Double Double Toil and Trouble…
Shakespeare’s three witches in Macbeth are symbolic of evil, darkness, chaos and conflict. Once again, the three witches have been very, very busy. We have been getting lots of queries regarding the recent bank failures and the potential implications across all banks and financial institutions. Without getting political and attributing these problems to any one administration or political party, as they all have had their role over the decades, we see lots of government agencies and individuals wearing tall, pointy, black hats. We apologize for the length of this article and the headache it is sure to bring on…but this is a complex issue that cannot be explained without lots of context…
The first question we get is, “is this as bad as back in 2008?” No, not yet, and hopefully not ever... Back in 2008 I ran the Nevada division of the Wells Fargo Private Bank…and it was scary. As in, another 1932 Depression scary. Collectively, banks had a credit problem in 2008. Banks had a disproportionate amount of low-quality borrowers and their risky loans. Concurrently, banks had fewer safe assets and too much leverage…when risk entered the system via the risky loans beginning to default, segments of the U.S. banking system became insolvent. Why is it different today? In 2008 cash and treasury securities as a percentage of bank assets was under 15%, and today they exceed 30%. The contagion of risky loans going bad was national if not global, but in the instant case, the banks in receivership are finite and unique in their customer base and risky loans. So, in 2008 we had a very different situation. Today’s banks are in much better shape with higher ratios of quality assets being cash and Treasury/Agency assets that have little to no default risk. In addition, because the debacle that 2008 was, the banks’ asset bases are healthier from a credit risk perspective.
Then why do we have a problem? Well, at any given point in time, a bank can be insolvent from a liquidity perspective. Depositors’ funds are turned into loans and reserves, with risk management and strong underwriting, the loans are profitable and ultimately paid-off returning liquidity to the banks. The reserves are in Treasuries and Agency debt, almost riskless from a credit perspective, but not from duration risk. The Federal Reserve raised interest rates at the quickest pace in decades (a 4.49% move in one year), and the quickest percentage pace of all time (from 0.08% to 4.57% in one year, or a 57x increase). Fiscal stimulus in 2020-2021 had brought a huge surge of deposits and banks used these deposits to buy securities that at the time were very low yielding, and with the rapid rise in interest rates cited above, drove the value of these securities down. As an example, if they bought 10-year Treasuries with a 1.5% yield, and new Treasuries now yield 4%, the Treasuries yielding 1.5% on the banks’ books must be discounted 15-20% to compete for buyers who can go into the market and buy new issue Treasuries yielding 4%. If the banks can hold the 1.5% Treasuries to maturity, or at least until rates fall again and the Treasuries rise in value, there is no loss of principal. But, if banks are forced to sell the securities in the short-term to raise liquidity, the loss will be realized. So, under this scenario, the bank is solvent as long as it has sufficient liquidity to meet depositors demands. Now, it is more complex than this, there is a government source of liquidity for viable banks to borrow short-term liquidity, but there are entire books written on the topic, so accept the foregoing as your need-to-know primer on the topic.
This is where the contagion fear comes in…at any given time, a depositors’ run on a given bank could deplete the bank of its liquid reserves. Silicon Valley Bank and Signature Bank had unique idiosyncratic risks in their portfolios of loans and depositor base, and the risks were real. But the risk of contagion, where a bank has exercised prudent risk control and lending standards becomes at-risk of remaining viable because depositors make a run on the bank and drain it of its liquid reserves is real. Faith in the system must be maintained. As an example, you and I can pass back and forth a green piece of paper printed by the US Treasury. If we both have faith this represents one dollar, it maintains its value. If either of us doubts that premise, then it is simply a green piece of paper. We are not saying there is no risk here…we encourage clients to make sure they are using institutions with FDIC coverage and that their deposits are right-sized to the coverage. There is no guaranty the Fed will bail out all depositors in future failures as they did with the Silicon Valley Bank customers.
Now, back to our day jobs…
We have endeavored to instill in clients that Investing is for the long run, in previous newsletters we discussed Warren Buffet’s wisdom when he opined that “The stock market is a device for transferring money from the impatient to the patient.” In our experience, after several decades of helping clients and being investors ourselves, the two places a lack of patience shows up most prevalently are (1) FOMO - the fear of missing out; and (2) – Prospect Theory, a theory developed by Nobel Prize winners in economics, professors Richard Thaler and Amos Tversky. FOMO leads clients to chase the “hot stock” or the latest fad investment. Prospect Theory demonstrated investors experience more pain from losing money than pleasure from earning it. Despite how far we have advanced in the last 2,000 years, we still have brains that react to fear with the instinct to move, change, run…whatever it takes to absolve our fear. In the instant case, that can be to make irrational, short-term decisions with regard to investment decisions.
Events like the banking crisis above add to investor angst. We explain behavioral finance traps with our clients to help instill the importance of taking emotion out of investing, but for all of us, this is easier said than done. While educating clients to help them understand behavioral finance pitfalls can help, we believe that having a plan with a process and investment thesis clients understand, can help limit rash decisions while keeping investors focused on the long-term.
‘Buy low and sell high’ represents some of the most time-tested investment advice, yet many investors tend to do the opposite. When performance is good, investors may be overcome with greed and the fear of missing out, they believe that even better returns will follow. When performance is bad and asset prices are low, investors may stay away in the belief that prices are headed even lower.
Such tendencies have severe consequences for investors’ portfolios. For instance, a survey produced by financial research firm DALBAR suggests that poor timing was a key factor that caused returns for stock mutual fund investors to lag the market by almost 4% during the past two decades.
Experts differ on opinions as to why investors struggle to stay focused. One theory is that poor timing is a consequence of the information age. In the mid-1990s, the dawn of the internet age made daily valuation a reality, and more recently, smart phones and tablets have geometrically increased the volume of good, bad, real and media manufactured information being pumped into investors’ sphere and exacerbating their natural inclination to take action…which we have discussed extensively is almost always destructive to their long-term goals.
For these reasons, we endeavor to help our clients by:
* Educating them on the behavioral tendencies in investing that have been shown to have severe consequences for their portfolios.
* Using powerful portfolio modeling tools to frame potential outcomes to help clients make informed decisions and stay disciplined to the process and reaching their financial goals.
Thank you for your friendship and business.
Dave & Drew