Investor’s Outlook April 2023. Written by Edward McIlveen, CFA (Chief Investment Officer of Francis LLC).
Welcome to this quarter’s edition of Investor’s Outlook. In this issue we look at the recent banking scare caused by the failure of Silicon Valley Bank and address some of today’s most pressing questions:
Could this turn into a full-blown financial crisis like 2008?
Are my savings accounts safe?
Why do financial crises keep happening?
Big Banks with Big Problems
The crash of Silicon Valley Bank (SVB) this past March and the failure of other regional banks has awakened fears of another financial crisis resembling 2008. Paradoxically, even one of the board members at Signature Bank in New York, which failed shortly after SVB, happened to also be one of the architects of the famed Dodd-Frank legislation aimed at preventing significant financial crises. Nevertheless, it hasn’t even been 15 years since the Lehman Brothers bankruptcy that another banking scare is upon us. Policy makers are clearly surprised by this adverse turn of events. Fed Chair Jay Powell and the rest of the FOMC is flummoxed, and Congress is holding hearings.
Will the Financial System Collapse?
There’s a unique psychology that gets a bank run started, and its momentum is unmistakable. Investors can generally accept the volatility of the stock market, but if they perceive that their cash savings is at risk, look out. Once the herd fears the worst, the stampede is on. Apparently nearly every customer at SVB demanded their money at once and former CEO Greg Becker blamed social media apps like Twitter for accelerating his bank’s demise.
With the unfavorable gap in yields between the typical savings account and government money market money market mutual funds, there’s heightened risk of further capital flight out of the banks offering paltry interest rates on savings accounts.
In an age of mobile banking, customers have unprecedented power to transfer their savings in the search of the best combination of safety and yield. A broader banking crisis can’t be ruled out due to big withdrawals from the banks, but recent actions taken by the FDIC to protect deposits classified as ‘uninsured’ at the distressed banks as well as the Fed’s new Bank Term Funding Program1 significantly lessen the chances of further contagion. Additionally, the resilience of the U.S. economy is another material item of note which should also keep the financial system from tipping over.
Are My Savings Safe?
Regardless of the government’s reassurances today that the financial system is safe and sound, people are still asking, is my money at the bank safe? It’s a good question. If you have less than $250,000 at a bank carrying FDIC insurance, your money is secure even if your bank goes out of business. If you have an account with a balance greater than $250,000, the difference from your total minus $250,000 is technically uninsured. This is why Silicon Valley Bank’s customers drained its coffers in a hurry when they smelled blood in the water. Oodles of their venture capital customers, among the savviest group out there, were unwilling to maintain their savings accounts at SVB as over 70% of them had balances exceeding the FDIC’s insured limit.
In an age of mobile banking, customers have unprecedented power to transfer their savings in search of the best combination for safety and yield.
Big bank runs haven’t been eliminated but their frequency has been meaningfully reduced since the introduction of the FDIC in 1934. Economists Milton Friedman and Anna Schwartz believed the implementation of the FDIC brought greater financial stability to the system during the depths of the Great Depression. They noted,
“Adopted as a result of the widespread losses imposed by bank failures in the early 1930’s, federal deposit insurance, to 1960 at least, has succeeded in achieving what had been a major objective of banking reform for at least a century, namely, the prevention of banking panics. Such panics arose out of or were greatly intensified by a loss of confidence in the ability of banks to convert deposits into currency and consequent desire on the part of the public to increase the fraction of its money held in the form of currency. The resulting runs on banks could be met in a fractional reserve system only if confidence were restored at an early stage.”2
To this end, the FDIC’s extension to guarantee all deposits (regardless of amount) of customers at now obsolete institutions like SVB and Signature Bank in New York removed a significant amount of angst that the banking system is risky. Psychologically, the FDIC insurance protections are critical in bringing financial stability to the banking system, and it’s largely been successful for nearly 90 years. One note of caution is that the expanded FDIC guarantee is limited and doesn’t cover all banks in the U.S., at least not yet.
Why Do Financial Crises Keep Happening?
The traditional banking model holds so long as customers deposit cash into its vaults and leave it there for some time. The bank then in turn lends most of those deposits to other customers who agree to repay the principal plus the interest charged over the amortization period. So long as the yield curve is upward sloping, meaning short-term interest rates are lower than long-term interest rates, the bank earns more on its loans than it pays out on deposits. This is known as ‘earning the spread’ and is measured by the metric, net interest margin. While this banking model usually works, it has a habit of breaking without warning.
Big bank runs haven’t been eliminated but their frequency has been meaningfully reduced since the introduction of the FDIC in 1934.
The Road Too Often Traveled
There’s a well-worn pathway for nearly every episode of financial woe: excess capital builds up in a productive economy, unusually low yields on government bonds prevail, and investors search for ways to earn more. Money is moving and intermediaries are pleased to jump in and assist in sloshing around as much capital as possible by underwriting deals, earning fees, and handing off the money to speculators.
From there, the speculators gobble up the lowest hanging fruit first and returns are usually quite handsome. But when there are no more companies with appealing earnings per share (EPS) to consider, the opportunists look with an ever longer gaze into the future and exchange EPS for the less than fundamental metric, IPS, or ideas per share, as the preferred screen for capital deployment.
Eventually the speculative period ends after all the ventures that make money have been identified but some banks are still aggressively handing out credit to organizations operating entirely on wishful thinking. It’s the loans underwritten on projects of dubious worth which start the dominos falling. Banks are intricately linked so when one institution goes bankrupt, the opacity of these interconnections can suddenly take what seems like an isolated event onto a bigger stage in a hurry. So irrespective of how tall the printed-out document of regulations stands, there’s no way to eliminate the fundamental realities of the fractional reserve banking model.3 Banks are inherently subject to these vulnerabilities linked to macroeconomics or agency problems like fraud and lax underwriting standards for loans which ultimately default. There’s always collateral damage of some magnitude.
The Punch Bowl is Taken Away
Years of loose monetary policy lured some bankers into riskier tactics which were exposed as financial conditions recently tightened. Interest rates are low in absolute terms, but the fed funds rate has surged to almost 5% in 12 months. The Federal Reserve’s principal aim during this time has been to combat inflation, but such a large move for interest rates in relative terms has triggered large unrealized losses on securities held by banks. Furthermore, the yield curve has been inverted since April 2022. Unlike the upward sloping yield curve, which is beneficial to the banking system, an inverted yield curve creates pain. Instead of effortlessly earning the positive spread between deposits and loans, banks struggle for as long as the curve is inverted. The rates banks must pay to dissuade customers from moving deposits elsewhere could be higher than what the bank can earn on their loans. The business model is upside down, crimping not only the profitability of the bank but reducing the amount of credit in the system. During the transition from looser to tighter money, the risks of crises and an economic hard landing rise.
For all the money and effort poured into making the financial system safer, there is always this seemingly unavoidable route to the next crisis. World history is replete with tales of financial pain. The ancient Romans faced a credit crunch in 33 linked to real estate, the British endured the pain in the early 1800’s, and of course North America, Europe, Africa, Asia, and Latin America have all had their share of crises in modern history. The first global financial crisis occurred in 1857, originating in the Midwest and hitting financial institutions in Cleveland, New Orleans, New York before hopping over the Atlantic into England, Scotland, France, Netherlands, Germany, Denmark, and Austria.4
If ‘financial crises’ could be personified and type cast for a movie, it would be perfect as the role of the ‘bad guy’ in an action film who never dies. Somehow, this villain keeps emerging out of every explosion that no one should survive. As a long-term investor, you should accept the recurring reality of financial crisis and move your mindset to one of preparation for the next.
How Can I Prepare, and Can I Profit?
The strategy for preparing should sound familiar. Stay diversified, keep your exposure to debt manageable, and be patient with your investment strategy.
With regards to diversification, first address your cash accounts. If you have savings above $250,000 in a single FDIC insured bank account, you are advised to place your savings into multiple FDIC insured banks at amounts below $250,000. Until the FDIC moves to expand its insurance guarantee for all deposits, this remains the safest way to protect your cash savings.
Money market mutual funds are another savings vehicle to consider, but these are not FDIC insured. While they are liquid and have a long history of providing investors with decent returns versus interest rates paid at the bank, they are not immune to crises. Although they have been heavily regulated after the Reserve Primary Fund5 fell in 2008, the lack of FDIC insurance for money market mutual funds is something you should consider and be sure to verify the investment strategies are focused on government securities.
When you borrow money, you take on risk. Depending on how severe a financial crisis is, it may leave you bankrupt if you are caught overextended. Borrowing money is a trade off as you essentially rent currency from someone else to deliver a good or service to you today that has an immediate or future benefit. From the point of view of the bank, the key is your ability to repay the principal and their fees. Your point of view should be to keep your personal financial balance sheet in a strong position.
Keep These Three Things in Mind When Considering a New Loan
First, you should know your personal credit score. Not only does it influence how much you will pay in interest, but it also serves as one benchmark for assessing how ready you are to proceed. If you have a lower credit score, say below 700, you must be cautious. Second, whatever you take out on loan for purchase, the rate of interest you pay should be considered in relationship to the economics of the asset you are buying.
For instance, if you finance a home with 80% debt carrying an interest rate of 7%, the value of your home will need to appreciate by 5.6% per annum over the term of your loan for you to maintain your purchasing power. If your home value can’t keep-up at that pace, you have the intangible benefits of living in a home, but the bank is getting the better end of things, at least financially. Sometimes the ARM, or an adjustable-rate mortgage, is tempting as its interest rates are lower versus a 30-year fixed loan, but they can be a trap. When it comes time for the rate to adjust, and if you are unable to afford an increase (yes, the rate could also decrease) just as a financial crisis hits, you could be unable to sell the home and then lose all your equity in foreclosure.
When you borrow money, you take on risk. Depending on how severe a financial crisis is, it may leave you bankrupt if you are caught overextended.
Third, be conservative with how far you are willing to extend yourself into debt. Quantify your debt-to-income ratio which is a measure used by banks for evaluating how much debt you can afford. You can determine this by adding-up your monthly payments on your mortgage, car loans, and minimum payments on credit cards along with other debts. From there, divide that amount by your monthly gross income. The maximum amount shouldn’t exceed 0.36 or 36% of your gross monthly income. The lower you keep your debt-to-income ratio far below 0.36, it is to your benefit. Even as aggregate consumer debt continues to grow in the United States, the average debt-to-income ratio for Americans is lower than it has been in decades at around 0.09 (9%) thanks to historically low long-term interest rates.
The best way to exhibit patience as a long-term investor is by establishing a strategy, remaining fully invested, and maintaining your unwavering commitment to dollar-cost-averaging. The dollar-cost-averaging strategy has been shown to be effective, especially since it forces investors to buy shares of stocks at discounted values. Though it takes time for markets to recover, the sacrifice of investing your savings when the headlines are scary is usually rewarded in the years to come. As ordinary as that sounds, this is as worthy for us to be reminded of as much as the football coach reminding a 5-star running back to ‘protect the football’ before a big game.
For both the more daring as well as the easily frightened, you may be tempted to market time your portfolio in whole or in significant part when volatility hits. There’s no reason to play this game. Having studied various money managers who attempted these strategies, I’ve seen it all too often turn into a career killer. You simply should not do it.
One strategy that blends patience with an opportunistic approach is setting aside a savings account to await deployment on substantial market weakness. Start building your savings account from your income sources and invest in the stock market following a 30% or more sell-off. Don’t know which stocks to buy? That’s okay as you can use the S&P 500 Index which has historically performed quite well coming out of steep market declines. Some professional money managers use an approach like this, but they typically don’t let cash grow to more than 20% of their overall portfolio. The message should be clear, stay invested and keep contributing.
While the history books probably won’t have a chapter titled “The Financial Panic of 2023” 100-years from now, future bank runs, panics, and financial crises await. Accepting the inevitable gives you an edge. The advantage isn’t so much with the goal of making boffo profits, but in providing discipline to maintain your nest egg and keep your financial ship afloat. Being prepared for a sell-off also turns them from being psychologically distressing into an opportunity.
Although the lessons learned from financial failures can optimistically make for better functioning markets in the future, financial crises just can’t be eradicated. Consequently, committing to keeping your cash in FDIC insured accounts, maintaining a low debt-to-income ratio, dollar-cost-averaging into a long-term investment strategy, and having some cash handy for opportunistic buying is the most prudent course of action.
Summary – The Panic of 2023?
While the possibility of a broader banking crisis can’t be ruled out and the failure of other regional banks, the odds of a scenario derailing the global economy are remote.
Big bank runs haven’t been eliminated but their frequency has been meaningfully reduced in the U.S. thanks to the FDIC. The expansion of FDIC to cover more deposits only at the troubled banks along with the Federal Reserve’s backstop facilities should reduce the pressure on the financial system near-term.
A sound strategy for preparing for the next crisis is familiar: stay diversified, keep your exposure to debt manageable, and be patient with your investment strategy.
1 – FederalReserve.gov Home > Monetary Policy > Policy Tool “The BTFP offers loans of up to one year in length to banks, savings associations, credit unions, and other eligible depository institutions pledging any collateral eligible for purchase by the Federal Reserve Banks in open market operations (see 12 CFR 201.108(b)), such as U.S. Treasuries, U.S. agency securities, and U.S. agency mortgage-backed securities. These assets will be valued at par. The BTFP will be an additional source of liquidity against high-quality securities, eliminating an institution’s need to quickly sell those securities in times of stress.”
2 – Milton Friedman & Anna Jacobson Schwartz, A Monetary History of the United States, 1867-1960, A Study by the National Bureau of Economic Research, Princeton University Press, pp.440-441.
3 – Some academics have proposed expanded use of alternative banking structures such as the limited purpose bank.
4 – https://www.economist.com/news/essays/21600451-finance-not-merely-prone-crises-it-shaped-them-five-historical-crises-show-how-aspects-today-s-fina
5 – The significance of this Fund’s failure was twofold as it was the first money market mutual fund created and was one of the earliest victims of exposure to Lehman Brothers. The fund was liquidated after it “broke the buck,” meaning its net asset value declined below $1.00 per share.