Is there a risk of contagion to the financial system in rate-sensitive areas? Probably yes, we will look at these areas today and give some examples.

The market watched regulators close the doors on Silicon Valley banks on Friday, capping a rapid decline that they are calling the bank's biggest failure since 2008.

The bank's collapse was a byproduct of the Federal Reserve raising interest rates. Once Treasury bonds started generating more attractive yields than SVB was offering, people started withdrawing their money and the bank needed a quick way to cash out. Eventually they were forced to sell their loan portfolio at a huge loss.

The chaotic series showed us that the Fed's aggressive regime of raising interest rates could upend institutions that were once considered relatively stable. It appears that rate sensitivity will soon be exposed and past risk-taking behavior will be retroactively reflected now.

There are already two recent high-profile examples that are not specific to the banking system but still suggest that the pressure is due to higher rates.

The first was the collapse of the cryptocurrency market. Since the Fed began raising interest rates in March 2021, bitcoin - previously a highly touted inflation hedge - has plunged more than 65%. This pressure on asset prices contributed to the demise of FTX (repeat contributed, there was more to FTX), which is facing criminal proceedings, and crypto bank Silvergate, which just entered liquidation last week. In the same period, there were also double-digit declines in high-growth technology stocks.

The big question today is which rate-sensitive areas will feel the pain next and whether there is a real risk of contagion to the financial system.

The new rate cycle brings a "perfect storm"

The SVB collapse is a perfect example of the kinds of dislocations that are revealed when rate cycles change.

In 2020 and 2021, tech startups were buzzing with dizzyingly high valuations, stock prices were soaring to record highs almost every week, and everyone was awash in cash thanks to trillions of dollars of government stimulus.

In this environment, Silicon Valley Bank thrived and became the bank for start-ups. Its deposits more than tripled from $62 billion at the end of 2019 to $189 billion at the end of 2021. After receiving more than $120 billion in deposits in a relatively short period of time, SVB had to put that money to work and its loan book wasn't big enough to absorb the massive influx of cash.

So SVB did the normal thing for the bank - just on terms that ultimately worked against it. It bought US Treasuries and mortgage-backed securities 👉 Fast forward to March 16, 2022, when the Fed embarked on its first interest rate hike. Since then, interest rates have climbed from 0.25% to today's 4.50%.

Suddenly, there was a portfolio of long-term JGBs that was yielding an average of just 1.6%, a much less attractive yield than the 2-year U.S. Treasury note, which offered nearly triple that yield. Bond prices plummeted, causing SVB billions of dollars in paper losses.

Continued pressure on technology valuations and a closed IPO market led to a decline in deposits at the bank. This prompted SVB to sell $21 billion of bonds at a loss of $1.8 billion, all in an attempt to shore up its liquidity, but this essentially led to a run on the bank.

As Deutsche Bank analysts said Friday, shortly before regulators stepped in:

"It is not an exaggeration to say that this episode is emblematic of a regime of higher rates over an extended period of time that appears to be beginning, as well as an inverted curve and a technology venture capital industry that has seen much tougher times of late. It's kind of a perfect storm of all the things we've been concerned about in this cycle."

What's next? Is there a risk of contagion?

When it comes to representing the risk of aggressive low interest rate behavior, SVB is the latest and greatest example and the tip of a larger iceberg of rate-sensitive areas. So which ones are particularly at risk?

Commercial real estate should be a major concern for investors as there are over $60 billion in fixed rate loans that will soon require refinancing at higher rates. In addition, there are more than $140 billion in floating-rate securities that will mature in the next two years, according to Goldman Sachs.

"Borrowers with floating-rate mortgages will have to reset interest rate hedges to extend their mortgage, which is a costly proposition," Goldman Sachs chief credit strategist Lofti Karoui said in a recent note. "We expect delinquencies to increase among floating-rate borrowers, especially for properties such as offices that face secular headwinds."

And there have already been several significant commercial real estate bankruptcies this year, with PIMCO's Columbia Property Trust recently defaulting on a $1.7 billion loan tied to commercial properties in Manhattan, San Francisco and Boston.

The stock market is also taking notice, with shares of office REITs such as Alexandria Real Estate Equities, Boston Properties and Vornado Realty Trust down more than 5% on Friday. Shares of Boston Properties fell to their lowest level since 2009, while Vornado shares hit their lowest level since 1996.

If that sounds grim, don't worry: despite all the drama, it's hard to imagine that the fall of SVB will lead to lasting damage in the broader financial sector, for two main reasons. First, banks are extremely well capitalised thanks to strict banking rules following the Great Financial Crisis. Second, few banks have such concentrated exposure to risky start-ups as SVBs.

However, there is something that all banks need to pay close attention to and that is the risk associated with higher interest rates and its impact on their deposit levels, fixed income holdings and profits.

There are already signs that firms that are particularly dependent on deposits could soon come under pressure. Deposit outflows have increased in recent months at all Federal Deposit Insurance Corporation (FDIC)-insured institutions as customers have opted for higher-yielding government bonds and money market funds.

Ultimately, it was the deposit-dependent nature of SVB's balance sheet that made it so vulnerable. Once people started pulling their money out, it was over.

And perhaps most ominously, SVB is probably not the only bank sitting on billions of dollars of paper losses in its bond portfolio, so watch out for the next wave of rate-driven losses.

"Silicon Valley Bank and First Republic have emerged as early examples of banks with business models and balance sheets that are ill-prepared for an environment of rising interest rates and ever-increasing recession risk. "Investors smelling blood will then turn their attention to the next bank exposed to interest rate risk and specific credit risk, and then the next."

Note that this is not financial advice.