1st Quarter Client Note — Bank Runs Are Back

By Steven Smith | Waypoints

Apr 14

The markets shook off news of dramatic bank runs and failed banks being taken over by the FDIC and sold off in piece parts. Led by a big rebound in technology stocks, the S& P 500 (Total Return) Index gained 7.57% in the quarter. Large cap growth technology stocks were up 14.3% with large cap value only up 1.01%.

International stocks outperformed US stocks, with the MSCI EAFE Develop Market Index up 8.47%. US REITs gained 2.77%. With inflation continuing to moderate, Commodities fell 5.36%

Fixed Income

Bonds continued to recover from one of their worst years ever in 2022. The benchmark Bloomberg Aggregate Bond Index gained 2.96%.

As usual, our friends at Dimensional Funds gather all the details in their Quarterly Market Review.

Failure of Silicon Valley Bank – The Country’s Sixteenth Largest 

Over the course of a couple of days in mid-March, there was a run on Silicon Valley Bank, based in Santa Clara, California.  SVB was an important institution in growing our technology economy, providing banking services to tens of thousands of emerging companies. It also had an extraordinary proportion of its deposits far above the $250,000 FDIC insurance cap; both from the cash holdings of its regular business customers and from wealthy Silicon Valley venture capitalists.

The irony is that what got the bank in trouble was not loans to start-up companies – theoretically the risky tranche of its balance sheet. But rather what was supposed to be the safe money. The bank grew so fast and attracted so much money from investors and depositors that it had difficulty placing it all. And then it made a rookie mistake; buying $ billions of long-term bonds at low interest rates right before the Fed began its historic series of interest rate increases. And we all know by now that when interest rates rise, the value of your bonds falls. Bank regulators were also asleep at the switch in not monitoring this mismatch.

Another irony is that capitalists with supposedly the highest level of risk tolerance, panicked and precipitated a bank run — withdrawing billions of dollars of deposits in a matter of hours, forcing the bank to sell bonds at a loss.  This may have been the first digital bank run. A Zoom meeting among the VC bigshots led to the run. People don’t have to stand in line for hours to get their money out, like they did during the depression. They just press a button on their phones. The run likely could have been prevented by giving bank executives some breathing room to restructure their portfolio and raise capital.

Bank runs and bank failures were a commonplace result of the Crash of 1929 and the Great Depression. One of the results was the creation of the Federal Deposit Insurance Corporation (FDIC) and the advent of government insured bank accounts.

The original insurance amount was $2,500 in 1934 and has been gradually increased $250,000 per account, per bank. Meaning a couple can each have $250,000 in individual accounts and an additional $250,000 in a joint account; for a total of $750,000 per bank. That should cover the bank savings of most Americans.

A third irony is that as part of the resolution of SVB and a couple of others, the FDIC was forced to guarantee individual deposits of tens of millions of dollars — miles above the statutory limit – because they had to.

Your Money or Your Life

There’s an old Borscht Belt joke that goes something like: My grandmother’s idea of diversification was to keep her money in a bunch of different mattresses. Well, maybe it’s not such a joke. Not that you should keep your money in a mattress. But this event presents a great opportunity to examine a crucial issue for investors — risk associated with custody, including where you hold your cash. While nothing is 100% safe, custodial risk can be reduced to a negligible amount through common sense and good diversification.

Banking. Any bank can fail. As discussed above, however, most people’s banking needs for holding cash and short-term deposits can be easily managed within the construct of FDIC insurance limits. And if $750,000 of coverage is insufficient, you can walk across the street and open an account at another bank. There are also services such as Max and IntraFi that can facilitate spreading your deposits out to multiple insured institutions.

Money Market Mutual Funds. These are open end mutual funds, with checking privileges, that seek to maintain a value of $1.00 per share so that they can always be redeemed at that price. Following one such fund’s “breaking the buck” during the 2008 financial crisis, rules were tightened resulting in greater protection for investors in funds that limit their investments to only US government bonds, such as Treasury and agency issues. Money market funds have mostly functioned as advertised since their inception in 1971.

Near Cash. If you don’t need 100% protection against volatility, mutual funds or ETFs that invest only in very short term (less than one-year) US government bonds can be a good choice and may offer a higher yield than money market funds. Buying short term US Treasury Bills/Notes from a broker or at Treasury Direct is also a reasonable option. CD’s, being mindful of the $250,000 limit, are a good option, as well. This allows for liability matching. If you need cash, for example, in three years, you can buy vehicles with a three-year maturity.

Brokerage Accounts. First off, brokerage firms are inherently different than banks. Banks take your money and lend it out or invest the money for their own profit. On the other hand, brokerage firms take custody of your deposits and, for the most part, invest it as instructed on your behalf and maintain ledgers to segregate and distinguish the accounts of their customers. They also have minimum net capital requirements. They do treat your cash holdings similar to a bank and many of the brokerage firms own subsidiary banks for this purpose.

Brokerage accounts have two separate levels of SIPC (similar to FDIC) insurance. Cash is insured at $250,000. Securities are insured to $500,000 per account type, similar to banks. So an IRA and an individual account would each have $500,000 of coverage. The major brokerage firms also buy extended coverage from Lloyds of London. In the event of insolvency, because of the segregation of accounts, an orderly unwinding is very likely. Even the customers of Bear Stearns and Lehman Brothers were made whole.

In order for a brokerage firm to become insolvent it would have to break these rules or become the victim of a massive fraud or hack. Not impossible, but probably unlikely

Rising Rates Were the Story

One of the favorite things I read recently was this old saw: When the Fed hits the brakes, someone is going through the windshield. We just don’t know who. This time it was SVB and a couple of other banks. Woe be unto any employee of one of those banks who kept an inordinate share of their net worth tied up in company stock.

Most anyone’s portfolios suffered drawdowns at the hands of the Fed in 2022. But most of us aren’t financing our portfolios with demand deposits. So, assuming we have built these occasional dust ups into our expectations, we can patiently wait for time to restore their values.

Goals, risk tolerance and time horizon remain the cornerstones of being a successful investor. And balanced portfolios have ordinarily been sufficient for investors to both meet their goals and sleep at night.

Be Prepared

That’s not just for Boy Scouts and Girls Scouts. There is always a financial crisis lurking around the corner. As best as we can, our portfolios and our emotional Segue machines should have built in stabilizers for managing through them. Even bonds can have bad years. The risks that matter are the ones we cannot see at the moment.

Diversification, including holding sufficient amounts of safely deposited cash and near cash, remains the operative strategy. And having the discipline to stick with the strategy when the world around you is convulsing.

And remember, investing is serious business, not like the fun of March Madness.

 

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