The implosion of 2 California lenders has investors worried worse is to come: 'There might be some kind of crack in the financial system'

• The implosion of the California lenders Silicon Valley Bank and Silvergate has investors worried.
• They're concerned a particular weakness in the banks is mirrored across the financial system.
• One investor called it the "first sign there might be some kind of crack in the financial system."

Silicon Valley is on a knife edge after the implosion of two banks at the heart of its financial system. But it's not only California's tech industry that should be concerned.

Questions are being asked about the ramifications of the collapse Wednesday of the crypto lender Silvergate and Thursday's meltdown at Silicon Valley Bank. One is whether they're tremors ahead of an earthquake in the broader financial system.

"This is the first sign there might be some kind of crack in the financial system," Bill Smead, the chairman of Smead Capital Management, a $5.5 billion asset manager, told The Wall Street Journal. "People are waking up to the gravity that this was one of the biggest financial euphoria episodes."

Christopher Whalen, the chairman of Whalen Global Advisors, a financial consultancy, said Silicon Valley Bank was "just the tip of the iceberg." He told Bloomberg: "I'm not worried about the big guys but a lot of the small guys are going to take a terrible kicking."

A common denominator for Silicon Valley Bank and Silvergate — and indeed banks across the world — is that a series of interest-rate hikes from a hawkish Federal Reserve has drastically cut the value of the long-term bonds they bought before rates went up.

The low-rate bond problem

Veterans of the 2007-08 financial crisis may remember the term "mortgage-backed securities." They are, in simple terms, financial instruments based on bundles of mortgages. In the run-up to the financial crisis, banks bought trillions of dollars' worth of mortgage-backed securities that were based on high-risk mortgages sold to low-income homeowners.

When the US housing market collapsed in the run-up to the crisis, these same low-income homeowners defaulted on their mortgages in huge numbers. This drastically devalued the mortgage-backed securities that had been built upon them — meaning that all of a sudden, banks were sitting on catastrophic losses. Chaos ensued.

There are parallels with the situation facing banks today. This time the concern for banks isn't risky mortgage-backed securities but the bonds they bought in the wake of the financial crisis. Interest rates have shot up from their postcrisis lows, meaning lower-interest bonds bought before 2022 are worth less than they paid for them. Indeed, on Monday, the Federal Deposit Insurance Corporation said US lenders were sitting on about $620 billion of unrealized losses on securities such as low-interest bonds.

The problem is, banks need to sell bonds to raise cash if customers decide to withdraw money en masse — the so-called bank run. And that was the crux of the problem for Silvergate and Silicon Valley Bank: They were forced to meet customer withdrawals by selling off low-rate bonds at a loss.

"Lots of banks hold large portfolios of bonds, and rising interest rates make these less valuable," Russ Mould, an investment director at the stockbroker AJ Bell, said. He added that the situation at Silicon Valley Bank was "a reminder that many institutions are sitting on large unrealized losses" on bond holdings.

Mould said the "fire sale" of Silicon Valley Bank's bond portfolio raised broader concerns. "In a heavily interconnected banking industry," he said, "it's not so easy to compartmentalize these sorts of events, which often hint at vulnerabilities in the wider system."

The same sentiment appears to be shared by Wall Street: America's top four banks suffered a collective $55 billion valuation wipeout on Thursday.

Pleas for calm

Regulators have closely monitored big banks since the 2007-08 crisis to ensure they can withstand financial shocks. Smaller banks — maybe even Silicon Valley Bank — could be in need of bailouts.

Silicon Valley Bank CEO Greg Becker on Thursday implored customers to "stay calm" in an apparent bid to stave off further mass withdrawals and avert collapse. In a letter to founders seen by Insider, Hussein Kanji, a partner at the London-based venture-capital firm Hoxton Ventures, said panic such as that seen at Silicon Valley Bank "creates the possibility of a self-fulfilling overreaction" that could cause "snowballing problems."

The "Big Short" investor Michael Burry was less diplomatic. "It is possible today we found our Enron," he said in a since-deleted tweet, referring to the scandal-plagued energy company that famously went bankrupt in the early 2000s.