Built on sand

In 2008 an executive in a very large Christian financial services firm asked whether I had a distinctively Christian approach the problem of financial risk management. I did. If a man obeys sound fundamental principles, he is like a man who builds a house on a foundation of stone. If a man doesn’t obey such principles, he is like a man who builds his house on a foundation of sand.

Houses built on sand look very much like houses built on stone right up until a storm comes, at which point one is washed away and the other remains standing. This contrasts with modern portfolio theory, based in Darwinism and skepticism, which sees risk as essentially random and risk management as investing in assets with low volatility.

Treasury bonds are historically low-volatility assets, which means that under modern portfolio theory they were deemed to be low risk. The collapse last week of Silicon Valley Bank illustrates the difference in worldviews with painful clarity. The storm came and the house collapsed. Or, switching to a slightly less pious analogy, the tide went out and we saw who had been swimming naked.

SVB was vulnerable in numerous ways. The Fed’s extremely easy monetary policy helped to drive up the price of treasury bonds because the actual mechanism by which the Fed pursues monetary expansion is the purchase of treasury bonds, and it was so loose that it created a treasury bond bubble. Low interest rates from the Fed also helped to create a tech sector bubble. COVID policy added to that technology bubble as consumption activity switched from bricks to clicks, and people hunkered down in front of social media and streaming services.

Then all that excess money led to the inevitable inflation and the Fed eventually was forced to admit the problem and reverse course, selling treasury bonds, driving down the price, and hiking interest rates, which hurt technology companies. Silicon Valley has been hit hard as has its eponymous bank. In addition, banks own a lot of treasury bonds, so they have also been hit by the Fed’s tightening policy. 

Regional banks with weaker and less diversified balance sheets were hurt more. Silicon Valley Bank, being a regional tech bank, was triply vulnerable. So, the storm that came was a perfect storm for washing away SVB.

In a storm, not every house collapses. The shaky ones do and SVB was shaky. Several issues stand out, but near the top of the list is that the bank had an unusually high concentration of long-term treasury bonds. One can understand why the bank would want them, they typically pay higher yields than shorter term bonds. But there is extra risk in those long-term bonds. As the Fed tightens, longer duration bond prices fall faster. In the past three years long-term bonds underperformed short-terms ones 11 to 1, and SVB had a lot of them.

In addition, it appears the bank did not adequately hedge against that risk, a point David Bahnsen makes. Furthermore, the bank recklessly tripled its deposits beginning in the COVID crisis. Remember, deposits are assets to you and me, but they are liabilities to banks. Our right to withdraw funds is their obligation to pay us. More sand.

Finally, there is an issue of managerial focus. SVB was as severely ideologically captured as one might expect of a high-tech favored bank in the Bay Area to be, and that seems to have caused distractions from its core mission. In fact, it appears the head of risk assessment refocused a lion’s share of her work towards a month of Pride celebrations and a wide menagerie of identity politics to the point of leaving the risk assessment job essentially unfilled.

Risk is failing to follow certain foundation principles, in a lifestyle, in a family, in a nation, or in a business. The principle of sound money was ignored by the Fed. Modern portfolio theory and self-interested government policy wrongly deemed treasuries as safe. The bank violated principles of diversification and prudence. It set aside its fiduciary duty to be stewards of the assets of others and to focus on business, not ideology.

As the nation debates this failure it will tend to turn to the old scapegoats, capitalism, greed, political enemies, etc. But fundamentally this, like most of our crises, arose from the application of wrong first principles. Humanistic and technocratic foundations are no substitute for Biblical foundations.