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“Till Something Breaks”

“Till Something Breaks”

March 13, 2023

Well, when the Federal Reserve sets out to raise interest rates, it is said they will do so “until something breaks”. 

And they did. 

Last Friday witnessed the first large bank failure since the financial crisis – and a second followed (to less fanfare) over the weekend.  Silicon Valley Bank was the 16th largest bank in the country, and it imploded on Friday in dramatic fashion.  How did it happen?  Well, that’s complicated, but it seems to be an old fashioned “run on the bank” accelerated by the fact that a “run on the bank” can be accelerated manyfold due to social media and online banking apps.  It was also completely different from the bank failures precipitated by the risky and dubious investments that precipitated the financial crisis in 2007.  The crisis was clearly brought on by the rapid increase in interest rates of the last 12 months.

Generally, a bank takes in deposits, then loans that money out.  They also keep “capital reserves” or cash on deposit with the Federal Reserve, to cover a portion of the deposits.  Regulations regarding capital reserves are supposed to ensure that there is always more than enough cash to meet any reasonable demand from depositors for withdrawals.  However, if all the depositors try to take the money out all at once, the bank may burn through its capital reserves.  Sort of like George Bailey’s “Building and Loan”!  Since it can’t all at once sell its loans (they are illiquid) the bank may be unable to meet a huge rush of withdrawal requests.  In a typical recession, the bank may fail because borrowers can’t repay their loans and the bank must write down their value.  This case is very unusual because loans or risky investments (as in 2007) aren’t the problem.  The problem is that the bank had more money than they knew what to do with, so they put much of it in US treasury bonds.  Regulators permitted this to count as part of their capital reserves, since US Treasury bonds are considered “risk free”.  But with the rapid rise in interest rates, the long-term bonds they had purchased were suddenly worth much less than had been stated on their books.  Thus, it could be said that – despite all the attention paid to bank regulation after the financial crisis, this was yet again primarily a failure of bank regulators to properly manage the system.  Every Wall Street professional knows that long term Treasury bonds are not “risk free” – yet regulators did not apparently grasp the potential risks from rising interest rates and falling bond values until it was already a crisis. 

The bank was preparing to raise more capital (by selling stock) but that caused the stock price to plummet, which caught depositor’s attention.  Depositors frantically tried to remove all their deposits and the bank failed almost overnight.  Regulators seized another bank over the weekend that was in similarly dire straits. 

First question on everyone’s mind may be “Is my bank next” and the second question might be “does this mean we’re due for another financial crisis?”

Well for the first question…the large retail banks most of us are familiar with are on extremely sound footing.  So I wouldn’t worry about your deposits at Bank of America, Chase, etc.  Some smaller banks may be similarly exposed, however.  Now, before you go to pull all your money out of Peapack Gladstone bank, remember that the Federal Government insures up to $250,000 per account.  The regulator seized the bank on Friday, and insured deposits were made whole on Monday.  So, if you don’t have more than $250,000 per account, you are guaranteed.  Now, to avoid panic, the FDIC has apparently promised to make all SVB depositors whole.  However, that is not required by law and it might be dicey to rely on the idea that the government will always everywhere bail out depositors.  This is a bit of a wakeup call to be mindful of FDIC and SIPC insurance limits.  

What about brokerage accounts?  SIPC insurance provides coverage similar to the FDIC for cash balances at brokerage accounts.  Note that your stocks, bonds, mutual funds, etc. are yours.  While there is no protection provided for their daily rise and fall in value, they are not at risk of a bank run either.  Only the cash (uninvested) balances are at risk if a brokerage firm fails – and thus the need for government SIPC insurance. 

Now, are we heading for another financial crisis?  That is the $50,000,000,000 question.  I don’t see major bank failures on the horizon, but on the other hand, there is a lot to worry about as we look under the hood of the SVP crisis.  One of the reasons that the bank was short on deposits was that the tech startup firms that were its bread and butter customers were burning through cash.  With higher interest rates, the “free” venture capital money they had relied upon had all but dried up.  Many of these companies were never profitable – relying on Wall Street financing to pay their bills.  Without that financing, they had to spend cash reserves.  The implication is that the high-tech industry that has been an engine for the economy and stock market for years is sputtering, and firms will likely start to fail as the money dries up.   That really shouldn’t be a surprise.  If there was a bubble created with the cheap money and government largess of the last half decade, it was in these speculative tech firms.  Clearly that bubble is bursting.   

But is a sputtering tech sector enough to bring on a financial crisis?  I don’t think so – but since this potential (for large bank failures) was largely invisible until it happened – who knows what other impacts rising interest rates may have on the system?  On the plus side, the market has decided that, due to the sudden fear of systemic risk, the Fed will ease off the brakes and slow the interest rate hike process.  As a result, bond prices have soared for the last two days.  That is good news for fixed income investors – and also for bank balance sheets. 

As always, predicting the future is impossible.  The Fed is trying to create a recession (they call it “slow the economy”) to bring inflation under control – and this is simply the first sign that they are having some success.  On the other hand, for banks this is more an issue of liquidity (availability of funds) than of solvency – and liquidity can be juiced up with tools available to the Federal Reserve.  So, it is also possible this will prove to be much ado about nothing.  We just don’t know.  Investors should remain diversified and focused on long term goals.  Those needing access to funds in the next 1-5 years should have a healthy allocation to safer investments such as CD’s, T-bills, shorter term bonds.  In a bit of good news for diversified investors:  Stocks tumbled on Friday on news of the SVP failure, but unlike the 2022 situation, bond prices soared – offsetting much of the loss for a well-diversified or conservative investor.  Maybe good old fashioned asset allocation is back!