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Your Deposits are Safe! But Did the Fed Break Something?

Posted: Brandon Arns

The last week has been especially busy in the banking world. Most of you have likely heard about the bank failures at either Silvergate, Silicon Valley Bank (SVB), or Signature bank, and banking stocks as a whole have gotten crushed with concerns that other banks could be next. This blog will work as a quick recap of what’s been happening, and how it will affect you as a depositor at a bank as well as an investor in stocks and bonds.

First let’s start with what happened. Banks for the most part have a simple business model, which is to take deposits from businesses and individuals, and lend that money out for a profit. The old quote is “borrow short to lend long”, and that’s exactly what they do. When you deposit at a bank, they keep some reserve, say 10%, at the actual bank to meet withdrawal requests, and lend out/invest the rest.

A few bad things can happen in this model:

1. They make bad (risky) loans. Subprime mortgages for example. If those loans default, the bank no longer has the money to pay back depositors. This is a SOLVENCY crisis.

2. They make good loans, that are longer term. Say a PRIME mortgage or a treasury bond. There is virtually no risk of default. However, if too many depositors ask for their money back at one time, the bank will not be able to pay back that money TODAY. It will eventually as the loans are good, but it needs time. This is especially the case today with interest rates going up like they did last year, leaving paper losses in their loans. This is a LIQUIDITY crisis.

3. Extending number 2, the risk of a LIQUIDITY crisis is enhanced if you don’t have a diversified depositor base. Take Silvergate as an extreme example. They were the primary bank for Crypto firms. Even though they had good, safe loans on their books, about 80% of their depositors pulled their funds due to their OWN issues. Most banks (probably all banks) would not have the liquidity available to meet that kind of a bank run. So, the bank must shut down despite making mostly good loans.

That last point is basically what happened with SVB as well. They invested deposits in mostly good, but long duration bonds, and had a twitter fueled withdrawal of about $40 billion in one day. The question that remains when a bank announces its closing is, what happens with depositors money?

As we know, the FDIC guarantees the first $250k. After that, it depends on the remaining value left on the bank’s books. In this particular case, the government recently announced that ALL depositor funds will be guaranteed, regardless of amount.

This is NOT a bailout in the traditional sense, as taxpayers aren’t going to be funding the gap. Essentially the government recognizes that the loans are in good shape for the most part, and so they are willing to guarantee all deposits since they know the banks investments will eventually mature at par.

However it does function as a sort of bailout to any banks that mismanaged how much duration risk (how long they lent) they had, as they are able to guarantee their loans at par despite paper losses, and because it will likely keep worried depositors from fleeing.

So if you are worried about your current deposits at a bank, don’t be. The government has effectively guaranteed all deposits, assuming the bank has quality loans as most do now.

The other major effect this has is on interest rates and your portfolio.

The Fed has raised interest rates from around 0 to over 4.5% to fight inflation. The Fed has signaled that it will continue to raise interest rates until it is clear inflation is at a reasonable level, even if that means some short term damage to the economy (unemployment going up, growth slowing, etc).

Well that narrative just became a lot more difficult to hang on to with the collapse of multiple banks. There has been a worry since the Fed started raising rates that doing so too aggressively could eventually “break something”. Until now, it hasn’t been clear what that would be. The economy for the most part has stayed strong despite the rate hikes. But now we know.

The market has aggressively adjusted its expectations of how the Fed will act going forward. Interest rates have plummeted, with the 2-year treasury yield going from over 5% to just above 4%. The market has also changed its outlook of continued rate hikes from the Fed, to now multiple rate CUTS by year end.

For investors, this translates to a significant rally in their bond portfolios for any longer duration assets (consequently, this will also help those banks struggling with liquidity issues). It also leads to a reduction in yields being paid out on cash.

This highlights an important benefit of owning bonds today over cash. If bond yields go lower, your bonds will appreciate in value as cash has to lower its future yield. We continue to recommend owning bonds over cash for money that’s not needed in the immediate future.

There’s plenty more to discuss regarding the recent banking turmoil, and news is coming in quickly. We’ll continue to write more about this as new information comes out, but in the meantime, if you have any questions please feel free to reach out.

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