The last couple weeks of financial market news have been high anxiety considering the second and third largest bank failures in U.S. history. Silicon Valley Bank and Signature Bank have both been taken into receivership by the Federal Reserve. The good news is that, although the dust has not settled yet, it appears that actions by the Fed to thwart any domino effect into the banking system have been successful.
These banks were in a volatile section of the economy – tech startups. When the Fed kept its uber-loose policies in place WAY too long after the Covid debacle, huge waves of money poured into these banks. In simple terms those depositors are essentially unsecured lenders to the banks. These deposits are liabilities on the banks’ balances sheets. The Fed’s own regulations limited the assets that these banks could buy with the depositors’ money. Subsequently, many of them bought low-risk but high priced assets including treasury bonds. Now the credit cycle is tightening, tech startups aren’t doing as well and there are investment alternatives to traditional savings accounts as interest rates rise, so the tide has rolled back out. The banks were forced to sell some of the assets they had bought to earn money on the deposits, but they were at much lower prices than where they were purchased. This caused a solvency crisis and now SVB and SB are under the Fed’s control. This is devastating for stock and bond holders of these banks and quite concerning for the people/companies that have more than $250K (the FDIC guarantee limit) on deposit with these banks themselves.
Clearly these banks were not well managed. But we don’t subscribe to some of the extreme ideas that they were criminal or even reckless. The system the Fed has created lends to bad events. The failure of the SVB and SB banks don’t qualify as Black Swan Events because this is not a big surprise. The Federal reserve created $6 trillion after Covid with interest rates at zero and then they raised the rates to 5% in roughly a year - and we didn’t think anything bad would happen? The banks are playing within a tight regulatory matrix and the last three years of monetary policy have been WILDLY variant and that is the reckless part.
So, the million-dollar question is - what now? This is more of a systemic problem than a couple of rogue banks as we have described so is it time to brace for impact as the rest of our banking system seizes up? Obviously, no one can know for sure. But we are certain that if the Fed simply continued raising rates and did nothing else there would be more banks failing. But the Fed is now backstopping the system with loan guarantees for banks that need liquidity but don’t want to sell underpriced assets. To keep it simple, we already have different liquidity mechanisms in place between the repo and reverse repo markets (overnight) and the Fed’s “discount window” (90 days) but this is more complete. What the Fed is doing now is allowing banks to borrow 100% of the “par” value of their assets for one year. They have already put forward that after one year they will extend these loans – of course they will…
Will this new liquidity policy be sufficient to stave off similar bank-solvency problems across the country? Talks of Credit Suisse needing a “bailout” of sorts is quite concerning as that is a global entity that is wildly complex. The Swiss National Bank seems to be backstopping a deal for UBS to absorb CS. There is talk of MANY other banks that are scrambling to hold off the same fate as SVB and SB. There is also talk of some of the bigger banks like Chase coming in to support medium banks like First Republic – so everything is still in flux. As of this writing the major central banks appear to be reading from their crisis playbook by banding together and providing daily rather than weekly dollar swap lines to provide liquidity. The cavalry is already here but there really isn’t a dip to buy in stocks as assumptions ran last week that the Central Banks would save us.
If banking situation looks rickety and concerning, it’s not time to panic yet. The Fed isn’t done backstopping. One thing we didn’t mention above is that the Fed is guaranteeing depositors in SVB and SB past the $250K FDIC limit. Reportedly Roku had nearly half a billion on deposit so that is quite a bailout if it comes to pass. Although it looks now as if banks big and small all around the country will foot the bill through higher FDIC fees, it has calmed a lot of fears.
The Fed has initiated other actions to backstop the banking system as well. Over the last couple of decades, they have bought many assets across the financial world and amassed quite a balance sheet in the process. We have complained repeatedly about the amassing a $9 trillion behemoth of a portfolio largely because it wildly distorted financial markets. Conversely, we have been pleasantly surprised over the last year as the Fed has reduced its portfolio by some $700 billion. That came to a screeching halt in one week! Take a look…
In one week, the portfolio reduction progress of the last year was cut in half as the Fed purchased $300 billion in assets. This signifies that the Fed’s strategies that began a year ago to tighten monetary conditions has changed. The aggressive interest-rate raises, and the balance sheet reduction has finally broken something. The Fed is having to adjust on the fly and of course we are hoping they are not losing control. The U.S. has by far the most sophisticated capital markets in the world– and part of the reason for that has been consistency and rules that were set and voted rather than officials calling audibles at the line of scrimmage so-to-speak when market conditions change. Let’s hope we can hold that together.
At this point we do wonder how the financial world held together so well to this point considering the actions of the Fed? Have their policies been so recent that they haven’t really hit the basic economic conditions yet? Are technological innovation streamline parts of the economy supporting it even in tougher times? Are markets still sitting on some of the $6 trillion the Fed created after Covid, and the excess cash is only now getting exhausted? Are foreigners sending assets to our capital markets as conditions are worse in their home countries? Is there something else supporting our economy and markets that we haven’t thought of?
No one can answer all these questions, but we want to say that the situation has officially changed no matter why markets have held together. We are not predicting imminent doom, but we are throwing out a word of caution. The Federal reserve has a meeting coming up this week and sadly that is the most important event for our economy and markets. Will the Fed still raise rates at their meeting this week? That will seem strange if they do, because the banking system cannot stand on its own with these rate increases – is the Fed OK with that? We will be stimulating with asset purchases to tighten with higher interest rates… The Fed has truly become arsonist and fireman.
Time will tell – but if investors want to make any changes to their portfolios – the first should be to buy gold or more gold if you already have some. More on that next week…
Regards and good investing,