Adnan Zai, a specialist resident advisor to global private equity firms, has worked in the financial world for decades. We sat down to talk to him recently about last week’s bank meltdown, which has brought new financial worries to the American people. Silicon Valley Bank “SVB” experienced a run on its deposits last week, beginning the ripple effect of worry across the country and indeed the world. A major lender for tech-focused venture capital funds and startups, SVB invested assets in longer-term treasury bonds with low interest, which got them into trouble as the interest rates continued to rise. They filed for Chapter 11 bankruptcy and are seeking a court-supervised reorganization. As of last week the government stepped in to help.

Silvergate Capital and Signature Bank followed. Signature Bank has been riding the coattails of the cryptocurrency balloon, but the bubble is bursting.

Kraven: Why was this collapse last week particularly devastating for the startups in Silicon Valley?

Adnan Zai: Big companies like JP Morgan, Citi, and Bank of America don’t always want to serve Silicon Valley tech startups because they don’t have much collateral and they burn through cash. Forbes Magazine declared that SVB was a lifeline for many of these companies, and when they started to teeter, the tech startups started getting nervous.

Kraven: Walk us through the crisis. SVB’s assets have boomed since 2019, so why are they in such a horrible place right now?

Adnan Zai: The Covid-19 lockdown in 2020 brought new ways of thinking about and doing business, especially for tech startups. With interest rates so low at the time, money was incredibly cheap. For startups, this meant they could get even more capital funds to begin their businesses. Sounds like a positive, but with all this cash being deposited into SVB, they needed to find ways to put that cash to work. The bank decided to invest in longer-term treasury bonds that were paying low interest. As the Fed began fighting inflation and interest rates started to rise, the bank’s investments in low interest bonds naturally became less valuable. The bank incurred a loss of $1.8 billion when they sold their available-for-sale portfolio. When they subsequently announced a $2.25 billion sale of shares, their customers started to panic.

Kraven: SVB was simply not paying attention. Too little too late, SVB wrote to investors that it was “taking these actions because we expect continued higher interest rates, pressured public and private markets, and elevated cash burn levels from our clients as they invest in their businesses.” Wouldn’t a company’s investments be protected from the beginning?

Adnan Zai: Because most of the depositors into SVB were large tech companies, their investment size is not protected by the Federal Deposit Insurance Company (FDIC). The protection is generally limited to $250K per depositor. When depositors started pulling out their money, the bank had less money to invest and generate the bank income. Everyone panicked.

Kraven: Should we feel bad for the bank and the investors who lost money? Or was this their own doing?

Adnan Zai: The government made it very clear that the interest rates would rise drastically to try to stop inflation. There were no surprises. Now the FDIC is stepping in, as SVB is the second-largest U.S. bank to fail. Customers are covered, but this situation could be a slippery slope for the nation.

Kraven: Yes, and for customers, the fact that a bank this big could fail is alarming. The Fed is trying to make it right. “Of the many moves that FDIC is making, the top priority appears to be giving customers access to their deposits,” Tech reporter Natasha Mascarehas wrote. “The same memo says that all insured depositors will have ‘full access’ to insured deposits no later than Monday morning, March 13, and that official checks ‘will continue to clear.’ Uninsured depositors will also get paid an advanced dividend.

Could this debacle have been prevented? Should there have been more regulations to begin with?

Adnan Zai: The answer is yes but not in the traditional sense. SVB had no risk manager on its team and if they had, things may have turned out differently because the CEO/CFO made some very risky decisions that were disastrous. So, regulation in the sense of putting in place mechanisms such as a risk manager to be part of the operational decisions, are key. The interest rates have continued to rise and the Fed made no secret of it. SVB should have been prepared.

Kraven: Even Time Magazine is reporting that the Fed saw this coming. The bank’s balance sheets were public knowledge, and the holdings that SVB had were going to be a problem in the long run, considering the rapidly rising interest rates. The highly trained economists should have blown the whistle on this long ago. What is your take?

Adnan Zai: The country does not want to imagine that we are heading into a recession. But putting our heads in the sand leads to disasters like the one you are seeing with SVB.

Kraven: As Dhaval Joshi of BCA Research pointed out last week “There are three classic signs that a recession is coming in the US: a downturn in the housing market, bank failures, and rising unemployment. Housebuilding is down by 20% in the past year, which means the first has already happened. The problems at SVB and other US regional banks suggest the second condition is now being met. The third harbinger of a US recession is a rise in the US unemployment rate of 0.5 percentage points. So far it is up by 0.2 points.”

“Banks tend to fail just before recessions begin,” Joshi added. “Ahead of the recession that began in December 2007, no US bank failed in 2005 or 2006. The first three bank failures happened in February, September, and October of 2007, just before the recession onset. In your opinion, are we headed toward a recession?

Adnan Zai: With the trajectory of this banking crisis, it certainly seems hard to believe that this is just a one and done situation. With all the recession indicators firmly in play, the country has been basically holding its breath waiting for the possible recession since Covid-19 shut down the world. We have been teetering on the brink of this for so long but I think it is just a matter of time and a slippery slope at this point.

Kraven: Thank you for your time, Adnan Zai. We appreciate your viewpoints as an expert in the field, as well as your take on this unfolding situation.