Bank Failures: Should we Worry?

By: Aaron Anderson, CFP®, CFA, Managing Partner

April 5, 2023

In my last article, Good Riddance!, I mentioned how I was glad that 2022 was over. It was the seventh worst year for the market since 1926 and bonds weren’t a safe haven for some of the reasons we mentioned in previous Focus articles.

Every new year marks a new beginning. People put the previous year behind them and make resolutions that they likely won’t keep. The gyms are full of people wanting to be healthier, at least for a few months, and optimism is in the air.

We saw this with the stock market. The S&P 500 was up over 6% and the much beleaguered tech stocks – as represented by the NASDAQ Composite – were up almost 11% in January[1]. There’s a saying on Wall Street that “as goes January, so goes the year”. Research has shown that there is a slight positive relationship there, but it’s not a strong one[2]. But even the 60% of the time that research shows would be a relief after last year.

Unfortunately, we gave some of that gain up in February. That happens in a skittish market. People believe the bounce won’t last so they sell which causes the bounce not to last. But, the market seemed to be holding up.

Then in March, we had the biggest failure of a US bank since the Great Financial Crisis in 2008. Small banks fail relatively frequently, but this one was the 17^th biggest US bank by asset size. At the risk of oversimplifying a complicated situation, two things happened that created a perfect storm.

The first thing is that there was a run on the bank. Like most banks, Silicon Valley Bank doesn’t just hoard all investor deposits in a vault for safe keeping like Scrooge McDuck in his money bin nor would we want them to.

They use most of those deposits to invest in other financial instruments. As a basic example, a savings account might pay 1% interest, but the bank takes that person’s deposit and uses it to fund mortgages at a rate of say 4%. The 3% difference is what the bank uses to run operations, pay employees, and make a profit; otherwise, we’d have to pay the bank to safely keep our money instead of them paying us for using it.

The issue when there is a bank run is that it becomes a self-fulfilling prophecy. An analogy I heard said it’s like someone yelling fire in a building that’s not on fire. In the panic, someone running out of the building trips over a candle and catches the building on fire. That’s what happens in a bank run. Banks keep some reserves on hand to take care of daily cash needs. But, if too many people try to withdraw at once, they run out of reserves and must start selling investments, which leads to the second thing in the perfect storm …

The Federal Reserve has been raising interest rates to try to get inflation under control. Their goal is to cool down the economy and decrease spending by making it more expensive to borrow. Even though they only control the Fed funds rate, interest rates in other things such as mortgages, car loans, and government borrowing increase because of it.

Interest rates on “safe” investments such as US Treasuries are higher than they’ve been in over a decade. As interest rates rise, the value of current bonds goes down. This picture from a few years ago of my daughter (representing interest rates) and nephew (representing bond prices) on a teeter totter illustrates the point. Why would someone pay full value for a bond paying 1% when they can get 4% for the same amount of money?

So, when the bank had to start selling bonds, they had to sell them at a discount. If the bank was able to hold the bonds to maturity, they would have received back what they paid. But, since they needed cash now, they had to sell at a loss which means they had to sell more to make up for that – creating a death spiral for the bank.

Every investment has risk and this is one for banks that people don’t talk about much. While FDIC insurance backstops the risk somewhat (basically up to $250K per person, per bank), deposits above that are typically not insured. In an effort to restore confidence in the banking system, the government has stepped in to guarantee all deposits at the failing banks. They’ve also encouraged (coerced?) some big banks to help buy the assets of the failing banks. The banking system seems stable for now.

The interesting thing is that despite that turmoil, the market was up 2.7% for March! There was a bit of a drawdown earlier in the month followed by a good final week. While the banking issues were being digested by the market, I would have never suspected we’d be up for the month.

That’s the issue with making predictions: one has to predict what will happen and then one has to predict the market’s reaction to it. Had anyone known in advance what Covid was going to do in 2020, it would have been “obvious” to sell and get out. But, as we saw, that would have been a big mistake. Despite all the things that could derail the market, it has continued trending upward long-term and we think it will get back to doing that again. We may be getting to the point where the market starts climbing the Wall of Worry. If a large bank failure doesn’t spook it at this point, what will?

Before our quarterly holdings discussion, I’ll start with the disclosures:

While we tend to use a similar investment mix across all accounts held with us [3], you may not hold some of these positions mentioned here – maybe it’s not appropriate for your goals and risk tolerance or maybe you didn’t have funds available at the time and we didn’t want to sell any of your holdings to make some available.
This is NOT a recommendation to buy or sell. It is an “after the fact” report of why we hold what we do. There is neither enough information given here to make an informed decision nor anywhere near the amount of analysis we do on our holdings or prospective holdings. You can of course assume that we have positive expectations for any of our holdings, otherwise we would have sold them. Beyond that, what is stated here is a backward-looking report at what occurred, not a forward-looking prediction of expectations.
We are long-term investors and so what happens quarter to quarter is not something to focus on. Our best performer one quarter might be our worst performer the next, so again, you should not make investing decisions based on what’s discussed here.

Better Performers

NVDA: Six months ago, Nvidia was one of our worst performers. Last quarter, it was by far our best. The AI bot, ChatGPT, came out and it was a big hit. People realized something we already knew: that Nvidia is the leading hardware maker for AI and if AI ever became viable, Nvidia would benefit from it.
TSLA: Tesla had a huge quarter after being an underperformer last quarter … after being an outperformer the previous one. Tesla has been able to cut prices while maintaining profitability to try to grow market share against all the competition that has come online over the last year or so. It seems to be working as they just reported record delivery numbers.
QQQ: This is the NASDAQ 100 exchange traded fund. Instead of picking our best stock from the group, I’ll give credit to the whole group. Apple, Microsoft, and Amazon – all three core holdings for us – along with SMH (the semiconductor chip exchange traded fund) did very well. As I said in last quarter’s article, sectors do that. Last year’s trash has become this year’s treasure so far.

Underperformers

ENPH: Enphase is a very volatile stock that has been trending downward as of late. We are investors in the solar microinverter company, as we believe that solar power and clean energy are in their infancy. We have been pretty successful trading it as well and use these pullbacks as buying opportunities. Most of us are up substantially on this one despite the recent volatility.
JNJ: After being one of the rare stocks to have an up year in 2022, it’s expected that the stock might take a breather to begin the year. They then unfortunately reported earnings in January that were below expectations, but as I write this, they announced a settlement in their baby powder lawsuits. The company has a long history of resiliency, does well in inflationary environments, and rewards shareholders with dividends and buybacks.

New Positions

DVN: Devon Energy is an oil and natural gas exploration company which focuses on onshore US production. Since the stock had a pullback due to a bit of a rough quarter, we’ve decided to start taking positions in it. It currently pays a steady 9.5% dividend with the potential for future stock price growth.

Sold Positions

None: We did not completely sell out of any position this quarter. We may have sold out of a position in your personal portfolio but did not across the overall firm.

[1] Source: https://pittand.com/2023/02/08/january-2023-market-recap/

[2]Source: https://qontigo.com/as-goes-january-so-goes-the-year-maybe-but-maybe-not/

[3]I say “similar” because we customize portfolios based on differing goals, risk tolerances, and timing of transactions. So, the size of positions and account performance, both in absolute and relative terms, will be different.

Content in this material is for informational purposes only and not intended to provide specific advice for recommendations for any individual. All performance referenced is historical and is no guarantee future results. All indices are unmanaged and may not be invested into directly.

The Standard & Poor's 500 Index is a capitalization weighed index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

The economic forecasts set forth may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Stock investing includes risks, including fluctuating prices and loss of principal.

Dividend payments are not guaranteed and may be reduced or eliminated at any time by the company.