Thoughts on the latest bank failures

It has been a really interesting week on the financial front, so I wanted to take a break from my normal focus on syndications and talk about what has happened so far, what seems to be happening in the short term, and some possible long term implications. While this isn’t specifically focused on real estate investing, what is happening out there will impact REI over the long term.

This is a long post, so you may want to grab a cup of tea before you get started.

A caveat before sharing my thoughts. I am not a macro-economic expert. I am still trying to wrap my head around the complex and highly interdependent financial markets that we all operate within. As a result, I am sure I am going to get some things wrong. I am also going to try to present the concepts in a way that is understandable, which will definitely require some simplifying assumptions. Finally, since we are still in the early stages of this event, I am sure a lot of additional discoveries will be made over the coming weeks. Hopefully, in 6 months, things will be much clearer than they are now. But right now, we need to make decisions about what to do and what not to do on the information we have.

Let’s start with the “big event”. For those that haven’t been paying attention to the financial market, Silicon Valley Bank (SVB) failed March 10 (the second largest bank failure in history), Silvergate Capital was seized by federal regulators March 12, and First Republic and Credit Suisse banks had to be bolstered or they would have also failed, and are still having problems.

In the most basic sense, the problem SVB faced is a simple run on the bank. In the case of SVB, their primary account holders were companies in silicon value, holding large deposits, who started pulling all of their money out of the bank based on rumors the bank was not in a stable financial position. As a reminder, when account holders put money into a bank account, the bank invests it elsewhere. The banks make money on the difference between what they pay the depositors and what they get on their investments. But this means that the bank doesn’t have immediate access to all of the deposits at any given point in time. SVB invested the money in “safe and secure” 10 year treasury bills (also know as T-bills), backed by the US government. That isn’t a problem if they were able to hold the T-bills to maturity since they would have gotten their money back at the end of the 10 year period. But, when account holders started withdrawing the money from their accounts as part of the bank run, SVB needed to sell those T-bills in order to pay them. At many times in the past 20 years, that wouldn’t have been a big deal. They would have either made or lost a little bit of money, but nothing that would have really affected the bank’s stability. However, most of the T-bills they own were purchased over a year ago, before the Federal Reserve (the Fed) [2] started raising rates. The Fed has raised interest rates 8 times, moving the federal funds rate from 0.00%-0.25% in March 2022 to 4.50%-4.75% in Feb 2023 (at the time of this writing, the March 2023 meeting has not occurred). As interest rates rise, the price of bonds fall. This means that what SVB could sell their T-bills for was significantly less than what they bought them for (a loss of $1.8B on March 8, before the bank run really got going). The losses caused by selling the bonds, forced by unexpectedly high withdrawals (ie the bank run), are what ultimately forced the bank to fail.

Other banks were starting to feel the ripple effect of this as people moved money out of smaller banks into the banks that were considered “too big to fail”. Without any additional action by regulators, these withdrawals would have caused the smaller banks to fail for the same reason – no bank has enough reserves to liquidate all of their deposits at one time since most of the bank’s money is invested in assets.

To calm the markets, the Fed stepped in and created an emergency fund that banks could borrow from, basically at no cost, using the par value of the bonds they hold as collateral. They have also guaranteed the deposits held at the banks that have failed, ensuring the account owners will get full access to their funds. Since the Fed can effectively print an unlimited number of dollars, they can cover any crises. For now, at least, that guarantee appears to have mitigated the threat of additional bank runs forcing more bank failures. There are still liquidity issues facing the banks, but again the Fed has stepped in as a lender of last resort and is providing the banks all of the funds they need to meet their customers demands.

While it is easy to think that this means the crisis is over, it isn’t that simple. This isn’t just about what is happening today, but how it affects the broader financial system.

The current crisis was created by falling bond values driven by an increase in the Fed’s fund rate. The bond market is much larger than the stock market and significant changes in bond valuations have a far reaching impact. You can see this looking at the UK pension fund crisis [5] caused when raising rates in England impacting the ability of the pension funds to meet their obligations. The reason the Fed has been raising rates is to try to tamp down inflation, which has been as high as 9% recently and is still at least 6% [6]. With the Fed’s target of 2%, they have a long way to go before they consider inflation in control. If the Fed stops raising rates, they risk inflation continuing or accelerating. If the Fed keeps raising rates, the bond market will fall even further.

I am not going to try to predict what they will do. They are definitely in a hard position. I know some people are predicting they will drop the rates, while others are predicting the rate hikes will continue. We should have a better idea of their stance after their meeting next week.

If they keep raising rates, banks will need more loans as the value of their bonds continue to drop. By providing no-cost loans to the banks, they are effectively increasing the money supply by printing new money to cover the loans. This increase in money supply is, by definition, inflationary [7]. However, it is likely to impact the economy in a different way than the current inflation, since the money isn’t going directly to people who will spend it. I am not exactly sure what this would look like, but it may be similar to the asset inflation that we have seen over the past decade.

With all that context, what should you do now? As I mentioned, I am not an expert in this area. However, my perspective:

  • In the near term, there may be a small number of additional bank failures, but with the Fed guarantee program in place, most account holders should have little or no direct impact from the most recent events. As a result, there isn’t a driving reason to switch banks unless you want to. If you don’t like your current bank, you should consider one of the big banks for security. You should also consider moving money into multiple banks if you have more than $250k in your accounts, just to be safe.
  • The interaction between the interest rates and the bond market remains a potential flash point within the financial system. Robert Kiyosaki, (author of Rich Dad, Poor Dad) has been warning about the fragility of the bond market for a while [8]. If bond prices keep falling, the impact will eventually be felt somewhere else in the economy. I can’t predict the exact location, but eventually something will break given the amount of debt in the system and the current focus on reducing inflation. To minimize your risk, try to stay informed and pay attention to smart people who are following current events. I would not trust the mainstream media since, irrespective of which channel you follow, they tend to alternate narratives between “everything is fine” and “the world is about to fall apart”. Usually the truth is somewhere in between. I leverage my network here since I can ask questions of people who have spent a lot more time than I have diving deep into this area. Get around smart people with different perspectives and ask questions.
  • Inflation doesn’t look like it is going to go away any time soon. Irrespective of what the Fed does on interest rates. Eventually, as other countries continue to be impacted by the inflating dollar, the US dollar will lose its unique reserve currency status. What it will be replaced by, I can’t predict, but there is some evidence of this happening already, with oil being traded outside of the petro dollar [9]. That said, I don’t see the US dollar collapse imminent as there really aren’t better choices right now. There are always people who raise concerns of hyper inflation and the complete collapse of the dollar, but that isn’t my most pressing concern at the moment. I think things will continue to limp along for several more years. Eventually the dollar will be replaced by something else as the world’s reserve currency (no currency survives indefinitely), but I don’t see that happening in the next few years.
  • It will become harder to get a loan. Similar to what happened in 2008, it looks like getting loans will be much harder for a while. This will make it harder to capitalize on the opportunities that are coming. If you currently have short term or floating rate debt this is a great time to convert it to long-term, fixed rate debt while you still can. I expect that the qualification process will be much more challenging for the next few years.

The best approach I can see, and what I am looking at doing myself, is to look for high value, real assets that become available at bargain prices. I am particularly excited about the potential opportunities in commercial real estate over the coming years. Real estate tends to be a great inflation hedge as both the value of the property and the cash flow typically increase along with inflation. And if the property is purchased using fixed rate debt, the loan payments remain constant while income increases and the loan is paid back with dollars worse less. If you are paying attention and not afraid to make a move, this can be a great time to invest. Ken McElroy [10] often credits the moves he made during 2008-2010 with establishing his fortune; this might be our time to shine.

Gold and silver can also be good long-term stores of value, but I don’t consider them investments and don’t really recommend most people go out and buy them. The prices fluctuate a lot (silver is up over 10% this week) and there is a big buy-sell spread so buying and selling without a long-term plan often doesn’t work out well.

If you have any questions about this post or want to discuss this topic further, please email them to me at blog@mbc-rei.com or add your comments on LinkedIn.

For additional reading / listening:

[1] https://www.investopedia.com/terms/b/bankrun.asp

[2] https://www.federalreserve.gov/faqs/about_12594.htm#:~:text=The%20Federal%20Reserve%20System%2C%20often,stable%20monetary%20and%20financial%20system.

[3] https://www.federalreserve.gov/monetarypolicy/openmarket.htm

[4] https://www.nytimes.com/article/svb-silicon-valley-bank-collapse-timeline.html

[5] https://www.cnbc.com/2022/12/13/bank-of-england-calls-for-urgent-global-action-after-near-collapse-of-uk-pension-funds.html

[6] https://www.bls.gov/news.release/pdf/cpi.pdf

[7] https://www.stlouisfed.org/education/feducation-video-series/episode-1-money-and-inflation#:~:text=Inflation%20is%20caused%20when%20the,round%20one%20to%20round%20two.

[8]https://video.foxbusiness.com/v/6322500717112#sp=show-clips

[9] https://www.investopedia.com/terms/p/petrodollars.asp

[10] https://kenmcelroy.com/

This article is my opinion only, it is not legal, tax, or financial advice. Always do your own research and due diligence.
Always consult your lawyer for legal advice, CPA for tax advice, and financial advisor for financial advice.