Lessons Learned and The Banking Crisis of 2023

Wooster Corthell |

To our clients and associates,

As you know, this past week has been an historic time in the markets. Silicon Valley Bank ($211.8 billion in assets), Signature Bank ($110 billion in assets) and a much smaller and more crypto-oriented firm Silvergate ($11.4 billion in assets) seemingly failed overnight. Fears of contagion spread throughout the market causing many regional banks and brokerage firms to be traded with a “sell first and ask questions later” philosophy.

Seeing the widespread fear, the Federal government took the unprecedented action to guarantee all deposits at Silicon Valley Bank and Signature Bank, sending the message that they will do what it takes to protect the US banking system.

Citizens, customers, and investors are obviously quite frustrated with a failure of this magnitude and wondering who is to blame. Given the complex nature of our economy there really is no one answer, but here is our understanding at this time.

For over 10 years we had an extremely low interest rate environment, which meant that banks paid little in the way of interest to depositors but also received very little in interest on the loans they wrote. This policy started during the Great Recession and over time had the effect of lowering the average interest rate on banks’ loan portfolios. This is because older loans at higher rates were paid off or refinanced into newer loans with lower rates. Additionally new loans were issued at lower rates.

Today we face inflation that hasn’t been seen in 40 years and the government prudently raised interest rates to slow the economy and bring inflation down. As interest rates go up, the equation for banks becomes a question of difficult tradeoffs.

On one hand, banks can raise rates to incentivize depositors to stay with the bank. The problem is when a bank raises interest rates on their savings accounts, they start to incur those costs immediately on most of their deposits. However, the bank is stuck with a loan portfolio at very low rates as they are being paid back over a number of years. Only a very small percentage of their new loans are being issued at the much higher rates. If the bank raises the interest rates on their deposits too fast, they can face a situation where they are paying more in interest to depositors than they are receiving in interest on loans. A recipe for a short life if you are a bank.

On the other hand, banks can choose to not raise deposit interest rates. The problem here is that people have plenty of alternatives. The banks that don’t pay their depositors are likely to lose deposits while the banks that raise them are likely to receive them. If a bank is faced with a significant set of withdrawals, they would need to raise cash to pay their depositors. Since much of the cash that is owed to the depositors is invested in loans at the bank, the bank needs to sell off these loans to raise cash for their customers. When the bank sells loans in this environment, they are typically done at a loss. This is because they are selling old loans with low interest rates, which are competing with more attractive, new loans with higher interest rates.

This brings us to now. Silicon Valley Bank and Signature Bank were more in line with the banks that faced withdrawals and needed to sell loans. As they took losses on their loan portfolio, fear grew about whether they had the ability to pay depositors. Long gone are the days where you had to wait in line outside your bank to get your cash. Once a puff of fear goes viral, all their customers can simply pull out their phones, click around in seconds and cause a bank to go up in smoke as they drain all the assets.

These types of issues for banks are called liquidity issues. A liquidity issue for a bank occurs when they don’t have the cash to pay for the withdrawals, but they have the assets. Imagine a family with a home worth $500,000 with no debt and no other assets. They need to write a check for $25,000.They have the value, but it’s going to take some time to sell the house to free up the cash before they can write that check. That is what happened with the failed banks.

In the Great Recession, banks faced a far different issue called a solvency issue. With a solvency issue, the bank quite literally does not have the assets to pay back their depositors in full, which can cause a liquidity issue as customers pull their money out. Using the above example, it would be as if the family tried to write a check for $1 million based on the $500,000 value of their home. They don’t have it and can’t get it.

Since today’s situation is a liquidity issue and not a solvency issue, the government has said no taxpayer money will be used. The idea is that the FDIC will come in and provide the cash up front for the depositors and sell the banks’ assets over time to recover the funds fronted.

So what are the implications for the markets going forward?

Historically, markets have been leading indicators. The markets tend to sell off before the bad economic data and tend to rally before the good economic data. Many lay investors see the markets drop and when the bad economic data follows, it tends to confirm their fears. They elect to sell out of their portfolio after it falls. (Note the emphasis on after it falls?)

For example, in 2022 the markets sold off indicating the belief that poor economic data is ahead due to higher inflation. We are now starting to receive bad data. If the data is worse than feared, we would likely see a drop from these levels. If the data is better than feared, but still bad data, the market would likely rally. It is important to recognize these views are consistent with history.

Take the Covid selloff in 2020. The market bottomed on March 23, 2020. The unemployment spike and much of the other associated economic turmoil happened after the market bottomed. Said differently, the market rallied as the actual economic data turned negative because the market priced it in by selling off before.

It also happened in The Great Recession. The market bottomed on March 9, 2009. The recession was declared over in June 2009. From March 9th to the end of June, the market rallied an impressive 36% off the lows.

It can be hard to stay invested while the bad data is coming through. Yet history shows us that it is one of the most important things we can do as long-term investors.

Thank you for your continued trust in our firm. If you have any questions or concerns, please give us a call.

Wishing you well,

Matt Corthell

Past performance is not indicative of future performance. Loss of principal and/or loss of portfolio value are possible.