Silicon Valley Bank's fall widens systemic cracks as cheap money vanishes

© Reuters. FILE PHOTO: A view of the Park Avenue location of Silicon Valley Bank (SVB), in New York City, U.S., March 10, 2023. REUTERS/David 'Dee' Delgado

By David Randall and Davide Barbuscia

NEW YORK (Reuters) -Cracks are appearing in the global financial system as the decade-long era of cheap money ends, with some investors worrying the shock collapse of Silicon Valley Bank signals world markets may be on the cusp of a reckoning. 

Over the past year, the U.S. Federal Reserve launched its most aggressive interest rate hiking cycle since the early 1980s and other central banks joined in, leaving global investors to face a gamut of consequences.

They have seen the longest selloff in technology shares since the dotcom bubble at the turn of the millennium, a collapse in the cryptocurrency industry, a run on U.S. and British real estate funds and an intervention by the Bank of England to prevent a near-collapse of British pension funds.

After the second largest bank failure in U.S. history on Friday, market participants worry more disruptions lay ahead, as climbing interest rates cut off access to cheap money and expose vulnerabilities in the economy.

Big investors including Kyle Bass and Bill Ackman argue the government must take quick action to avoid Silicon Valley Bank's collapse sparking more widespread withdrawals in the banking system.

So far, the pain has been largely felt by investors and institutions who placed risky bets. It remains to be seen whether the pain spreads to others and a new crisis emerges. That could be determined by how hard the world's central banks continue to push interest rates higher.

"When you go this aggressively into a hiking maneuver after creating so much inflation you’re going to break something," said Kyle Bass, founder and chief investment officer of Hayman Capital Management.

"And what they (the Fed) are going to learn is that the rapidity with which they raised rates is as reckless as the rapidity with which they printed money,” said the investor, who does not have a position in SVB.

Federal Reserve Chair Jerome Powell on Wednesday reaffirmed his message of higher rate hikes, but emphasized the debate was still underway, depending on upcoming data. U.S. officials have also argued the banking system is robust.

Even so, signs of market unease have grown in recent days: the S&P 500 fell 4.6% this week, nearly erasing its gains for the year, while the Cboe Volatility Index, known as Wall Street’s fear gauge, surged to its highest level in 3 months. Yields on two-year Treasuries saw their biggest plunge since the 2008 financial crisis. That suggests a flight to safety among investors as well as bets that economic distress may force the Fed to ease up or reverse its aggressive tightening.

The U.S. administration said they see few signs of a 2008-style financial crisis, in which failing institutions threatened to bring down others in their wake. U.S. Treasury Secretary Janet Yellen and the White House both noted the U.S. banking system remains more resilient than it was in 2008 financial crisis.

The market is signaling contagion could factor into the Fed's calculus, possibly prompting it to slow down the pace of interest rate hikes. Investors were now pricing in a 38% chance that the Fed will raise interest rates by 50 basis points later this month, down from a 68.3% chance seen the day before.

"The Fed normally tightens until something breaks," said Jack McIntyre, portfolio manager at Brandywine Global.

California banking regulators shut down Silicon Valley Bank on Friday after the bank, which had $209 billion in assets at the end of 2022, saw a run, with depositors pulling out as much as $42 billion on a single day, rendering it insolvent.

Similar to the UK pension fund crisis in September, the firm appeared to be on the wrong side of the surge in yields, leaving it exposed to interest rate risk and unable to meet its liabilities.

Investors looked for vulnerabilities elsewhere and fled other banks where they perceived risks. The KBW Bank index has fallen more than 10% over the past two days, its worst decline since March, 2020.

Some banks rushed to reassure. U.S. lenders First Republic Bank (NYSE:FRC) and Western Alliance (NYSE:WAL) issued statements to say liquidity and deposits remained strong, even as shares in both companies fell more than 14% Friday. Germany's Commerzbank (ETR:CBKG), meanwhile, said that it saw no “corresponding risk” to itself on a day that its shares fell 2.6%.

"Contagion risk stemming from the collapse of SVB Financial triggered a sell now, ask questions later, backdrop for stocks," said Adam Turnquist, chief technical strategist for LPL Financial (NASDAQ:LPLA). He noted that less than half of the companies in the Standard & Poor's 500 were trading above their 200-day moving average, down sharply from 79% in February.

Silicon Valley Financial Group was deeply woven into the fabric of the technology industry. It was a source of funding for startups and a popular provider of payroll processing and personal wealth management.

Regulatory data shows 89% of the bank's $175 billion in deposits were uninsured as the end of 2022, and billions were stranded while regulators tried to find a buyer.

The fallout has hit a number of companies who did business with the bank. In the latest, Stablecoin USD Coin (USDC) lost its dollar peg and slumped to an all-time low after Circle, the U.S. firm behind the coin, revealed that a chunk of the reserves backing it were held at Silicon Valley Bank.

The bank's failure will likely increase pressures on companies to become profitable, ending the era in which investors were willing to withstand years of losses for the sake of expanding market share.

Bass and Ackman separately warned that the government would have to move quickly in resolving Silicon Valley Bank to assure depositors. 

"The unintended consequences of the gov’t’s failure to guarantee SVB deposits are vast and profound and need to be considered and addressed before Monday," Ackman wrote in a Tweet on Saturday.

"If they don’t do that by tomorrow we have a systemic problem," Bass told Reuters in an interview.