Stocks rebounded yesterday, stemming the recent sharp losses that followed the bankruptcies and bailouts of several large regional banks. All 11 S&P 500 sectors finished with gains. Bonds sold off a bit, stopping the steepest short-term decline in yields in decades.
Note that I used the word bailout in the first sentence, contrary to the assertions from the Biden administration that the FDIC/Fed actions over the weekend to protect all depositors wasn’t a bailout. The actions didn’t protect stock or bond holders of the securities of the respective banks. To that extent, the government comments are accurate, but even assuming that banks will have to pay higher insurance premiums in the future to guarantee deposits, no entity of the government has the funds available to protect all depositors all the time. Allowing banks to sell bonds with current market values 10-50% below par to get par from the Fed in the form of a term loan can’t be described any other way. It is a short-term effort to restore confidence and prevent further runs like what happened to Silicon Valley Bank (SVB) last week. In today’s high-tech world, it took less than two days to wipe out SVB, making it the second largest bank failure in history. The largest, Washington Mutual (WAMU) also failed after a run related to a reduction in its credit rating. That happened in 2008 and took 9 days.
It doesn’t appear that yesterday’s rally is going to be long lasting. This morning, European markets are down over 3%, led by bank stocks. U.S. futures are lower in sympathy.
As investors, banks provide unique problems. When I look at Procter & Gamble, what I see is what I get. Its assets are either liquid, including cash and inventory, or they are plants and equipment that make very recognizable products like toothpaste and paper towels. Its liabilities are current liabilities, like accounts payable and debt, which is easily measured. But a bank is different; its assets are securities and loans. When interest rates rise, the value of those assets decline. When times get tough, the safety of both its security holdings and its loans come into question. Banks reserve against possible losses, but given the leverage they use and the fact that we as investors don’t have a clear picture of the assets, particularly in tough economic times, or when interest rates rise sharply, we lose clarity as to their value. On the liability side, a significant portion is comprised of demand deposits. As we saw with Silicon Valley Bank, they can leave instantly if depositors fear risk. As deposits leave, banks must replace them by raising capital. If a true run on a particular bank happens for whatever reason, raising capital in time is almost impossible.
Let me stop there and note that this isn’t a replay of 2008. The rules have been changed. Banks, overall, are much better capitalized. The leveraged derivative instruments, like collateralized mortgage pools, are gone. Money must go somewhere. You and I and the companies we work for are not about to stuff all our money in mattresses. There aren’t enough Treasury securities available should we all want to put our cash there.
The problems right now are the following:
1. Tools used last week to save depositors of SVB and Signature Bank, cannot be used repeatedly. The actions last week curtailed fears but didn’t end them.
2. Even if no other bank fails, banks are going to have to change how they operate. They are going to have to increase liquidity, at least in the short run. They will also increase lending standards. They will need to raise fees to offset a certain rise in deposit insurance premiums, and they will also have to pay depositors in some way to keep them as customers.
3. Most important is the uncertainty. Depositors want to know their cash is safe. They want to also get the best risk-adjusted return for their money. Investors want to know more about the bank balance sheets as well as the income model as modified for the future. Right now, many are opting to run first and ask questions later.
4. A monetarist view of GDP is that it equals M (money) times V (velocity, the rate money circulates). Fear will freeze velocity. Fed tightening is already freezing growth in the money supply. If access to money from banks becomes more difficult or expensive, companies will have to focus on liquidity and cash flow. Thus, what is happening to both, increases the odds of a recession.
Over the past many months, I have talked about a new world order. For roughly 40 years interest rates have fallen. For most of the past dozen years, the cost of money has been less than the rate of inflation. In real terms money was free. Companies borrowed. They bought other companies. They built new structures. They bought back stock. But money isn’t free anymore. Every credit crunch ultimately has its crisis. The SVB and Signature Bank failures may be the tip of the iceberg. We don’t know how big the iceberg is below the water line. Going forward everyone is going to have to incorporate the rising cost of money into their operating equations. Lenders will insist on better terms, higher yields. Being cash flow positive, even in tough times, will be a huge competitive advantage.
It was tempting yesterday to think that the problems “solved” over the weekend brought the crisis to an end. That’s still a possibility. Maybe markets just need a bit more time to settle down, but history suggests it isn’t that simple. Even if no other significant bank fails, behavioral changes will impact the economy going forward. Demand will fall; caution will do that. It also likely means that inflation will come down faster. The FOMC meets next week. Thoughts of a 50-basis point increase are off the table now. Some suggest there may be no increase at all. The FOMC is an arm of the Fed, the same Fed that thinks actions taken last week have stabilized the banking system. Does that mean it sticks to its game plan and moves towards a 6% Federal Funds rate? Obviously, market behavior over the next week will be key. If stocks are in free fall, a rate cut isn’t even out of the question.
The bottom line is this. The saga isn’t over. European banks are sinking sharply this morning as fears of bank failure spreads. The ECB has yet to act, and so far, no significant banks in Europe have failed. The Fed here is closely watching money flows at all constituent banks. Companies and individuals are taking necessary steps to protect their assets and make sure they have adequate liquidity for the near term. This is crisis behavior, all normal, and often scary. Note that the Federal Reserve doesn’t have a limitless tool kit. Dodd-Frank legislation after the Great Recession limits what it can do. Should more tools be needed, Congress would have to pass legislation. That might be a big ask in today’s bifurcated world. This is not the moment to be a hero. It also isn’t the moment to panic. Generally, the best advice when a storm is brewing is to get as far from the center as possible until skies clear. Stocks of certain banks may be the best buy in a generation, or maybe some will get swallowed in the storm. Financial statements offer clues, but not clarity.
With all this said, life goes on. Travel and leisure components of the economy remain strong. The tech sector leaders are rationalizing how fast they can grow and adjusting investment levels in the process. That’s a good thing. Tomorrow’s world will be different than the last 40 years. Money will have a price, but money almost always had a price before the 21st century. Twice now, in the last 25 years, the Fed has tried to goose growth with overly accommodative policy. Both times the party ended badly. Hopefully, in the future, the Fed will resist calls to make money so cheap again.
Today is a musical birthday. will.i.am, the lead singer of the Black Eyed Peas, is 48. Sylvester Stewart is 80. Who’s he? It’s the birth name of Sly Stone, the lead of Sly and the Family Stone.
James M. Meyer, CFA 610-260-2220