Hi all,
In case you’re not laser-focused on the happenings in the financial world, let’s catch you up to speed. The second and third largest bank failures in history occurred this month with the receivership of Silicon Valley Bank (SVB) and Signature Bank (SBNY). Confidence in the financial system has been shaken, but the Treasury department, the FDIC, and the Federal Reserve are attempting to reassure markets and stem the tide. Their quick and decisive action to backstop uninsured depositors (over the 250K FDIC limit) was the right thing to do…for now. The entirety of the unintended consequences can’t be known at this time, but there will be a price to pay down the road. We’ll save that for another blog post.
So what happened? Can it happen at my bank?
Firstly, no bank can withstand a massive run. If everyone in the country shows up at Bank of America tomorrow and asks for their cash, it’s gonna be a problem. It’s the reason that the faith and confidence in the banking system is so crucial. So why did SVB fail? A healthy dose of stupidity, with a dash of quirkiness. Banks have an odd accounting rule that allows them to not mark down a bond if they intend to hold it to maturity. This effectively hides huge unrealized losses when interest rates rapidly move higher (bond prices and interest rates are inversely related). When a bank has a problem and has to liquidate some of those bonds in order to meet demands for outflows, they sell what they can, not what they want. At SVB, the percentage of their deposits above the FDIC limit was approximately 94%. At Bank of America, it’s 46%. At Charles Schwab, it’s 20%. But what happens is that you end up with a deposit base that grew from $60B in 2019 to $190B in 2021 (mostly from the recent tech craze) and SVB ended up buying long term bonds paying 1.5%. Flash forward two years and eight rate hikes later, you’re left with massive unrealized losses and a highly concentrated deposit base (startups and tech firms) running businesses which are bleeding cash. In one week, $48B of deposits left the firm, causing them to sell their bonds at fire sale prices, realizing losses in excess of the entire value of the company. Right now, it feels as though the problem is idiosyncratic, and somewhat of a fence is being put around select regional banks, but it’s not that simple. ALL banks are sitting on massive unrealized losses because interest rates have risen so quickly. The system needs time for these bonds to mature (years) and massage balance sheets to reflect the current interest rate environment.
That brings us to what this means for the overall economy and what it means for your money. If you have a cash balance above the FDIC insurance limit with one financial institution, please fix this. It’s $250,000 per account type, meaning you can have $250K in an account for you and 250K in an account for your spouse, making the total insurance coverage $500K. Another alternative would be to transfer money into your brokerage account to purchase a money market mutual fund or short-term treasury bills (hopefully you aren’t getting tired of us asking you to do this as we’ve been doing so for the better part of the last 12 months).
Most interest rate hiking cycles end when something breaks. The problem right now is that the FED is stuck between a rock and hard place. They massively raised interest rates to fight inflation (a real danger), but in doing so, caused financial system instability. The million dollar question is whether or not the FED will pause their interest rate hikes to let the “long and variable lags” of monetary policy work their way through the system, or do they believe this was a “one-off” problem that can be dismissed and continue on their path to tackle inflation. Time will tell.
As the saying goes, “When the tide goes out, only then do you realize who isn’t wearing a bathing suit”. Is it a few bad actors, or a sign of things to come? It all depends on how much longer the FED wants to lean on the economy to get inflation under control. This week there is potential for another rate hike, and unlike any meeting in recent memory, there is massive uncertainty about what they are going to do. Some analysts think they should continue on their path. Some believe they should pause or even CUT rates with recent bank failures as proof they’ve gone too far. My honest guess is that the FED will try to have its cake and eat it too. They will raise another .25% next week, but the commentary surrounding the rate hike will be a clearer timeline of when they intend to pause. This should give the market a little more clarity, which it desperately wants.
Either way, we’ll be watching.
– Adam