Making Sense of the Silicon Valley and Signature Bank Failures

Events are still unfolding in the largest bank failure since Washington Mutual went down early in the mortgage crisis of 2008, but banking law expert and author Thomas Vartanian says there are already key lessons the industry and Washington need to take from this episode. A fundamental that seems to have gotten lost in the crypto and tech euphoria is the necessity of avoiding overconcentration.

The fallout from the failure of Silicon Valley Bank is still a huge question mark that will take months to play out.

But the potential ripple effects started even before regulators stepped in Friday morning, California time, to close the $209 billion-asset bank that had been the primary financial engine for technology startups in this country.

A deposit run had taken on such momentum that they could not even wait until the end of the day, as typically happens with a bank failure.

It took less than 48 hours for the nation’s 16th-largest bank by assets to be toppled in what is the largest bank failure since Washington Mutual, then $307 billion in assets, was closed in 2008.

The ripples already had turned into a tsunami by Sunday evening, as New York regulators closed the $110 billion-asset Signature Bank. Signature, the 29th-largest bank in the country, had been one of the main banks serving companies in the crypto sector. It was among a group of regionals — including First Republic in San Francisco, Pacific Western in Los Angeles and Western Alliance in Phoenix — that came under grave pressure as the Silicon Valley Bank panic spread.

To quell the threat of a contagion, federal banking regulators — the Federal Reserve, the Federal Deposit Insurance Corp., and the U.S. Treasury Department — jointly made two major announcements Sunday evening.

In one announcement, they said all deposits of the two failed banks would be fully covered at no expense to taxpayers.

They also announced an emergency program that aims to give all banks and credit unions nationwide the ability to cover all deposits on demand, should there be a need. The new “Bank Term Funding Program” will provide one-year loans to banks that pledge collateral such as mortgage-backed securities and Treasury bonds.

Unrealized losses on such assets — the total across the banking industry was $620 billion as of Dec. 31, according to the FDIC — is prompting some of the concern about more turmoil.

Part of what set off the trouble at Silicon Valley Bank was that it sold $21 billion of bonds at a $1.8 billion loss. Many of the tech companies it served have been burning through cash and drawing down their deposits. To cover those withdrawals, the bank had to sell off some of the bonds it had invested in.

Its announcement about that loss had taken the market by surprise just two days earlier, especially given the unfortunate timing. Silvergate Bank, which had served companies in the crypto sector, had just announced a voluntary liquidation, after a run on its deposits left it flailing.

Though Silicon Valley Bank also announced plans to raise capital, it never got the chance.

See our detailed timeline of these events and the fallout.

How Could All of This Affect Your Institution?

To obtain some clarity and perspective on the unfolding drama, The Financial Brand sought out an expert who literally wrote the book on bank panics.

Thomas Vartanian is a veteran regulator and bank regulatory attorney. He is also the author of “200 Years of American Financial Panics,” a historical account that included his thoughts on how panics could be avoided in the future.

Vartanian chaired the financial institution practices at two major law firms, Dechert LLP and Fried Frank LLP, after serving as general counsel at the Federal Home Loan Bank Board and the Federal Savings and Loan Insurance Corp. (Both no longer exist, their functions absorbed into other federal financial regulatory agencies.) Today he is executive director of the Financial Technology & Cybersecurity Center.

During his career, he was involved in the resolution of nearly 1,500 failed and failing savings institutions. In private practice, he represented uninsured depositors and other parties in multiple failed bank situations. One way or another, he’s been involved in 30 of the 50 largest financial institution failures in the United States.

“You just keep your eyes and ears open,” says Vartanian. “You learn a lot just by being at the scene of the accident.”

Tom Vartanian quote The banking system work on confidence and falls apart on lack of confidence

Regarding bidding for the remnants of Silicon Valley Bank, Vartanian wondered whether a buyer would step forward. He noted that after the financial crisis of 2008, some of the big banks that stepped in to buy failed institutions at government urging were later criticized — or worse — for actions the acquired companies had taken prior to failing. “Banks felt used and abused,” Vartanian says.

He recalls that an embittered Jamie Dimon of JPMorgan Chase remarked in a letter to shareholders that his institution would not be inclined to do regulators any more such “favors” while he was in charge. (It had taken over both Wamu and Bear Stearns, only to be sued later for activities at those institutions before their collapse.)

What follows is an edited transcript of a conversation Vartanian had with both Bonnie McGeer, editor in chief, and Steve Cocheo, senior executive editor, after the collapse of Silicon Valley Bank.

To Contain the Problem, Regulators Must Maintain Confidence in the Market

Q. How bad could this situation get?
Vartanian: Compared to some of the episodes that I saw in writing my book, “200 Years of American Financial Panics,” I think this is a relatively segregated and segmented problem. We’ve seen two monoline banks [SVB and Silvergate] end up in trouble inherited from trouble in the technology and crypto businesses.

I’ve written an op-ed for The Hill that basically says that we should be thanking Sam Bankman-Fried [founder and former CEO of the embattled FTX cryptocurrency exchange] for screwing up so early in the process before crypto became too integrated with the traditional financial services of this country. I draw a straight line from him to an increasing loss of confidence in financial markets. It is very much psychological.

In 2008, there weren’t enough subprime mortgages outstanding in this country to cause the global panic that occurred. What happened, though, was that the balance sheet of every financial institution fell into disrepute because of a crisis of confidence. But I don’t think the current situation should cause a crisis in confidence. I think it can be well contained if handled properly.

That said, one thing scares me. The regulators looked like they were not prepared for this. Yet a lot of us have been writing about this coming for over a year. The fact that FDIC set up the Deposit National Bank for Silicon Valley Bank means it didn’t have a bidder ready to take it over. So the regulators have some work to do to contain this.

Something that shows up in every crisis and panic: Things fall to pieces when confidence in the market erodes as things fall apart that you didn’t anticipate falling apart.

A Key Accounting Policy Drives Broader Concern About Perception Risk

Q. But what about the underwater securities portfolio problem that turned a slow-brewing crisis at Silicon Valley Bank into one so dramatically urgent?

Vartanian: The way the accounting rules work, basically, is that if an institution purchases a security to hold to its maturity, it doesn’t have to mark it to market value. However, if the institution holds it for possible sale, it does have to mark it to market, and take the loss.

Right now there are around $10 trillion, give or take a few trillion, of 30-year fixed-rate mortgages out there at 3%, because we’ve had low rates for so long. That loss, on paper, is spread out so diversely that it shouldn’t be a major problem. Some of that loss is embedded but not reported because the institutions are holding the investment to maturity. [Editor’s note: Often some of this can be sorted out using footnotes in financial reports from publicly traded banks.]

Here’s the problem. If you have a liquidity crisis, such as occurred in the crypto business, with those companies pulling their deposits, then an institution may have to break their held-to-maturity portfolio and start selling pieces of it. And once you sell one loan or one security from that portfolio, the rules say you have to mark the whole thing to market.

If things start cascading that’s when you have the possibility of confidence being affected by a larger, rolling problem. Confidence is a fickle thing. It can affect the pricing and valuation of instruments on financial institution balance sheets.

Read More: Why Silence Isn’t Golden on SVB & Signature Bank Failures

Q. But that’s the concern: If there is a report on television or a website about unrealized losses in portfolios being held at banks all across the country, that could trigger consumer worries.

Vartanian: As I said, many bond portfolios are probably underwater right now at fair market value because of when they were put on the books. The FDIC mentioned an embedded loss of $620 billion. I think the answer is that the banking system has so much capital — arguably more than it needs — that it should be well positioned to weather these kinds of storms. The issue is confidence and liquidity.

“It was determined that uninsured depositors at Silicon Valley and Signature Banks would be covered. This is a dangerous precedent.”
— Thomas Vartanian,
banking attorney and author

The 2008 crisis was a liquidity crisis, and yet the Dodd-Frank Act hasn’t got one sentence about liquidity. However, it forced banks to raise capital and started the process of identifying those that are systematically significant. It put us in the position where the federal banking regulators and the Secretary of the Treasury should be able to stand up and say, “Look, we have stress-tested these banks for just this event and they are fine.”

The banking system works on confidence and falls apart on lack of confidence.

Part of the problem in 2008 was that people from Treasury and the Fed panicked on TV. You can’t go to Capitol Hill and panic in front of the klieg lights and think the markets won’t panic. When I served as general counsel at the Federal Home Loan Bank Board, Richard Pratt, the chairman (1981-1983), instilled in all of us that “We can never, never look like we are not in control.”

Late Sunday, it was determined that uninsured depositors at Silicon Valley and Signature Banks would be covered. This is a dangerous precedent. The FDIC has been criticized for 30 years for paying out on uninsured deposits in some past cases. Why? Because that’s not the way the system was built to work.

The long-term loss of market discipline that derives from continued bailouts ultimately impacts the performance and expectations of the market. It has to be done only when absolutely necessary.

Read More: Failure of Silicon Valley Bank May Foreshadow Innovation Crisis

What Messenging Should Other Financial Institutions Be Putting Out There?

Q. What can banks and credit unions nowhere near Silicon Valley do to give their depositors confidence?

Vartanian: In this situation, people are not looking to their depository institutions to tell them that they should be calm. They are looking for someone more trustworthy in their minds. And that includes the Secretary of the Treasury, the Chairman of the Federal Reserve, and maybe the White House Director of the National Economic Council. Those are the people who should stand up and make a cogent statement, with facts and figures, about why this is not a problem. That’s what you need.

When I was in government, Paul Volcker, as Fed chairman, had that stature. When Volcker spoke, people listened — and believed him.

There’s a fundamental problem now and it shows up during these kinds of events: People don’t believe the government today the way they did in the 1980s. There’s been a loss of credibility.

It’s extraordinarily dangerous when social media — the mob — determines what people learn, know and believe. What we have today is not an economic problem, it’s a confidence problem.

Money Isn’t Red or Blue — It’s Green

Q. There are going to be some knee-jerk reactions out of Washington. We’re seeing some of that already. Will Capitol Hill start talking about “too big to fail” again?

Vartanian: People on the Hill are going to be a little more cautious this time, because they received a lot of money from the tech business. I’ve written about how Congress has been asleep at the switch with crypto, but you have to ask, why? Were they asleep because Sam Bankman-Fried and FTX gave them $70 million over two years? Bitcoin was inaugurated in January 2009 and yet there hasn’t been one law written on the federal level to deal with crypto. And it’s had zero regulation. Think about this: Add up direct crypto, crypto derivatives and crypto-related leverage and you are talking about at least $10 trillion. That’s basically the size of the country’s direct mortgage market.

But no, I don’t think too big to fail will come up much because these banks failed.

“If we don’t get politics out of financial services, we’re going to keep having these kinds of crises over and over and over again.”
— Thomas Vartanian,
banking attorney and author

I have a broader concern: If we don’t get politics out of financial services, we’re going to keep having these kinds of crises over and over and over again. Something I wrote in my book about panics was that “Money isn’t red or blue. It’s green.” When you try to make it red or blue, you will cause some aberration in the marketplace, and, eventually, some sort of crisis.

Today every politician thinks he or she has got some role in financial regulation, and they shouldn’t. It is a complicated business. Banking is based on fundamentals, not politics. Banks are in the business of understanding and valuing risk. The best banks won’t have a problem. The worst banks will. That’s just the way it’s always been.

Q. What is the banking lesson here?

Vartanian: In a word, diversification. When Jerry Hawke was Comptroller of the Currency (1998-2004) he set out to get rid of monoline banks, because he felt doing just one line of business was not good, you needed diversification.

But somehow or other we got away from that. Silvergate and Silicon Valley Bank were focused on narrow segments of the economy. There should have been no doubt that when those segments experienced problems, the banks would experience problems. When you study financial crises, you learn that banks reflect the economy.

You don’t have to be very smart to figure that the margin for error in the crypto business was literally paper thin, because there’s no value there, only the hope that somebody else will think there is. At least with subprime mortgages, there was a home securing the loan.

I come back to a simple question: Where were Congress and the regulators?

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