Everything You Didn't Think Of.
Risk is obvious after it happens, isn't it?
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After a fun two weeks in Japan (you can read about that here), I’m back on the writing grind, and it looks like I missed a bank collapse or two. But don’t worry, I’m not sharing my thoughts on the merits of a fractional reserve system, the potential moral hazard implications of a bailout, or whether or not this is bullish for bitcoin.
I want to share eight thoughts on “risk.”
First, risk is highest when everything seems perfect.
Founded on October 17th, 1983, Silicon Valley Bank became the premier banking partner for America’s most promising startups, and two years ago, business was booming. After a brief decline in deal flow during the initial Covid shock, venture funding exploded to new heights, with companies raising a record $344B in 2021.
No one benefited from the VC bull market more than Silicon Valley Bank, whose deposits grew from $49B in 2018, to $102B in 2020, to an astounding $189B by the end of 2021. And of course, shareholders benefited as well as the bank’s stock price 6x’d from $100 to $700+.
Everything was perfect at Silicon Valley Bank. And then it all came crashing down in the blink of an eye.
Second, the conditions that create prosperous outcomes often plant the seeds of their own unwindings.
Silicon Valley Bank was the ‘cool bank’ during the biggest venture-funded bull market ever. Interest rates steadily declined, funding rounds and valuations continued to increase, and the lion’s share of newly-raised startup cash went to the same place. Why wouldn’t it? Who else would hook founders up with below-market mortgages and host steak dinners at Austin’s South by Southwest conference? And these tactics worked: 88% of Forbes’ 2022 Next Billion Dollar Startups were SVB clients.
But this concentrated customer base that was so valuable in a bull market was vulnerable when market conditions changed, and when fundraising slowed, startups across the country had to withdraw cash to pay employees and rent. When one client needed cash, thousands of clients needed cash. Minimal diversification leads to correlations that approach 1 on both the way up and the way down.
Put more simply, the same factors that contribute to outsized wins often cause catastrophic losses.
Third, risk happens fast.
“Consider a turkey that is fed every day. Every single feeding will firm up the bird’s belief that it is the general rule of life to be fed every day by friendly members of the human race “looking out for its best interests,” as a politician would say. On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief.” - Nassim Taleb
For years at Silicon Valley Bank, business was booming and its stock price climbed, and climbed, and climbed. And then in a matter of days, everything collapsed.
Failure always happens faster than the progress that preceded it, we use terms such as “collapse” and “crash” for a reason. This is even more true in the internet age, where a few investor memos cautioning founders to withdraw their cash can circulate around social media in a matter of hours, and a seemingly healthy bank can experience $42B of withdrawals in a single day.
Risk happens fast.
Fourth, boring is often a feature, not a flaw. Leaving money on the table isn’t a bad thing if it provides a margin for error.
One key factor that accelerated Silicon Valley Bank’s demise was management’s decision to invest most of their capital in long-dated mortgage-backed assets when interest rates were around ~1.7%.
The thought process was simple: yields were higher in these longer-dated securities, and the Fed wasn’t planning to raise rates in the near future, so the bank could generate larger returns by purchasing these assets.
Of course, every undergraduate finance major knows that when rates rise, bond prices tank, and the Fed’s about-face to raise rates several times in 2022 and 2023 decimated SVB’s portfolio.
Had the bank maintained larger positions in lower-yielding, short-dated securities, it probably would have survived the rate hikes. But they were chasing higher profits and got their forecast wrong.
Higher profits are great until the tide goes out when you aren’t prepared. Outsized returns come with a price.
Fifth, there is never one single catalyst to any existential risk.
One reason that Silicon Valley Bank collapsed was that a cautionary memo went viral, causing a scare that led an ever-increasing number of companies to withdraw their cash, which caused thousands of folks to opine about SVB’s possible collapse on Twitter, which caused even more companies to withdraw their cash. Of course, the speed at which this information moved from party to party was only possible thanks to the internet and the ability of individuals to stoke fear on Twitter.
Another reason that Silicon Valley Bank collapsed was its decision to invest in long-dated mortgage-backed securities, but the bank only did this because yields on short-dated fixed-income securities were near-zero, but yields were only low because of 2020’s quantitative easing, but we only had quantitative easing because of the coronavirus.
Another reason that Silicon Valley Bank collapsed was because of the heavy issuance of securities-related loans and venture debt for startups, but the bank only offered these products because its proportion of startup clients was much higher than the rest of the industry, but its customer base was majority startups because there was a decade-long VC bull market that made this segment an attractive customer base, but this decade-long VC bull market was influenced by a decade of declining interest rates that forced investors to look for sectors such as venture capital for increased returns, but interest rates were initially cut in response to the Great Financial Crisis, but the Great Financial Crisis was caused by….
Do you see where I’m going with this? If one of these dozens of things never happened, Silicon Valley Bank doesn’t collapse. But all of these things did happen, and their combined outcome was a bank failure.
Sixth, the biggest risks, by their very nature, can’t be forecasted.
In 2019, the bigger global macroeconomic fears were a trade war with China, nuclear weapon development in North Korea, and unrest in the Middle East. In 2020, a new virus killed millions, sending the world into a multi-year lockdown.
Covid-19 wasn’t on anyone’s bingo cards, was it?
We take steps after every crisis to ensure that it never happens again. With Covid-19, those steps included the development of mRNA vaccines. With the Great Financial Crisis, those steps included regulatory overhaul for banks and rating agencies.
We have never seen a startup-focused bank fail because it invested in fixed-income securities paying 1.70% interest coming out of a pandemic-induced recession. There wasn’t a historical example for management to point to and say, “Well, we better not do what they did!”
I promise you that the next crisis won’t look like the last one, either.
Seventh, when you have already achieved “success,” no terminal tail risk is worth it, regardless of the probability.
Warren Buffett once said, “It’s insane to risk what you have and need for something you don’t really need.”
I’ve written several times now about my own SPAC trading journey during the Covid Bubble, where at one point I had turned $6,000 into more than $400,000. When I was getting started, I could have made a good argument for taking bigger risks: losing $6,000, in the grand scheme of things, isn’t that big a deal.
But a year later, I was making the same high-risk trades with $400,000 that I had been making with $6,000, and, as you could guess, it blew up in my face, causing me to lose around $250,000 from my peak.
When Silicon Valley Bank was just getting started in the 80s, high risks would have been understandable. If a 1-year-old, no-name bank fails, who cares? Whatever.
But in 2023, Silicon Valley Bank was one of the largest financial institutions in the country and a cornerstone of the startup community. Risky activities now had exponentially larger consequences. SVB didn’t need to take on additional risk. They had won. Game over. But as their deposits ballooned, they played stupid games and eventually won stupid prizes.
Terminal tail risks, no matter how unlikely, should never be pursued once the potential losses outweigh any potential gains.
Eighth, the biggest risks always look obvious in hindsight, yet we never catch them beforehand.
Hundreds of articles have been written about Silicon Valley Bank’s countless red flags over the last two weeks. It’s funny that these issues only became apparent after the bank collapsed, isn’t it?
It’s easy to determine what caused a failure, but predicting the next crisis before it occurs? Well, that’s another story.
- Jack
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Jack's Picks
Matt Levine and Marc Rubinstein both published excellent pieces breaking down what happened with Silicon Valley Bank.
Paul Skallas wrote a good piece on how “optimization” has been killing baseball.
Noah Smith shared his thoughts on why we should ban TikTok.