SVB’s collapse exposes the huge carry trade problem

When Silicon Valley Bank slid into a death spiral last week, Peter Thiel, the (in)famous libertarian, shot into the spotlight. The reason? Last week, his Founders Fund reportedly pulled its business accounts from SVB. That led to angry accusations that Thiel and other venture capitalists had sparked a bank run.

This will provoke plenty of political mudslinging. But there is another, little-known, wrinkle that investors should also note. “I had $50mn of my own money stuck in SVB,” Thiel tells me in his defence. Apparently, he failed to flee fast enough — never mind what Founders Fund did — because he did not quite realise or believe that SVB might fail.

He is not the only one feeling disorientated. As finance suffers from what Larry Fink, chief executive of BlackRock, calls “a slow rolling” crisis in confidence, devastating banks from Credit Suisse to First Republic, three crucial points are becoming clear.

The first is that the events around SVB were akin to the blowing up of a gigantic “carry trade”. This is the phrase that financial traders invoke when they borrow cheaply in one asset (say, a currency or short-term bond) to invest in a higher-yielding one (such as a different currency or longer duration instrument).

Bankers rarely describe themselves as rabid carry traders — they prefer to think that banks perform carefully controlled maturity transformations (that is, turning deposits into loans) for their clients, with asset-liability management.

However, maturity transformation is at the heart of banking and SVB did it in such an extreme way that it was very similar to a carry trade. Most notably, the bank had $180bn in deposits, which provided cheap but potentially short-term (and flighty) funding. And since loan demand was weak, it bought long-term bonds that, stupidly, were unhedged.

That produced big profits for a while. Carry trades usually do. But when the yield curve inverted last year, it produced losses. And once depositors eventually realised that, some (though not Thiel) fled — with shocking consequences.

The second key point is that SVB was not the only carry trade around. Far from it. Many other American banks also have big hits to their bond holdings; indeed, total unrealised securities losses for US banks are more than $650bn on paper. US regulators have urged the banks to buy these supposedly “safe” assets in recent years and imposed looser liquidity and asset/liability matching rules than in Europe. That was also ill-advised.

And the problem extends beyond banks. “There are many carry trades [in the system], and they can’t all be bailed out,” JPMorgan analysts warned this week. Commercial real estate, say, “was a good investment at zero interest rates” — but not when rates rise. It is particularly nasty when commercial real estate is funded with flighty capital, such as real estate investment trusts. (This is why groups such as Blackstone have recently gated some REITs.)

Similarly, while private equity and venture capital perform well on low rates, things can also go horribly wrong with higher rates — albeit less swiftly since part of the funding is locked up and there is less transparency.

“This bank failure is a ‘canary in the coal mine’ of a changing cycle,” warns Ray Dalio, founder of Bridgewater Associates, a hedge fund. Dalio notes that while the pain in “2008 was heavily in residential real estate, [now] it’s in negative-cash-flow venture and private equity companies as well as commercial real estate companies”. Ouch.

However, the third crucial point is that the scale of this carry trade unwinding is hard for most onlookers to appreciate. Depositors like Thiel seem to have been particularly blind to the looming risks at SVB (even though they were raised by the Financial Times and others beforehand). This is possibly because techies tend to assume that 21st-century computer science is infinitely more interesting than issues such as cash management or capital adequacy. They only focus on banks when they hope to disrupt them with clever apps or crypto.

But it is not just the tech sector who were naive. A decade of crazily cheap money has left many investors assuming that low rates were usual. Carry trades have become so normalised that they have gone unnoticed — until they blow up.

Of course, a cynic might suggest these low rates could yet return if the Federal Reserve ends the tightening cycle to ward off a financial crisis. After all, former Fed chair Paul Volcker stopped raising rates in 1984 when the Continental Illinois bank collapsed.

Conversely, a global recession might bring lower market interest rates too. If so, the next thing investors and bankers will need to worry about is not just interest rate risk but credit risk — ie, the danger that borrowers go bust en masse.

But right now it is those carry trades that most urgently need thinking about. After all, as Fink observes, this is the “price . . . for decades of easy money”. Or, to put it less tactfully, SVB’s collapse is the consequence of the Fed having left monetary policy far too loose for far too long — even as US bank regulation was rolled back.

That probably won’t hurt Thiel: his $50mn, like other SVB deposits, has now (controversially) been protected. But investors exposed to other carry trades may not be as lucky. Expect them to feel mad.

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