The notion that banks can collapse might seem extraordinary, yet it is indeed a reality that has unfolded in financial historyA notable example comes from the recent turmoil surrounding Silicon Valley Bank (SVB), which saw its stock plummet by 60%, leading to its sudden downfall just a day after its financial troubles became publicWith assets totaling a staggering $200 billion, the demise of such an institution left many in disbelief and prompted a deeper inquiry into the causes behind this crisis.

At the core of SVB's issues was its abrupt announcement to sell off a portion of its securities, amounting to $21 billionThis was intended as a regular asset management maneuver, yet the fallout was severe, culminating in an $1.8 billion after-tax lossSuch a significant financial shortfall thrust the bank's management into a precarious position.

To mitigate the immediate losses, SVB swiftly decided to raise $2.25 billion through the sale of common and preferred stock—a move that can be likened to "robbing Peter to pay Paul." However, this strategy backfired, igniting panic among investors who had long regarded the bank as a stable and well-capitalized financial entity

Observers were puzzled as to why a bank with a storied reputation would find itself in such dire straits, now forced to liquidate core assets and dilute shareholders' equity to survive.

In an attempt to reassure the market, SVB's management presented various data points demonstrating that liquidity was still robust, asserting that offloading some short-term debt securities would suffice to weather this stormNevertheless, once investor confidence erodes, it often spirals into an unstoppable torrent—similar to a dam breakingThe anxiety spread, leading investors to vote with their feet, triggering a frenzied sell-off of SVB stock that day, with transaction volumes skyrocketing 22 times their usual levels.

Ultimately, the vicious cycle of panic and financial strain meant that SVB could not recover from this onslaught, resulting in the heartbreaking conclusion of its operations.

Such episodes trigger contemplation about the lessons embedded within financial history

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Notably, there is a pattern that is disquietingly evident—most major financial crises occur during times of tightening monetary policy and frequently toward the end of such cycles.

Take the collapse of Japan's economy in the early 1990s, for exampleThe bursting of real estate and stock market bubbles during a period of increasingly restrictive monetary policy sent shockwaves through the global economy, marking what has been termed "the Lost Decade," attributed to the Bank of Japan's efforts to prick asset price bubbles.

The Asian Financial Crisis in 1998 also illustrates these dynamics, initially ignited by Thailand’s devaluation of its currency, which reverberated throughout Asia—dynasties were toppled, currencies fell dramatically, and economies faltered amidst the backdrop of the Federal Reserve’s escalating interest rates that burned emerging markets with heavy debt burdens.

Another instance occurred after the tech bubble burst in 2000, when many internet companies, heavily reliant on venture capital yet lacking sustainable profits, faced obliteration, driven down by the Federal Reserve's tightening measures that left them gasping for funding

The resulting collapse of the NASDAQ index is a testament to this rapid inversion from exuberance to despair.

Then came the mortgage crisis of 2008, a cataclysmic event fueled once again by monetary tighteningAs the Federal Reserve raised interest rates to combat inflation, the cost of borrowing escalated sharplySubprime loans, already precarious, fell into delinquency at alarming rates, exposing vulnerabilities in personal and corporate financial structuresCompounding this was the proliferation of complex financial instruments—such as Collateralized Debt Obligations (CDOs)—that spread the contagion far and wide throughout the financial system, akin to a virus.

Lehman Brothers serves as a case study for how these dynamics can spiral out of controlBefore its collapse in the first quarter of 2008, it boasted total assets of $786 billion, with a heart-stopping 82.3% of its assets comprised of derivatives, mortgage bonds, and repurchase agreements

Faced with a liquidity crisis, the firm was compelled to sell vast quantities of assets, flooding the market and triggering a cascade of panic that ultimately led to a systemic collapse.

The onset of economic downturns can unearth deeply embedded risks, which may remain shrouded in the euphoria of low interest rates and buoyant growthIn eras of easily available credit, companies and individuals may overlook underlying financial vulnerabilities; however, tightening monetary policy can abruptly expose these hidden perils, akin to pulling the rug out from under a house of cards.

Reflecting on the SVB crisis in light of its asset structure as of the end of 2022 unveils another layer of complexityWith $120 billion in securities investments dwarfed against a total loan portfolio of $74 billion, SVB's holdings included $91.32 billion in mortgage-backed securities (MBS) and $26.06 billion in available-for-sale financial assets

Generally, fluctuations in the value of a bank’s securities portfolio are not disastrous as long as there is adequate liquidity to meet depositor withdrawals.

However, SVB was caught in a particularly treacherous situationOnce confidence waned, depositors began a rush to withdraw funds, exacerbating the bank's plightWith the value of its securities holdings plummeting, SVB found itself ensnared in a vicious cycle of falling asset prices and draining deposits, culminating in its eventual closure.

Recent years have witnessed a notable surge in leveraged loan markets, alongside a rise in related securitized products like Collateralized Loan Obligations (CLOs). In 2019, global leveraged loan volume reached an impressive peak of $3.22 trillionWhile recent data on this market remains undisclosed, it is clear that the scale of these financial instruments remains substantial, posing risks that could ignite even greater crises in unfavorable market conditions.

In summary, four primary factors converge to incite financial crises: the presence of a tightening monetary environment, a proliferation of potentially toxic assets, the widespread prevalence of derivatives, and institutions like SVB that wield substantial influence in the financial landscape—together creating a cocktail ripe for disaster.

The similarities in the current situation with previous crises ought to serve as a red flag