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Regional Bank Failures – Why They’re Important

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Imagine waking to the news that individuals and businesses with more than $250,000 in deposits at regional banks were withdrawing their assets from their banks.  These banks were closing.  It’s not difficult to imagine the impact of the panic and fear on the markets and economy.   We weren’t as far from that scenario as we’d like.   What follows is our take as to how this catastrophe could have happened, how it was avoided, what markets are doing now, and how this event may change the course of the economy. Additionally, we describe some of the protections offered by Charles Schwab. 

In the last week, two regional banks have failed, Silicon Valley Bank (SVB) and Signature Bank.   These are not especially large banks from an economic viewpoint; but their failure could have led to tragedy.   

The FDIC has insured bank deposits for up to $250,000 per account as shown in the nearby image which you may have noticed if you’ve actually set foot in a bank.   Depositors up to that amount had no reason to worry about a bank failure.   Those with deposits over that limit were in a different boat.   When uninsured depositors of SVB became worried about its ability to continue, they started withdrawing funds creating a run on the bank.  For brevity and speed, I’m skipping details of the events at SVB.  They are well documented and available by search if you like.   

Fortunately, the combined policy reaction of the Treasury, the Federal Reserve and FDIC avoided a worse outcome.  Secretary of the Treasury Janet L. Yellen, Federal Reserve Board Chair Jerome H. Powell, and FDIC Chairman Martin J. Gruenberg issued a press release  saying the Federal Reserve “will make available additional funding to eligible depository institutions to help assure banks have the ability to meet the needs of all their depositors.”    

For simplicity, we’ll divide banks into large banks which are considered too big to fail and regional banks.  By too big to fail, we mean that the government would not let them fail for fear of the impact on the economy.  The Dodd–Frank Act imposes heightened supervision standards (including being subject to the annual USA Stress Test) on any bank holding company with a larger than $50 billion balance sheet.  These large banks are considered to be systemically important – the belief is that their failure would threaten the financial system and thus the economy.   

When SVB failed at the end of last week, it was unclear how much depositors with more than $250,000 would receive and when.   If they were not made whole quickly, there might have been runs on many, many regional banks across the country.  Their large (over $250,000) depositors might have asked themselves why am I taking the risk of having so much money at this regional bank when I could deposit it at a large, too big to fail, bank?    

Banking is important because loans (credit) are important.  The impact of many regional bank failures would impact not only the banks themselves, but their individual and business depositors.  Think 1929-lite.    

Over the weekend, the Treasury, the Federal Reserve and the FDIC announced their support of the banking system.  We breathed a sigh of relief and believe this is a good policy.  We expect some in Washington will have a different view and it remains to be seen what effect this policy will have over the long term. 

That’s where we are today.   How are markets reacting?  An index fund of regional bank stocks is down 11% today bringing the loss since the beginning of last week to about 25%.  The broad U.S. stock market is flat today.   There has been a flight to safety with investors buying Treasury bonds.  The U.S. dollar is declining. 

Where are we going?  We avoid short-term forecasts.  We do offer the following ideas on how these recent events will impact the future.   Financial stability is a mission of the Federal Reserve.  The SVB crisis (and to a certain extent the closure of Signature Bank) threatened that stability.  The Federal Reserve has recently been raising rates to reduce inflation.   Higher rates made the Treasury bonds purchased by SVB decline in value.   We see the Federal Reserve now being more cautious in their inflation fight.  In other words, inflation risks are higher and recession risks are lower.    

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For our clients with assets at Charles Schwab, we provide the following information.    

Unlike deposits at a bank, customer securities-such as stocks and bonds that are fully paid for are segregated from the securities of a broker dealer like Charles Schwab.  In the unlikely event of insolvency of a broker dealer, customer segregated assets are not available to the creditors of the broker dealer.  

An excerpt from “How client assets are protected at Schwab”: “At Schwab, our customers receive an extra level of coverage. We’ve chosen a program led by Lloyd’s of London, a well-respected name in the insurance industry, as underwriter for additional brokerage insurance. This “excess SIPC” protection of securities and cash is provided up to an aggregate of $600 million, limited to a combined return to any customer from SIPC and Lloyd’s of $150 million, including up to $1,150,000 in cash. This additional protection becomes available in the event that SIPC limits are exhausted and client accounts have not been made whole.”    

An excerpt from a missive from Schwab on recent events:   “Investments at Schwab are held in investors’ names at the Broker Dealer. Those are separate and not comingled with assets at Schwab’s Bank.” and “Schwab has access to over $80 billion in borrowing capacity with the Federal Home Loan Bank (FHLB), which is an amount greater than all our uninsured deposits. That helps provide the firm significant access to liquidity, so money is there when clients need it.” 

The Schwab default sweep for cash is a deposit at Schwab Bank.   However, we at Red Tortoise have always preferred purchasing money market mutual funds for their higher interest rate.

Let’s Get Real – Don’t Blame Inflation

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Stocks: Russell 1000 Index with/Div; Bonds: Barclays Capital Aggregate Bond Composite

Year-to-date (May 2, 2022) and over the last 12 months, both stocks and bonds have lost money. Generally, we think of bonds and stocks as diversifying one another. Lately they’ve been moving in the same direction. What’s going on?

Here is what usually happens. Interest rates are the prices to borrow money and are the primary driver of bond returns. As the economy improves there’s more demand to borrow money so rates rise.  An improving economy means more growth which is good for companies and their stocks. In this scenario, bond prices fall, and stocks rise.  On the other hand, as the economy falters, as in a recession, interest rates fall so bond prices rise. As the prospects for growth diminish, the stock market weakens. These scenarios are why bonds and stocks are commonly combined to diversify portfolios. Stocks do well when there’s unexpected growth; and bonds do well when growth unexpectedly slows. Over the past 173 quarters (43 years), just eight quarters (less than 1 in 20) have experienced negative returns for both the U.S. stock market and the U.S. bond market. That happened in the first quarter of 2022 and, so far, the second quarter is tracking in the same direction.

So why isn’t that happening now? The short answer is that interest rates are rising, but growth expectations are not. Consequently, the future dividends of stocks and the future interest payments from bonds are both worth less.

That was a simple answer, and probably satisfies most readers. That real rates have risen is the more technical reason that stocks and bonds have both lost value. Real rates are rates adjusted for inflation. If inflation is 3% and an investor earns 5%, he or she has enjoyed a 2% real rate before taxes.

Real rates can be observed from the yield on Treasury Inflation Protected Securities (TIPS[1] )[1]. Currently, the real rate is 0.18% on a 10-Year TIP, up 1.15% from -0.97% at the start of the year. A negative real rate indicates investors are getting a return less than the rate of inflation as was the case at the start of the year. Today’s real rate of 0.18% indicates investors are earning a return slightly greater than inflation.

The interest rate on the 10-Year U.S. Treasury (not TIPs) jumped from 1.63% at the first of the year by 1.36% to 2.99%.  The bulk of the change in interest rates is accounted for by the 1.15% increase in real rates. Inflation expectations rising from 2.60% by 0.21% to 2.81% accounts for the remainder.

An increase in real rates hurts both stock and bond investors whereas rising inflation mainly hurts bondholders whose interest payments are fixed. When there’s inflation, companies increase prices -that’s basically what inflation is after all. Even if their expenses rise by the same rate, their profits rise. A company with revenues of $100 and expenses of $80 that experiences 10% inflation will see its profit increase 10% from $20 to $22.

Where do real rates go from here and how will bonds and stocks be affected? Our loyal fans know we don’t try to time markets and promote diversification. Based on the history in the preceding chart the rate could come down or continue to rise. We’d expect markets to suffer if the rise continues and to recover if it reverses.

Here is one scenario. How much might a 1% rise in real rates be expected to impact the stock market? A simple model provides insight. The simple model assumes that stocks (think the S&P 500) pay a dividend that will grow by some amount (g) indefinitely. Let’s assume that g is 4% or 5% which is a ballpark long-term rate for the U.S. stock market. There is some rate at which we discount future dividends to convert them into today’s dollars. For starters, let’s use 6%. The simple model says the price of the stocks will be the dividend value divided by the difference between the discount rate and the growth rate: P = D / (k – g). Some math allows us to calculate the percent change in the stock price if k increases 1% as % change = (k – g) / [(k + 0.01 – g)] – 1. Assuming a 4% growth rate with the discount rate rising from 6% to 7%, the model indicates a 33% drop in stocks (-33% = (0.02/0.03) – 1). Here are results with different assumptions:

g4%5%4%5%
k6%6%10%10%
k+1%7%7%11%11%
% Change33.3%50.0%14.3%-16.7%
% Change in Stock Prices Given Various Values of g and k

The point of the table is to show that a 1% change in the real rate can easily explain a double-digit drop in the stock market.  Given how low rates have been, we’d argue that k was likely closer to 6% than 10% at the start of the year. So, we may have gotten off lucky; otherwise, we may have more pain to endure.

It’s worth discussing what drives real rates. Demographics are a driver over the long term. The ratio between people 65 years and older and people 15 to 64 years old is an example. As people save, particularly for retirement, they increase demand for investments. Retirement spending tends to reduce demand. Higher demand reduces the real rate while lower demand increases it. In the short run, the Federal Reserve, especially with its massive bond buying, creates demand for securities. It is possible, even likely that anticipation of tightening by the Fed is pushing real rates higher. What does all this mean? There’s good news here. Whereas investors in the 10-year Treasury were expecting to lose almost 1% annually after inflation, they can now expect a positive, albeit small, inflation-adjusted return. For those who are adding to their investments, higher real rates are more attractive. Understanding that movements in interest rates can be attributed to changes in the real rate and changes in inflation expectations brings important information to light.  We also expect value stocks to outperform growth stocks when real rates rise. Here we are broadly categorizing stocks with higher earnings and dividends per dollar of market price (lower P/E, higher dividend yield) as value and higher P/E, lower dividend yield stocks as growth. Growth stocks are expected to get more of their value (earnings and dividends) farther in the future than value stocks. If real rates rise, but growth expectations do not), the valuation of growth stocks will suffer more than that of value stocks.

[1] TIPs are bonds issued by the U.S. Treasury.  The principal is adjusted by the rate of inflation and interest is paid on the adjusted principal thereby providing a return relative to inflation.

War! Russia Invades Ukraine

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The headlines today are about Russia’s invasion into Ukraine. How does this impact our thinking about portfolios? 

Earlier this month I was at a dinner with Ian Bremmer a political scientist and founder of Eurasia Group which bills itself as ” the world’s leading political risk research and consulting firm.” He dismissed the idea of a Russian invasion as have others despite repeated warnings from Washington. Northern Trust Asset Management issued a commentary on February 14, just 10 days ago, assigning a 10% probability of full invasion. The future is hard to predict and experts often get it wrong. Our approach is to build portfolios that produce successful outcomes for our clients across a wide range of possible geopolitical and economic outcomes rather than to maximize value in the one outcome we think most likely. This leads to diversification. 

Let’s consider how markets have reacted to past geopolitical events. The Northern Trust commentary looks at 21 geopolitical events post 1940. They report that, on average, the market recovered in an average of 37 days (coincidentally, the longest recovery happened to be a Russian led event – the launch of Sputnik – which took 215 days). They observe “Historically geopolitical events do not impact financial markets for long unless the market outlook fundamentally changes.” That begs the question – What, if anything, has changed?

Until the Russia-Ukraine conflict captured the headlines, market anxiety was largely driven by rising inflation and how the Federal Reserve would respond. Now, sanctions against Russia will increase energy costs exacerbating inflation. There’s a difference between inflation created by rising demand (growth) and by a supply shock (Russia not selling its energy). The Fed can slow economic growth by raising borrowing costs which was the market’s outlook. Higher interest rates however do not increase the supply of energy. Higher energy costs caused by supply disruptions will also slow growth which may alter the Fed’s calculus. 

Core to our practice is a belief that market prices for stocks and bonds reflect expectations for growth and inflation rates. Prices change as the unexpected occurs. By its nature the unexpected can’t be predicted. At any point we could have unexpected changes in growth and inflation expectations. We expect stocks to do better when growth and inflation are unexpectedly rising and bonds to fare better when they unexpectedly fall. Our approach is to have both in portfolios but to varying degrees based on risk tolerance and time horizon. The recent events do not change our approach but reinforces our view. We believe in patience and a cautious approach to current events.

As someone once said, if there’s no conflict, there’s no interest

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Fiduciary (noun): a person to whom property or power is entrusted for the benefit of another.

Recently, the “fiduciary rule” has been in the news.  As the home page on our website says “We hold ourselves out as professionals and fiduciaries meaning that it is our legal and ethical duty to put your interests ahead of our own.”  We hope that is clear to you.

What’s clear to us is that a lot of investors have more trust in their advisors than is warranted.  Brokers and advisors are not always required to put their clients’ interests first.  There have been unsuccessful efforts to change this.  As reported by CNBC:

The 5th Circuit Court of Appeals ruled on March 15 that the Labor Department overstepped its authority by creating the so-called fiduciary rule, parts of which went into effect last year. In general, the rule requires advisors and brokers to put their clients’ interests before their own when advising on retirement accounts such as 401(k) plans and individual retirement accounts.

Advisors and brokers do not have to put their clients’ interests first.  In our opinion this can lead to higher fees and less appropriate investments.

If you have questions, let us know. If you know someone who could benefit from our services and fiduciary standard, we’d like to know that too.

 

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