Let’s Talk About The Banking Crisis… Why It Matters… And Why Stocks Could Rally
Editor’s Note: I’ve been discussing the banking fiasco with my colleague Jimmy Butts for the past week or so. I’ve read through a ton of analysis from other sources, but I think Jimmy just gave the most concise summary of what’s going on and why to readers of his premium newsletter, Capital Wealth Letter.
In his analysis, Jimmy pulls no punches. But he also offers some hope for investors at the end. And for that reason, I had to share it with you.
Let’s Talk About The Banking Crisis… Why It Matters… And Why Stocks Could Rally
It’s Monday, September 15, 2008. And the financial system quakes as the 160-year-old investment bank Lehman Brothers falls into bankruptcy.
That day will be forever etched into financial and economic history books. But what happened the following day is reminiscent of the current banking problem…
Tuesday, September 16, 2008, was the day that the $62.6 billion Reserve Primary Fund “broke the buck.”
Investors were panicking, and the run was on. Except this wasn’t a bank run — it was a run on money-market accounts — seen as the safest of investments (much like Treasury Bills).
You see, money-market funds maintain their share price at a $1 value. That’s its benchmark. If a money market fund falls below $1, it’s called “breaking the buck,” meaning investors would lose money if the fund was sold.
Only two money market funds have ever broken the buck. The first was a small institutional fund in 1994. The second was the Reserve Primary Fund in 2008.
By September 19, 2008, when the U.S. Treasury finally acted, investors had withdrawn a record $172 billion out of money market funds.
It was a catastrophe.
But that’s what happens when investors panic. And we’re seeing it happen again…
The Current Banking Crisis
First, let’s quickly cover what happened. I’ll try and make it brief because you can read about the recent bank collapses everywhere in the mainstream media.
Two weeks ago, there was a bank run on Silicon Valley Bank (SVB). $42 billion was pulled from the bank in 24 hours — an astronomical and historic amount. By Friday, March 10, the bank collapsed. It is the second-largest bank failure in the United States.
The contagion quickly spread.
Signature Bank collapsed two days later, and by Monday morning, March 13, regional banking stocks were getting clobbered. Customers were panicking and pulling money out of the banking system.
Why Did SVB Collapse?
Silicon Valley Bank was a niche bank that catered to tech startups. For years tech startups were flush with cash as venture capitalists pumped money into these companies.
Silicon Valley Bank saw its deposits skyrocket. In 2018 it had $49 billion in deposits. At the end of 2021, it had $189 billion in deposits.
Banks make money by taking a portion of those deposits, investing them, and loaning them out. These tech startups didn’t need loans since they were flush with venture capital. So, Silicon Valley Bank invested the deposits in super-“safe” Treasury Bonds.
Because interest rates were so low, these five- and 10-year bonds yielded 1.5%. Which is fine. After five or 10 years, the bank will get its principal back plus 1.5%.
But then the Federal Reserve raised interest rates… fast.
Now, you can buy bonds that offer 4.5%. Which means nobody wants to buy a bond yielding 1.5%. So, those bonds that yield 1.5% aren’t worth as much if you had to sell them today. For example, if you bought a $1,000 bond with a 1.5% yield and had to sell it today, you might only get $800 for that bond. That’s a 20% haircut.
Deposits at Silicon Valley Bank dwindled since these tech stocks were burning cash and no longer receiving funds from venture capitalists. Silicon Valley Bank had to sell some of these bonds they purchased during the low-interest rate era at a loss (nearly $2 billion is what was reported on their latest — and last — conference call).
That spooked folks, and the run on banks started.
We saw Credit Suisse (CS) nearly fail — and get purchased for pennies on the dollar by UBS Bank. For the record, Credit Suisse’s demise wasn’t for the same reasons as Silicon Valley and Signature Bank. It’s been in trouble for years. This was just the final breaking point.
One final thing I want to point out is that bank failures happen almost every year…
Usually, it’s only a few financial institutions per year, and they are small banks. For example, in 2017, six banks failed and closed their doors. In 2019, four banks went under. But during times of economic uncertainty, we see a massive spike in bank failures. In the wake of the financial crisis, more than 320 banks shut down with more than $640 billion in assets.
What Should We Be Concerned About?
There’s an unsettling feeling in the air… are more banks going to fail? What will the Fed do? What will the government do? Is my money in the bank safe? Should I buy gold, bitcoin, or stash cash under my mattress?
People are already taking sides, sometimes extreme ones.
For instance, one guy has made a $1 million bet that the banking sector will fail, the global economy will collapse, and we will see hyperinflation, and Bitcoin will soar to $1 million… All within the next 90 days.
That’s pretty extreme.
On the other side, you have folks like hedge fund guru Bill Ackman who believe that if the FDIC temporarily guarantees all bank deposits, it will calm nerves while they update the insurance deposit guarantee (aka increase the current $250,000 FDIC limit). If the government does this, this will all pass within weeks.
My sense of the situation falls somewhere in the middle…
One of my biggest concerns is that if a bunch of these regional banks go under, or get gobbled up by bigger banks, then we have even more power centered in the biggest banks in the world (i.e., JPMorgans, Citi, and Bank of Americas of the world).
Regional banks play a vital role in our economy. They drive home, construction, farm, and equipment loans. They often offer these loans at cheaper rates than the big guys. And they have superior customer service compared with the big banks. If they suddenly disappear, that’s not good for Main Street.
My other big concern is the Fed… and its balance sheet.
I’ve talked a number of times about the Fed’s balance sheet and its effects on the market. For instance, in January 2022, I sounded the alarm on the market in an interview with my colleague Brad Briggs. I pointed to the reduction of the Fed’s balance sheet — known as Quantitative Tightening, or “QT” — as a primary culprit that wasn’t getting enough attention.
In May 2022, I reiterated the tight line the Fed was walking and my concern for stocks and the economy.
When the Fed finally started to reduce its balance sheet in April last year, stocks tumbled. The Fed kept reducing its balance sheet throughout 2022 and into 2023.
But then Silicon Valley Bank collapsed.
The Fed stepped in to provide liquidity and help calm consumer nerves, but to do so, it had to raise its balance sheet again.
As you can see in the chart, the Fed’s rescue plan essentially erased the past four months of balance-sheet trimming.
Why Is This Important?
I won’t get into the nitty-gritty of it all, but here’s what you need to know…
We had the highest inflation in 40 years. Inflation is good, but high inflation and hyperinflation are terrible. Just Google Argentina’s economy if you want an example.
To fight inflation, the Fed went to its bag of tricks and started increasing interest rates and draining the excess liquidity it had pumped into the system through its quantitative easing/printing money policy. This slows growth as borrowing money becomes more expensive and liquidity dries up, which is supposed to help bring inflation back down.
This is all fine and dandy and works well in theory.
Unfortunately, we don’t live in theory. We live in the real world. In the real world, the Fed cranked interest rates higher than many banks thought it would. For example, executives believed the Fed would raise rates by 0.75 percentage points in 2022 — thus investing in longer dated bonds. Instead, the Fed raised them nearly six times as much, by 4.25 percentage points.
Now their portfolio of safe government bonds is sitting on massive unrealized losses because they didn’t think rates would climb this fast. Also, all bank executives know what happens to bond prices when interest rates rise. Bond yields and prices are inverted, which means as yields go up, prices go down. That’s something you learn in Finance 101.
Those unrealized losses aren’t a big deal so long as you have liquidity (aka cash). But the Fed is also reducing liquidity because it’s no longer buying Treasuries and Mortgage-Backed Securities, which banks would exchange for cash.
This all comes amidst a time when businesses were burning money at a fast pace, trying to catch up on inventory, keep employees by boosting wages, and battling inflation of goods and products. Meanwhile, their borrowing costs are also increasing.
The perfect storm.
All it takes is a little panic (which we saw with Silicon Valley Bank), and the ripple effects can become disastrous. It could bring the financial system and the economy to a grinding halt.
The central bank has one way to avoid this outcome… provide liquidity to the financial system by increasing its balance sheet. Which they’ve already started doing.
Here’s Why Stocks Could Rally
Historically, when liquidity is reintroduced to the financial system, it helps stabilize asset prices, and stocks would go on a tear…
Just look at the Covid-19 pandemic as the most recent example. The Fed more than doubled its balance sheet from $4 trillion in February 2020 to a peak of $9 trillion in April 2022. Over that time, the S&P 500 rallied 58%.
During the great financial crisis — between September 2008 to January 2015 — the Fed’s balance sheet swelled from $900 billion to more than $4.5 trillion. During the same period, the S&P 500 rose 102%.
Now, I don’t think the Fed will increase its balance sheet by that much this time as it’s still fighting inflation. But the good news is that even a temporary bump in liquidity could provide a nice little rally in stocks. It will take some time for confidence to rebuild and fears to subside, but if the Fed stays on this path, I’d expect stocks to rally.
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