality bonds paying 4%. So, what does the bank have to do? They are forced to sell these bonds at a discount. And the formula is straightforward. They calculate a price for a bond that will give the purchaser effectively the 4% yield. But this means a loss for the bank.
If it is just Joe who wants his money, no problem. The bank has many other assets to cover Joe’s withdrawal, and can hold the bonds to maturity and get the full $10,000 back. But if multiple customers start needing money (because of hard financial times, for instance?) then the bank can be in serious trouble – even though its assets were put into what is traditionally very safe investments.