This Is Not 2008
I’m writing as promised. The following represents my beliefs.
I had planned on writing briefly for those who wanted the only top and then in more detail “For Those Who Dared to Venture Forth.” Due to time constraints, this letter is written for everyone. Please try to give it a quick skim now. You can always go back and read it again as many of my clients tell me they do.
Apples to Sneakers
In 2008 an inordinate number of banks had cash flow problems. Banks loan money for many purposes, including home loans (mortgages), corporate loans, car loans etc. During a downturn a portion of bank creditors may have a hard time paying their debt obligations. In 2008, the main problem was mortgage loans. Basically, there were too many mortgages given to too many people who could not afford the mortgage. The economic downturn of 2007-2009 exacerbated the problem. The mortgage system needed better regulation. We got better regulation (although some will argue it was too much while others will argue it was too little).
I believe today is different from 2008. How different? It’s like comparing apples to sneakers. Read on.
What Do the Banks Do?
They borrow money from savers (depositors), safely store it, and lend some of it back out to those who require a loan (borrowers). It’s the bank’s job to assess the creditworthiness of those who seek to borrow from them.
How Do They make Money?
Generally, the interest they pay to depositors is lower than the interest they charge borrowers. The bank keeps the difference. This can be very profitable.
How Does a Bank Get in Trouble
Usually, when a bank gets in trouble the assets they hold lose value, such that, should depositors need money (or want their money should they fear the bank’s solvency), the bank is forced to sell the assets at a loss to meet withdrawals. During a “bank run,” the pace of withdrawals is faster than the bank’s ability to provide for the withdrawals – and this often happens during what is often a bad time to sell the asset. In the last 50 years, bank failures were typically related to a downturn in the real estate markets. Mortgages are bonds and are held by bank-like institutions. Institutions often buy and sell mortgages – they can be traded in the bond markets. Although infrequent, during these periods a certain percentage of people found it hard to pay their mortgage payments making the mortgage worth less than face value. So, a forced sale of the mortgage created a loss for the bank. This is what happened in 2008. But this is not 2008.
First of All, There is FDIC Insurance
Most individuals are not concerned about the strength of their bank. Aside from the fact it is hard for any individual to assess their bank, they know if they keep their bank savings at or below FDIC insurance limits, they have little to worry about. Those who have savings well above FDIC limits may use several banks. As many of you know, you can invest with a number of different banks through your brokerage firm via “Brokered Certificates of Deposit.” The point is most individuals can ensure they are not above FDIC limits in any one bank.
For a corporation with millions of dollars, it may not be so easy to have all of your money in FDIC insured bank deposits. But there are ways for even very large companies to keep from being too heavily exposed to a bank failure. For instance, the company can have much of their money in an investment account, which is not part of the bank’s FDIC assets, invested in US government bonds or other relatively safe instruments. They could replenish their checking account (which is part of the bank’s FDIC assets) as needed, thus reducing their uninsured deposit exposure.
But the Money Has to Go Somewhere!
Generally, a bank run is not a bank run on all banks. Why? If, for example, you have a million dollars and you take your money out of a bank, you’re probably going to want to put it in another bank where you perceive it to be safe and where it can earn interest (as opposed to under your mattress). So, during an economic downturn, money often moves from banks perceived to be “shaky” to banks perceived to be strong. It can be very profitable to be perceived as strong. So, there is a huge incentive to be a “solid” bank.
So, Why Do Some Banks Fail?
I believe some banks:
- Are victims of circumstances such that they are in a geographic region that suffers beyond what might be reasonably expected during an economic downturn.
- “Step too far out on the limb” in the pursuit of profits. A bank may be able to make more money by taking extra risk in their loans and in the investment of their bank deposits.
- Leave themselves open to misfortune but it is not as readily apparent – except in hindsight.
- Leave themselves open to misfortune – the circumstances of which may be atypical, but should be apparent to management and regulators, but somehow slip through the cracks. I believe this is the case for Silicon Valley Bank (SVB).
Although there are rules, regulations, and audits, there have always been bank failures – often even outside of economic downturns. To what extent?
Banks Fail Nearly Every Year.
Banks fail. Several banks often fail in most years – even during “normal” times when there is no economic downturn. Since the end of 2000, there have only been 5 years in which no bank has failed in the US. Outside of the major economic downturns, many of these banks may have been a victim of unfortunate local circumstances, others may have been poorly managed. There are a lot of banks in the US. (1)
Why Was SVB Different?
The bank was nearly 40 years old, catered to newer companies (“startups”) and was very successful for many years. They had their bank deposits largely invested in safe securities, such as government bonds and government-backed mortgages etc. So, it was not a case of bad loans. It was a case of timing. SVB realized an increase in withdrawals and had to sell mostly “safe” bonds, but at a bad time. It was an atypical situation. But I believe they let their guard down. Approximately 93% of SVB’s deposits were not covered by FDIC insurance. I may write more on this, but it is beyond the scope of what I need to say. (2), (3)
Why Did SVB’s Failure Create Such a Ruckus?
SVB was a fairly large bank – it was the 16th largest by deposits in the country. It failed very suddenly and begged the question, “If SVB failed are there more ‘SVB’s’ out there?” Furthermore, approximately 90% of their deposits were above the FDIC limits. Much of this money was owned by a large number of fast-growing US companies, as opposed to retail depositors. If a number of small and medium US companies lost their money, what would be the fallout? How many companies would fail because the bank failed? Do we want companies to fail because their bank failed? (2)
In these situations, a strong bank often steps in and takes over the failing bank. A bank would do this if they felt it would be a good return on their investment. Although a number of banks “kicked the tires,” no bank stepped in. Although the FDIC and the Treasury department said there would be no bailout, once a buyer failed to materialize, it was quickly decided there was no reasonable alternative. The Federal Reserve Bank (The Fed) is charged with stabilizing the system so depositors can maintain faith in their bank. And, although their work may not be done, this is what they have done so far.
Who Got Bailed Out?
Keep in mind, the Fed has guaranteed the depositors of the banks in question. But the shareholders (those who invested in the stock of the bank) have lost their money and the management of the bank have lost their jobs. Since shareholders were not saved – just depositors, we’ve seen downward pressure in the stock prices of many regional banks (i.e., banks of a similar size). (4)
What Does This Mean For you?
I believe most of my clients stay within the FDIC limits with their bank deposits. If so, the questions remaining are:
- Is the US banking system strong?
- What will this do to the markets?
The Banking System
According to Treasury Secretary Janet Yellen, the banking system remains sound. How so? Although things can change:
- The real estate market isn’t suffering from excess speculation and prices have remained fairly steady even in the face of much higher mortgage rates and The FED trying to slow the economy.
- Unemployment remains near historical lows –even though The Fed would like to see it rise slightly to offset inflationary pressures.
- There is still a large amount of “excess savings” from government stimulus payments and some economists expect it to last through the end of the year.
- Adversity makes us stronger. After 2008, I believe the whole banking system has become stronger and better able to withstand difficult times. (5), (6)
I believe this challenge will create more positive changes in the system.
Will We Have a Recession?
I’ve been writing and talking for nearly a year about the chance of a recession. I believe the likelihood of a recession has risen since last week. Recessions are like snowflakes; they are all different. I continue to believe any recession would be shallow to moderate for the four reasons listed above.
Recessions Are Cleansing
The silver lining is, recessions cleanse the economy of excesses. A good recent example is the real estate boom that ended with the “Financial Crisis of 2008” – a very deep recession (generally caused by an asset bubble that resulted from inadequate mortgage underwriting standards and abuses thereof). Once excesses are cleansed, the economy often has a long runway of growth in front of it.
The Fed is Trying to Slow the Economy
The Federal Reserve Bank (The Fed) has been raising interest rates to slow inflation. Higher interest rates raise the cost of money. As the cost of mortgages and other loans rise, the economy will face headwinds to growth. As the growth in the money supply slows, the demand for goods should continue to slow. At the same time, the supply of goods is expected to rise – bringing supply and demand back into line, thus reducing inflation.
So, the Fed wants to slow the economy, but they don’t want to slow it too much. They are trying to engineer a “soft-landing” that re-sets the economy without too much pain.
Fallout from SVB will likely lead to less lending to business by banks, as many will accumulate cash from their operations to further strengthen their balance sheets. Less lending by banks will help to slow the economy. Again, The Fed is trying to slow the economy to reduce inflation. So, the economic headwinds created by the SVB failure may do some of The Fed’s job for it. This may mean inflation is licked sooner and interest rates may peak sooner. I believe this is why some of the “up” market days occurred this week.
In round terms, the markets are at about the same level as on Thursday March 9th – when the ruckus began. If we have to endure a recession, I believe we may have more work to do on the downside. If we skirt a recession, we may have already seen the bottom of this cycle. But no one knows.
Markets Are Forward-Looking.
Since the markets are forward-looking – they tend to move down ahead of the news, bottom I the midst of the malaise and turn-up in the face of deteriorating news, as they look ahead to “better weather coming down the road.” This is what confounds the average investor who tries to time the markets. I believe the recent market resilience is a good sign.
Although past performance cannot guarantee future results, I believe:
- Banks are the main engine of economic growth via their loans to individuals and businesses.
- It is in our best interest for the banking system to remain healthy.
- Banks fail periodically. Depositors under the FDIC insurance limits have little about which to fret.
- The Federal Reserve Bank is charged with stepping in as a “lender of last resort” to help maintain faith in the system.
- We’ve had stubborn inflation since Covid was brought under control for a number of reasons.
- The Fed has been trying to slow the economy to reduce inflationary pressures.
- As I’ve written, I believe many of these pressures were expected to cycle away over the coming months.
- I believe fallout from SVB will lead to less loan origination and will help to slow the economy. This may help the Fed slow the economy.
- We may or may not endure a recession in the coming months or quarters. If we do, I believe it will be shallow to moderate.
- Recessions are “cleansing.” Post recession, the economy often has a long runway of growth in front of it.
We may have seen the market lows; we may not have. Because markets are forward-looking, stock market bottoms happen when you least expect them – usually well ahead of the worst news. So, smart investors deal with volatility via asset allocation.
We Have Pre-Planned for This
So, the ride has been a bit rocky this year, but we deal with volatility via our asset allocation. Generally, when stocks move sharply, a portfolio with a portion in bonds will not go up as much as a portfolio of all stocks, and a portfolio with a portion in bonds will not go down as much either. We know this, but we often forget this. Investors who properly attend to their stock to bond ratio have pre-planned for any downturn.
My glass remains “half full.”
Stay safe and please feel free to call me with any questions.
As you’ve probably noticed, we don’t generally ask clients for referrals, as I don’t wish to obligate anyone. At the same time, given all of the turmoil in the world, there are a number of things that concern us and we fear many people are in need of guidance. If there is anyone you care about who could use a second set of eyes, we’d be happy to meet with them to try and help them out. If so, please let me know.
P.S. Please feel free to send this along to those who may benefit.
Eppolito Financial Strategies, LLC. is not a registered broker/dealer, and is independent of Raymond James Financial Services. Investment advisory services offered through Raymond James Financial Services Advisors, Inc.
Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™ CFP® (with plaque design) and CFP® (with flame design) in the U.S., which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements.
(2) Wall Street Journal
(3) The Economist
(4) Thoughts of the Week, Eugenio J. Alemán, PhD, Chief Economist, Giampiero Fuentes, Economist, Raymond James, 3/17/2023
- Financial Advisor Magazine
- The Wall Street Journal
- New York Times
- The Boston Globe
Any opinions are those of Larry Eppolito and not necessarily those of RJFS or Raymond James. Expressions of opinion are as of this date and are subject to change. This information is not intended as a solicitation or recommendation of any kind. Investments mentioned may not be suitable for all investors. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. Diversification and asset allocation do not ensure a profit or protect against a loss.
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