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  • Writer's pictureBen TeSelle

Dorato News - April 2023

Portfolio Issues - Banks and Bumps

Two large US banks were taken over by the FDIC, and one large Swiss bank was forced to merge with a competitor. The media, of course, calls this a banking crisis. But should we be worried?

Our view is that 2023 is not 2008. The largest banks have strong capital cushions and a decent book of loans. Silicon Valley Bank failed because they targeted a specific clientele (venture capital) whose accounts were far above the maximum insured level of $250,000. When deposits started to leave, and the bank had to sell some assets at a loss, a trickle of lost deposits turned into a torrent. For the record, the bank’s stockholders and management did not get bailed out, but the depositors definitely did. So any argument about whether there was a bailout has to be specific about who was bailed out.

Without getting bogged down in details, Signature Bank and Credit Suisse had their own issues. What they do have in common is that they were all pushed into trouble due to rapidly rising interest rates. We think most bank investors and account holders are not at risk. But we do think there will be some more shenanigans, and probably not only in the banking sector, and probably involving creative accounting.

When people’s assumptions get tested is when prices move in big swings. Silicon Valley Bank assumed they had a strong relationship with their depositors. Depositors assumed their deposits were safe, no matter the size. Whoops. Companies and investors assumed inflation and interest rates wouldn’t rise so high. There are likely to be a few more whoops. Half the battle of investing is knowing what to expect. Expect some bumps.

“Nobody is scared of us anymore. They’re only scared of banks.”


Market View - Call and Response

We have had a series of shocks followed by rapid government responses. First there was COVID, which prompted huge government stimulus to rescue the economy. Not long after that, inflation reared it’s ugly head and the Fed responded with rapid interest rate hikes. Now those interest hikes are catching some off-guard, leading to the bank issues we discussed on the previous page. The government then intervened once again to quell panic and maintain stability. It seems like we are jumping back and forth on a seesaw without ever pausing to find the balanced middle. As we have mentioned before, it takes time for government actions to work their way through the economy and those actions often play out in unpredictable ways.

Will the FDIC raise the coverage amount? It seems like they will be forced to make a change in the near future. Although they ultimately covered all deposits from Silicon Valley Bank and Signature Bank, that is not the precedent they want to set. Unlimited protection will encourage complacency and will likely lead to riskier behavior. The FDIC limit is a fairly arbitrary amount, so there isn’t a strong case for maintaining the current amount. Limits on FDIC insurance have increased over time since it was established in 1933 (following the market crash of 1929). The current limit of $250,000 was established in 2008, so it seems fitting that the amount will be raised once again in light of the current situation.

Banks will not be the only sector to feel the pain of higher interest rates. Any company or sector that relies heavily on debt will struggle. Real estate is a good example. Both commercial and residential real estate rely on large amounts of borrowing. Values have already decreased overall and that will likely continue as mortgage rates move higher. There are approximately $2.6 trillion worth of commercial mortgages due to expire over the next few years. Combine that with rising office vacancies and you can see that owners of office buildings are looking at a daunting environment.

The Fed is still hiking rates after the bank failures. They have made it clear that inflation is their primary concern. Although several banks have failed, they view those failures as outliers caused primarily by lack of adequate risk management, not a harbinger of a financial collapse. We generally agree, however we won’t be surprised if we hear that a few more companies are facing financial strain from shortsightedness.

2008 looms large in people’s memories. It was a traumatizing period so, understandably, whenever there are events that have any similarities, investors will get jittery. The mention of mortgage backed securities and bank failures is enough to keep people up at night. We don’t think we are headed for a repeat of 2008. It’s also worth mentioning that investors who stayed in the market during that time period ended up better off a few years down the road. So if there is an inkling to move out of the market, it’s worth considering how that can impact your goals.

You are likely to hear more about the national debt in the coming months. The US reached it’s debt limit in February, meaning we cannot borrow additional amounts. We have had a huge amount of government spending stemming from COVID. Higher interest rates have made debt more expensive, bringing the $31.4 trillion that the US currently has outstanding into a brighter spotlight. The debt ceiling has been raised numerous times since it was created, not raising it would be an extreme step that would damage the US economy. But continuing to raise the debt ceiling and borrow greater sums will eventually have consequences.

Investors are facing an uncertain environment and that is a feeling the markets do not like. Once the dust settles, it will be clear who kept a steady hand and those will be the ultimate beneficiaries.

Sources: Economist, Wall Street Journal, Value Line, Vanguard, Applied Finance Group, Schwab

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