Did Something Break?
By Cory McPherson | March 2023
On Thursday, March 9th, news began to swirl of trouble at Silicon Valley Bank (SVB) and a possible run on the bank, sending its stock price tumbling. By the next day, the bank was shut down and taken over by Federal regulators. Then, over the weekend came news of another bank, Signature Bank, being taken over by Federal regulators as well. As you can imagine, this sent shockwaves across the market, especially in the financial and banking sector. SVB is the second-largest bank failure in U.S. history. We’ll review what happened and what effects it will have going forward on the market and the economy.
As we’ve been saying for most of the last year as the Federal Reserve has continued hiking interest rates, they usually raise rates until something breaks. It’s quite possible something just broke. Typically, what leads to bank failures are bad loans. What makes this different was that bad investments by the banks ultimately led to their demise, not bad loans.
As worries grew last week about the bank’s viability, many depositors demanded their cash and SVB did not have the liquidity, or cash on hand, to meet the enormous, unexpected demand. SVB’s customer base was largely start-up technology and healthcare firms, and venture capital firms. The extended low-interest rate policy and the stimulus/money-printing of the last couple of years led to outsized growth in the bank. Deposits to the bank doubled between 2020 and 2021. Most of their customers were also depositing large sums of money, above the $250,000 FDIC insurance limit. In fact, it’s estimated that between 85% to 90% of the banks $173 billion in deposits were uninsured, meaning above the $250,000 insurance limit. With customers having such large deposits, it may have taken only a small number of those with large deposits demanding their money to put the bank at risk. If large customers sense trouble with the bank, knowing they are above the $250,000 limit, then they will act to protect themselves and move their funds.
So, how did SVB get into this position of not having the cash on hand to pay depositors? Part of it was the bank growing in size too fast. The easy-money policies of the last few years directly led to much of their growth, as it was the tech start-ups that most benefited from that. In the zero-interest rate world of 2020-2021, the bank was looking to squeeze out higher interest by investing in long duration Treasury bonds with some of the large amount of deposits the bank was taking in. They were most likely lulled into thinking at the time that interest rates would remain low and near historic bottoms for an extended period of time. Well, we know how that turned out. With interest rates rocketing higher last year, the value of those long duration bonds lost value. As depositors demanded their cash, the bank had to sell assets, many at large losses, and not having enough to cover deposits. Of course, regulators then stepped in on Friday in the middle of the day taking control of the bank.
So, the question now is, was this an isolated incident or does this create a domino effect? Stock prices of regional banks were hammered late last week and on Monday of this week. The chart below shows the price of an exchange traded fund tracking a pool of regional banks. Worry has spread that there are more banks that may have similar problems as SVB. Signature Bank became another victim and was taken over by regulators on Sunday.
Many are wondering if this is a repeat of 2008. While this certainly is a problem, it does not appear to be similar to the great recession. As mentioned earlier, bank failures are usually caused by bad loans given. That does not appear to be the case with the current banking problem. But, if more and more small and regional banks have a run on their deposits, a crisis can occur. The psychology of people almost makes it self-fulfilling, as they get scared and demand their money back, which causes the stress on the bank.
Early this week, the Biden administration made clear that all depositors in SVB will be made whole, covering those that were above the $250,000 insurance limit in hopes of calming the market. While it is important for people to have trust and faith in the banking system and know their money is safe, this also can create moral hazard. Those that had more than the insurance limit should know the risk they were taking. Having the government and FDIC there as a backstop though creates a mindset of zero risk on any deposit amount, even above the insurance limit. Special assessments will be levied on banks to recoup the losses on covering the uninsured amounts. As the administration made clear, this is not a bank bailout, but it is a bailout of uninsured deposit holders of the bank. Of course, while we all remember the bank bailouts of 2008-2009, this is different. But, the moral hazard from that time of bank bailouts can also be partly to blame for the problems today. Those bank customers that started the run on the bank took their funds from the smaller bank and most likely put them into one of the largest banks in the U.S. (JPMorgan Chase, Bank of America, Citigroup, etc.) Why? Because the government has already shown those banks are too big to fail, so any deposit amount or investment with those banks could be deemed safe. Those largest banks have reported record account openings and incoming deposits the last few days. A sign that people are becoming leery of having cash in small and mid-sized banks and moving them to the “too big to fail” banks.
A look at the overall market shows that stocks had been beginning to trend down going into the news of the collapse of those banks. The 200-day moving average (blue line) had been serving as support during the pullback, but failed to hold after the fear of the bank failures began to spread. That moving average could now serve as resistance to any market rally. The next support for the market comes around 3,800 on the S&P 500, which is where the market bottomed in late 2022 before beginning its next rally. Dropping below that level leads to the possibility of re-testing the lows from October or making a new bear market low.
The Federal Reserve’s reaction to this with their interest rate policy could have a big impact on where the market goes from here. Their next interest rate decision comes out next week. Another rate hike could shock the market as higher rates appear to already be causing problems in the economy. While a pause from rate hikes would most likely spur the market higher with the expectation that the Fed could begin lowering rates later this year. A pause from the Fed though could mean they see something seriously wrong with either the banking system or economy as a whole. That shouldn’t be beneficial to stocks, but so much of what the market does has become attached to interest rate policy.
As we’ve pointed out previously, the combination of the bond market and stock market going down almost in unison last year was rare. We may be seeing the beginning of a change. With the news of the bank failures, treasury yields plummeted, sending bond prices higher. It looked much more like a real flight to safety event then anything we’ve seen since this bear market started. When investors get skittish about stocks, treasury bonds historically have served as a place to go. That, of course, didn’t occur last year as interest rates continued to rise throughout the year. We could be seeing a more normal relationship now between the stock market and treasury bonds and their yields. If so, that would appear to be a positive for bonds, and a negative sign for the economy. The 2-year treasury yield posted its biggest 3-day drop since 1987, going from 5.05% to 4.03%. Longer-term rates are also dropping but not near at the pace of short-term rates.
The inversion of the yield curve (short-term rates higher than long-term rates) has been ongoing for over a year now for most parts of the curve, and recently reached levels not seen in 40 years. The inversion has historically been a precursor or warning of oncoming recession. Timelines are never known and have varied in the past. When the yield curve begins to steepen is usually the final warning of imminent recession. That could be what’s happening now as yields on short-term bonds are dropping much faster than long-term bonds, leading to the yield curve beginning to steepen. That could accelerate even more if the Fed decides not to hike rates any more next week.
In summary, the recent banking failures could be the beginning of what’s been called the most anticipated recession ever. A lack of confidence in the system can spread quickly. The fact that SVB failed in just a matter of hours was shocking and has never been seen before. The hope is the problem does not cascade to other banks and other parts of the economy. But even if the problem remains isolated to just a small number of banks, a lack of confidence can still cause problems. Not only by customers, but also by banks. If banks become more reluctant to loan money out of fear of an eventual run on deposits, it becomes harder for businesses to grow. This can bring the economy to a screeching halt if the Fed’s interest rate policy hasn’t already done that.
Cory McPherson is a financial planner and advisor, and President and CEO for ProActive Capital Management, Inc. He is a graduate of Kansas State University with a Bachelor of Science in Business Finance. Cory received his Retirement Income Certified Professional (RICP®) designation from The American College of Financial Services in 2017.