Well then. In more than one sense, March madness is here. I’m sure some of you are tuned in to actual March Madness, the NCAA basketball tournament to crown a National Champion. Others may be like me, a fan with a team (Go Gators) that failed to make the dance and, therefore, flip channels to the other March Madness—the one that shows the markets and discusses the recent bank failures.
Both Silicon Valley Bank and Signature Bank failed in the last weeks. Other banks, like First Republic and Credit Suisse, have looked to be in trouble and have recently received funding to help keep them alive. So, what are investors to do in an environment like this? Let’s first consider how we got here…
Why did the banks fail?
On the face of it, banks have a relatively simple business. Take in deposits and either lend that cash-out or reinvest it to make higher rates than what they pay. Silicon Valley Bank held many securities like US Treasury’s and government-backed mortgage bonds, considered very safe, at least in terms of credit risk. However, interest rate risk can pose a different problem, especially in a rising interest rate environment.
Think about it: if I offer you a treasury bond that pays 2% over the next ten years, and someone else gives you a treasury bond that pays 4% over the next ten years, you obviously will choose the one that pays 4%. The only way I can sell you my bond is to reduce the price and offer it at a discount so that the ultimate yield will be the same. The further out the maturity, the deeper the discount will be. This is called interest rate risk, and with the Fed raising rates so fast, longer-term bonds have taken a beating. To put it into perspective, TLT, an ETF that tracks longer-term treasury bonds, was down 31.24% in 2022.
Interest rate risk isn’t necessarily problematic if one can hold the bond until maturity. You know what you buy the bond for, you know what the coupon is, and you know what it will mature for (assuming the issuer can make the payment). If you hold it until maturity, the outcomes are defined. On the other hand, if a bank is forced to sell, it can’t hold the bonds to make the losses back. When depositors started to fear the stability of Silicon Valley Bank (SVB), they withdrew money in masses, creating a snowball effect where SVB had to sell more and more securities, realizing more and more losses. Ultimately, SVB couldn’t raise the cash it needed to cover the outflows.
Didn’t we put protections in place after 2008?
In 2010 Dodd-Frank was signed into law following the global financial crisis. The law was designed to prevent excessive risk-taking by bankers and avoid another meltdown. Banks that were deemed as “systemically important” are required to maintain certain liquidity levels and capital requirements to prevent such a bank run, as we have seen. In 2018, those regulations were eased, with the definition of “systemically important” changing to a much larger size. Even though it was the 16th largest bank in the country, Silicone Valley Bank did not meet the new standard and therefore was not held to stricter capital requirements.
Still, the impact of the rate increases should not have been an unknown issue to regulators. In fact, the CEO of SVB was a director of the Federal Reserve Bank in San Francisco (he has since been removed). The Fed banks include local business leaders as directors and on advisory committees to stay in touch with what’s happening. So presumably, they should have been talking to SVB and all banks about what’s been happening well before the run. In an even more sinister twist of fate, Barney Frank, co-author of the Dodd-Frank banking regulations, is a board member of SVB.
What happens now with banks?
It’s reasonable to have questions about other banks’ health. Realistically, they all are facing the same challenges with rapidly raising rates. There are potentially some differences as well. For one, SVB and Signature may have been unique in that a large majority of depositors were over the FDIC-insured limits. Theoretically, if a bank has depositors under that limit, there may not be as big of a rush to immediately pull money out.
Additionally, the government has stepped in, with uninsured depositors receiving government assurances that deposit balances will be made whole. They were able to do this by designating both banks as systematic risks to the financial systems. While they have not made blanket assurances that the government will step in for any bank, I believe the precedent has now been set, and it will be hard for them to walk away from it.
The Federal Reserve also created a new lending facility for banks to borrow cash by putting up some of the securities that have fallen in value as collateral. It’s not to say there won’t be other bank issues, here or abroad, but the government clearly shows that it intends to help provide liquidity to keep the financial system running.
There will be justified criticisms and questions on how they ended up in this situation again, which will likely result in increased regulations. The first question I would ask is, why is SVB considered systematically important enough for the government to step in and bail out depositors but not systematically important when considering capital and liquidity stress tests? Why do big banks report their assets under different accounting standards than the rest of the banks? Why didn’t the rating agencies downgrade their credit well before this happened? Why does it seem like the Fed was caught blindsided?
Even with the recent turmoil, markets are still positive. For the year,
- The S&P 500 is up 4.67%
- International Index (MSCI EAFE) is up 4.48%
- Bloomberg Aggregate Bond index is up 2.07%
The Smart Investor:
While the government has set a precedence on making depositors whole, they have not made it an explicit guarantee at any bank. We encourage you to ensure that deposits you have at banks are within FDIC-insured limits. We have an article from last week here, talking about the rules and how to go about doing that.
The recent bank runs have brought added market volatility, and while there have been steps to help solve the problem, there are still banks in trouble. In other words, we expect the big market swing days, both up and down, to continue.
I believe this is the first market monitor in over a year where I have not focused on the Fed, inflation, and monetary tightening. Maybe that’s why this turned out to be such a long post. It bears noting, though, that the PPI numbers, the Fed’s preferred measure of inflation, fell by an unexpected amount in February. That, combined with the banking issues, has opened up the possibility that the Fed may tone down its aggressiveness in tightening monetary supply.
There’s an old story about a study that Fidelity ran on its investors, trying to identify what class of investors had the best performance. Funnily enough, the study concluded that those with the best returns were dead or had forgotten about the account. While there are questions if this study actually exists or if it’s an old wive’s tale, the premise is sound. Investors tend to make rash decisions based on emotions, and that usually leads to poor results and bad timing.
We say it a lot, and we will repeat it now. “Stuff” happens in the short term. It sometimes becomes hard to stay disciplined and grounded when we overwhelmingly see bad headlines on our phones and news stations. Fear and greed do not make good investment decisions. Stay the course and keep your long-term perspective.
The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities that represent the stock market in general. The Bloomberg Barclays US Aggregate Bond Index is a broad base, market capitalization-weighted bond market index representing intermediate-term investment-grade bonds traded in the United States and is used for measuring the performance of the US bond market. Indexes are unmanaged and do not incur management fees, costs, or expenses. It is not possible to invest directly in an index. The MSCI EAFE Index is a stock market index that is designed to measure the equity market performance of developed markets outside of the U.S. & Canada. It is maintained by MSCI Inc., a provider of investment decision support tools; the EAFE acronym stands for Europe, Australasia and Far East.
This material is provided as a courtesy and for educational purposes only. Investing involves risk including loss of principal. Please consult your investment professional, legal or tax advisor for specific information pertaining to your situation. This article contains links to articles or other information that may be contained on a third-party website. River City Wealth Management is not responsible for and does not control, adopt, or endorse any content contained on any third-party website. The information contained herein is derived from sources deemed to be reliable but cannot be guaranteed. Past performance is not indicative of future results.