Fragile Capitalists

Published on March 12, 2023

“They are all libertarians until they are hit by higher interest rates.”

— Nassim Nicholas Taleb

We have all seen the embarrassing spectacle of a child at the grocery store throwing a tantrum when they are deprived of a sugary snack in the checkout line. It is easy to stop the tantrum by simply buying whatever the child wants, but any parent with an ounce of common sense knows that doing so will only make the next incident worse. 

“OK, Timmy, we will get the Oreos this time, but never again! This is the very last time!”

I don’t think that I am being too harsh when I compare some of the chatter this weekend among supposedly sophisticated capitalists to the whining of a child in a grocery story. Yesterday, I attempted to explain the basic contours of the fall of Silicon Valley Bank. I knew that there would be anguished calls for government action this weekend, but some of the arguments I have read are cringeworthy beyond belief. 

Perhaps I will not win any friends by making the following comments, but that’s a risk I am willing to take. I have absolutely zero interest in ever working on Wall Street or on Sand Hill Road. I do not care how many readers subscribe to my (free) Substack, and I am fortunate enough to not be someone that can be easily “cancelled”. So, I will use my small platform to protest against the absurdity of crony capitalism. There is no point in freedom of speech if you will not put skin in the game.

Let’s start with Bill Ackman’s monster tweet that I read shortly after posting my article yesterday. If you thought that Twitter threads are unwieldy, click on this one to see a wall of text attempting to justify a government lifeline for Silicon Valley Bank:

Mr. Ackman’s plea is that government must come up with a plan to protect all depositors before Monday morning or all hell will break loose. FDIC insurance already provides protection up to $250,000 and the FDIC has indicated that Silicon Valley Bank customers will have access to insured funds on Monday morning. There is no risk of individuals or small businesses being deprived of funds up to $250,000.

Supposedly, without a bailout, depositors with over $250,000 at Silicon Valley Bank will wake up to the shocking realization that they are, in fact, unsecured creditors. 

Well, they are in fact unsecured creditors of a failed bank. 

Here is what the FDIC had to say about the situation on Friday:

“All insured depositors will have full access to their insured deposits no later than Monday morning, March 13, 2023. The FDIC will pay uninsured depositors an advance dividend within the next week. Uninsured depositors will receive a receivership certificate for the remaining amount of their uninsured funds. As the FDIC sells the assets of Silicon Valley Bank, future dividend payments may be made to uninsured depositors.”

I can understand why there could be ordinary individuals who were somehow unaware of the $250,000 limit on FDIC deposit insurance, but there is absolutely zero excuse for a business owner to wallow in such ignorance. If you deposit over $250,000 in a financial institution, you absolutely are an unsecured creditor of the bank. 

Mr. Ackman’s tweet goes on to suggest that a “giant sucking sound” will occur next week because “substantially all uninsured deposits” will be withdrawn from all but the systemically important banks (SIBs). Funds will drain from regional banks like Silicon Valley Bank into SIBs, money market funds, and short-term treasury bills. In short, the regional banks will fall like dominos as depositors flee. A widespread run on all but the largest “too big to fail” banks will commence. In addition, demand for treasury bills will drive short-term rates lower which will make it harder for the Federal Reserve to tighten monetary policy.

Perhaps there will be outflows of deposits from regional banks with a risk profile similar to Silicon Valley Bank into larger financial institutions and the market for treasury bills. We are now more than 36 hours into the weekend and corporate treasurers and CFOs should have been working overtime all weekend to assess their exposure and determine whether they, as unsecured creditors of banks, have taken on more risk that they are comfortable with. The notion that large depositors should be protected from their decisions only invites massive moral hazard in the future.

Mr. Ackman goes on to suggest that “thousands of the fastest growing, most innovative venture-backed companies in the U.S. will begin to fail to make payroll next week.” The implication is that bailing out large depositors is not something that must be done to protect wealthy venture capital investors but to protect employees who would otherwise go without pay. 

This implies that an otherwise promising venture-backed company will be allowed to fail by losing its employees due to a liquidity issue. It should be noted that deposits over $250,000 are not expected to be totally lost. The FDIC will provide receivership certificates to large depositors who will receive recovery of funds as unsecured creditors in due course as Silicon Valley Bank’s operations are wound down. As I noted in yesterday’s article, the bank likely has no value for its equity holders, but there are significant assets to liquidate and depositors are very likely to receive substantial recovery. Large depositors will lose money, but not their entire deposits.

Is it unreasonable to expect venture-backed technology companies to receive funding from their equity owners to bridge the gap between this week’s payroll and eventual recovery of deposits from Silicon Valley Bank? 

If a venture-backed startup is promising, the venture capital investors have every incentive to figure out a way to ensure that the startup does not fail. Further capital might need to be injected or the receivership certificates received by the startup may need to be sold at a discount to obtain immediate liquidity. This is called capitalism. 

If you would like to sample a series of absolutely cringeworthy tweets and retweets, sample the offerings on the timeline of Garry Tan, the President and CEO of the famous venture capital firm Y Combinator.

The usual absurd hyperbole surrounding 120 hour workweeks is combined with a series of tweets claiming that the true victims here are tiny startups that, like naive little children, placed their funds with a bank while being totally unaware of the limits of FDIC deposit insurance and completely oblivious to the obvious option of purchasing treasury bills that would ensure complete safety and liquidity. 

Will Y Combinator allow their startups to simply fail because they cannot meet payroll due to the failure of Silicon Valley Bank or another bank that might fail this week? Or will they use their famous discernment to identify the startups that are deserving of equity injections to ensure their survival while perhaps letting the more marginal firms in their portfolio fail? In other words, will they practice capitalism as owners of these firms and step in to save those that are promising?

It is disingenuous but common this weekend to see tweets from various politicians as well as extremely wealthy individuals who are crying for a bailout by using the image of individuals of modest means who will not receive their paychecks next week if government does not step in to protect all unsecured creditors of failing banks. Of course, it would be less politically palatable to ask for bailouts to protect wealthy venture capitalists who should have exercised better oversight of their portfolios.

I have read many extremely dubious comments this weekend about how unfeasible it is for corporate treasurers to split up their funds among multiple banks to take advantage of the $250,000 FDIC insurance limit at multiple institutions. The reality is that technology makes it quite possible to do this, but there is another very obvious option: A firm can simply hold a ladder of short term treasury bills that mature every week and address cash flow needs.

Take a very simple example of a CFO of a Silicon Valley “pre-revenue” firm that received a $50 million equity injection at the beginning of 2023 and expects to burn about $1 million per week this year, mostly on payroll expenses. It seems like more than a few such firms simply plopped their funds in Silicon Valley Bank, earning next to no interest, and obliviously becoming unsecured creditors.

Instead, it would have been very easy to purchase $1 million of treasury bills maturing every week this year to cover cash flow needs. Instead of having $50 million sitting in the bank at the start of the year, the startup would have kept $1 million in the bank for immediate liquidity. Every week, a treasury bill would mature and be deposited in the bank providing liquidity for next week. The CFO might have even opted to split the $1 million into four fully insured FDIC accounts at separate banks. But even if the entire $1 million was at Silicon Valley Bank, only $750,000 would have been uninsured, not their entire $50 million of working capital for the full year.

Is this impractical? As an individual, I use this strategy for my own personal liquidity, matching maturities of treasuries with occasions when I know that I will need funds to pay larger expenses such as property taxes or estimated income taxes. I do this even though I could have all of my cash for the year parked in a single FDIC insured bank account which would be well under the $250,000 limit because my annual spending is far lower than that figure. If I can create a simple treasury ladder for my own personal funds, is it too much to ask a CFO of a technology startup to do the same?

I am skeptical that venture capital firms will allow their most promising startups to simply fail due to a liquidity crisis caused by Silicon Valley Bank’s failure. The most promising startups will receive equity injections and perhaps the weakest will be allowed to fail, with the venture firms conveniently claiming that the failure was due to the government’s negligence rather than their own decision to permit failure. 

Will some ordinary employees suffer as a result of this situation? Regrettably, the answer is yes, but in any capitalist system there will be business failures caused by all sorts of factors, and if we wish to harness the benefits of capitalism, we must also be cognizant of the fact that failure is part of the deal. It is extremely disingenuous for the venture capital industry to pretend that a bank failure is responsible for the situation when they should have exercised better oversight of their investments. 

I will conclude by returning to Mr. Ackman who had the following to say toward the end of his lengthy tweet:

“The @FDICgov and OCC also screwed up. It is their job to monitor our banking system for risk and SVB should have been high on their watch list with more than $200B of assets and $170B of deposits from business borrowers in effectively the same industry. The FDIC’s and OCC’s failure to do their jobs should not be allowed to cause the destruction of 1,000s of our nation’s highest potential and highest growth businesses (and the resulting losses of 10s of 1,000s of jobs for some of our most talented younger generation) while also permanently impairing our community and regional banks’ access to low-cost deposits.”

While it is true that the banking regulators should have been on high alert given SVB’s business model, it is not the job of government regulators to protect unsecured creditors of the banking system who did not do their own job of properly assessing risk. As I pointed out in yesterday’s article, the risk at SVB was well known and obvious to anyone who is even vaguely aware of how to read financial statements. 

The idea that tens of thousands of jobs at highly promising growth businesses are going to be allowed to be destroyed with the venture capital industry watching helplessly seems highly dubious and is only serving as a scare tactic to justify a massive bailout of venture capital backed firms.

Large segments of the investment community seek to harness the power of capitalism and enjoy its upside during good times but avoid responsibility and losses that represent other side of the coin. 

That is not how the system is supposed to work. 

Bailouts introduce massive moral hazard into the system and promote misallocation of capital. The only way for capital to be allocated to its highest and best use is for capitalists to be aware of the risk of loss and allocate their funds accordingly. No safety net should be provided to large depositors who, despite anguished pleas this weekend, are in fact unsecured creditors of a failed bank.

“Sorry Timmy, no Oreos for you today or in the future. Cry all day if you want to, I’m not caving in. You’ll thank me later.”

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Fragile Capitalists