At their core, banks make money by lending out deposits at positive yield spreads (you pay more for a mortgage or car loan than you earn on deposits). When they can’t make a loan, they buy bonds just like the rest of us. Together, loans, bonds and other investments are a bank’s assets while deposits are liabilities. Unlike a conventional, term liability, demand deposits can be withdrawn from the bank at any time, which can create a mismatch between the bank’s assets (loans) and its liabilities (deposits). This mismatch is created because banks cannot just call away a mortgage from a customer at any time to meet the withdrawal request. Fixed income securities that the bank buys when they cannot find a loan to make, on the other hand, can be sold.
However, after a year like 2022 where we saw the worst bond market in history due to rapidly rising interest rates, many intermediate and longer dated bonds were down 10-20%. When word gets out that a bank reached for yield by buying longer dated securities, and therefore has suffered more impact to their bond portfolio than a shorter dated portfolio would have, it creates a negative feedback loop, which is precisely what destroyed the confidence in Silicon Valley Bank and created a run on deposits. The Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) stepped in to prevent contagion fears and took the additional step of making all depositors whole, not just those with balances below $250,000, which is the normal FDIC limit.
It is easy to paint all banks with the same brush at a time like this, but we believe most diversified banks, with multiple lines of business and strong capital ratios, are in better defensive positions to protect their franchises than banks with limited business diversification that cater to niche markets that are experiencing stress. But, confidence is a delicate thing, and the reason why we believe regulators moved so forcefully to restore it. Questions about new precedents and regulations will have to be sorted out later.
Considering this backdrop, there are three key takeaways for investors to create structure and peace of mind around their decision making:
- Focus on your asset allocation and personal liquidity needs. These are two of the most important and simplest risk management tools available to investors. If you want to sleep well at night, know what your comfort zone is on asset allocation and adhere to it. Just know that with less volatility, typically comes lower returns. There are no free lunches. In terms of liquidity, if you are working, it is wise to have a liquidity margin of safety of 3-9 months, notwithstanding your income. If you are not working and instead rely on your financial assets to provide your household’s spending needs, then longer liquidity buffers could be appropriate.
- Where you have your liquidity matters. Consider how much you want or need to hold in bank savings and how much can be held in an all-government money market option instead. Not only will you likely earn more interest, but for balances over $250,000 it is probably safer in an all-government money market than it is at a bank. Modern transfer technology makes going back and forth between a money market and bank savings essentially seamless.
- Avoid margin. Time is probably the greatest asset investors have. It is as close to a free lunch as there is on Wall Street. Not only does margin take away from your ability to ride out the storm, but it also potentially commingles your assets with the custodian’s balance sheet, creating an additional worry item that you don’t need when it is an important time to think clearly, like it is now.
If you do these three things, while you may not welcome the inevitability of old-fashioned market volatility (which seems almost quaint by systemic risk discussion standards), you will have eliminated most of what you can from an asset-safekeeping standpoint and ensured that time remains a valuable asset in your portfolio.
In closing, one final point that Kevin Gale, Ancora’s Head of Fixed Income, has previously pointed out is that Fed Chair Powell appears resolved to stick to a hawkish position with interest rates until material and sustainable gains in the fight against inflation are made, or until something breaks. We are not sure regulators taking over two banks in the span of 48 hours would qualify as something “breaking,” but it may be close. In fact, estimates now are for minimal additional rate increases and 0.50% of rate cuts starting before year end. The Fed may be realizing that the least bad outcome of decades of excessive spending is a higher base case for inflation, with 4-5% persistent levels rather than 2% being the shared price of our past spending sins. We’ll see how it plays out, but we will be ready to advise you, regardless of the path.
Please reach out to your Ancora team if you have any questions, comments or concerns that we can address.