We figured the initial stresses would emerge in the hedge fund world, in pensions, or in 401K plans, which are all substantial buyers of mortgage-backed securities. Little did we know that the headline stress would emerge with U.S. commercial banks. We figured most commercial banks sold the mortgages they originated in order to eliminate exposure to fixed-rate mortgages. It turns out some banks were actually increasing their exposure to fixed-rate loans by loading up on mortgage-backed securities.

Silicon Valley Bank did the unthinkable. It not only loaded up on mortgage-backed securities in a time of rising interest rates, but it bought them with the proceeds they received from deposits. Deposits for a bank, keep in mind, are liabilities. They are short-term in nature because depositors can withdraw them at any time. They are variable-rate because in a rising interest rate world the bank has to increase the interest rate it pays on the deposits in order to stay competitive with higher-paying alternatives outside of the bank. SVB, in short, funded the purchase of long-term fixed-rate securities with what is essentially short-term variable-rate debt. SVB exposed itself to not just one, but two asset/liability mismatches: it funded long-term assets with short-term debt and also funded fixed-rate assets with variable-rate debt.

Here is SVB’s balance sheet as of December 31, 2022:

The long-term held-to-maturity securities of $91 billion represent the bank’s mortgage-backed securities portfolio. That portfolio lost value as interest rates started rising. Because SVB intended to hold these securities to maturity, it carried them on its balance sheet at face value. That is, the $91 billion represents the price SVB paid for the securities, not what the securities were worth in the market. The $91 billion, in other words, overstated the market value of that portfolio.

The footnotes in the 10K clearly spell out that SVB as of December of 2022 had $15 billion of mark-to-market losses on that portfolio, losses that were not reflected on the balance sheet. These are the unrealized losses incurred by SVB on this portfolio of mortgage-backed securities as a result of higher interest rates. This is value that shifted from the lender to the borrower of these fixed-rate loans.

That $15 billion in unrealized losses, keep in mind, was as of December 31, 2022. Interest rates are higher today, which means unrealized losses on the portfolio as of today would also be higher than $15 billion.

If we glance down the balance sheet we find that, on December 31, 2022, SVB had $16 billion of equity. A company’s equity is its assets less its liabilities. In this case, the value of the assets on the balance sheet overstated the market value of those assets by $15 billion at the end of last year, a number that has only grown larger since the end of last year. Marking the assets on SVB’s balance sheet to today’s market values, in other words, would wipe more than 100% of its equity.

SVB’s first problem, then, was it was insolvent. That is, the market value of its assets did not cover the market value of its liabilities. If the bank’s assets were liquidated and sold into the market, the proceeds would not cover its liabilities.

SVB undoubtedly had a second problem. A company is illiquid when its short-term funds are insufficient to meet short-term obligations. Going back to the balance sheet, we see $13 billion in cash and $26 billion in marketable securities (both liquid assets) against $173 billion of deposits (a short-term liability). In the unlikely event that all depositors needed or wanted their money at the same time, the bank had $39 billion of short-term assets to fund $173 billion of withdrawals. That again was as of the close of last year. Since the close of last year, the bank most likely ran out of short-term assets to fund withdrawals, which explains the nearly instantaneous takeover of the bank by the regulators.

SVB’s insolvency and illiquidity problems, it is important to note, are very much related. First, they both result from the bank’s boneheaded move of locking up deposits in long-term fixed-rate securities. The more important link between the two problems is with depositors: once depositors get a whiff of insolvency, they rush in unison to withdraw their deposits and create the liquidity problem. That is a classic run on the bank which SVB triggered by taking depositors’ deposits and investing them in securities that lose money, in this case mortgage-backed securities.

The most frightening thing here is SVB’s portfolio of mortgage-backed securities is miniscule compared with the massive mortgaged-backed securities market overall. SVB’s portfolio represents about 0.8% of the total market. The other 99% of mortgage-backed securities out there somewhere in the market have suffered similar consequences. The losses on those mortgage-backed securities are most likely considered unrealized, which means the holders of those securities have not yet owned up to their true losses. Who knows what nooks and crannies hold all these mortgage-backed securities. In time, we think we will find out.

The head of the Federal Deposit Insurance Corporation (FDIC; the agency that insures personal deposits at U.S. commercial banks) commented last week that U.S. commercial banks as a group have $620 billion of unrealized losses associated with holding long-term fixed-rate securities in a rising interest rate environment. That is 40x the $15 billion that wiped out SVB. Something tells us we are just getting started. More companies, in our view, will end up like SVB: toast.