The Legacy Perspective - April 2023
by Steve Wachs, CFP®
Basketball was the “family business” as my dad was a college coach for over 40 years. March is that special month when even non-hoop fans cheer for their alma mater, colleges we didn’t know even existed defeat blue blood basketball power houses, and last-minute buzzer beaters provide thrills and heartbreak. Reflecting back on over 30 years in the financial planning and investment world, “March Madness” has been found to exist in the financial markets, and this past March was no exception.
From 2000 to 2003, dot-com companies busted, the tragic events of 9/11 took place, and the war in Iraq began. The S&P 500 declined almost 50% from March 2000 to October 2002, one of the longest bear markets in history. Markets then rallied into fall 2002 and optimism returned at the beginning of 2003 until March Madness - 2003 returned. Here’s the headline on March 23, 2003 - “Dow sees worst session in about 6 months on bets that victory in Iraq will be tougher than expected.”
October 2007 began the biggest bear market I have been involved with. The worst economic shock since the Great Depression took place as huge financial institutions went away and global financial markets seized up leading to what has been termed “The Great Recession.” The S&P 500 fell 56% from peak to trough. The Wall Street Journal headline on March 9, 2009, stated “How low can stocks go?” It was the lowest point of the S&P 500 since September 1996. March Madness - 2009 style.
March 2020. COVID entered our vocabulary. I was at an investment conference in Chicago - the flight there on Wednesday was normal. By the time I returned on Saturday, the plane was half empty and the decision was made to cancel the NCAA basketball tournament. No basketball March Madness, but a good dose of financial market’s March Madness as the S&P fell 34% in 36 days culminating in the low on March 23.
March 2023 Madness was marked by banking system troubles topping the headlines. Matt will unpack below what has happened so far and our thoughts on the future impact.
The rapid failures of Silicon Valley Bank and Signature Bank in mid-March brought back painful memories of the Great Financial Crisis (GFC) and renewed concerns about the integrity of the US banking system. While bank runs have happened before (and will happen again), we believe there were unique circumstances that led to these failures. Further, we believe the Federal Reserve has taken sufficient action to stem the tide of further failures through the creation of a new bank lending program.
Like the recent bout of inflation, these bank runs have their roots in fiscal and monetary stimulus stemming from the COVID-19 pandemic. According to the Federal Reserve, deposit balances at US banks grew an unprecedented $5.5 trillion (35%) from the fourth quarter of 2019 to the fourth quarter of 2021 as households and businesses were flooded with cash through a series of US government relief packages. With the economy shut down, households and businesses had enormous propensity to save and invest, which initially propped up the value of all financial assets and led to substantial growth in bank and brokerage account balances. With demand for loans essentially non-existent, banks invested these funds into what they deemed to be low risk investments such as US Treasuries and mortgage-backed securities. According to Fed data, banks invested more than $2 trillion into these assets over the course of 2020 and 2021. As inflation heated up and the Fed began to raise rates, the value of these ultra-safe investments declined by double digits, and in 2022 we saw the worst returns for bond investors since the Barclay’s US Aggregate Bond Index was created in 1976.
Rather than recognizing the losses on the value of these securities held, banks can elect to designate these securities as ‘held to maturity’. Theoretically, if you have the flexibility to hold a bond to maturity, you will get paid back the par value of the bond and thus never really recognize the loss in value. Before its demise Silicon Valley Bank had designated 43% of its assets as held to maturity securities, which substantially limited its ability to meet client deposit redemptions. The unique thing about Silicon Valley Bank is that many of its customers were early stage, private equity backed technology and healthcare companies with high cash burn rates. These companies were flooded with investment cash during 2020 and 2021, and Silicon Valley Bank benefited from a near doubling of its deposit base. As these early-stage businesses became concerned about the safety of their uninsured deposits, a bank run ensued. A similar scene played out days later at Signature Bank, which is also known to have a high percentage of uninsured deposits and a significant presence in the highly speculative cryptocurrency industry.
Why didn’t we see this scene play out at more than just these two banks? After all, most banks have seen the value of their bond investments decline and an increase in redemptions as households and businesses spend down savings and/or seek higher yielding savings options. The key reason the crisis has not spread further is that the Fed worked quickly to create the Bank Term Funding Program (BTFP). The program will provide eligible depository institutions with short term (no longer than one year) loans that can be used to meet deposit redemptions. Rather than selling the held to maturity securities mentioned above, eligible depository institutions can post these securities as collateral at par value with the Fed, eliminating the need for these institutions to quickly sell these assets and add further stress to the bond and banking markets.
So, what happens next? The financial sector, particularly the banks, look to have emerged from the bank run with more clarity on winners and losers in the current environment. While we cannot altogether rule out another run on smaller and/or less than well capitalized banks, backstops have been adequate to stem the spread of contagion across the system. If you happen to be at the top of the banking heap, those “too big to fail banks” like JP Morgan, you must be feeling good about all those deposit inflows and stability of your balance sheet. The other side to all of this is that lending activity has clearly slowed and those companies reliant on borrowing money to fund their business activities now sit at a sizable disadvantage with fewer institutions willing to lend (particularly acute for early-stage private equity and cryptocurrency companies) and rates sitting significantly higher than they were a year ago. This means even slower growth is likely ahead for heavily indebted or more speculative businesses.
Whenever “Madness” enters the financial markets, we know two things are true. First, it is our commitment to make sure emotions do not dictate investment action. We do our best work when fear is front and center. Second, having a logical, proven investment process is crucial. We prepare, we evaluate, and we make our best recommendations to help you maintain your path to financial independence.
Disclosures
Legacy Consulting Group is registered as an investment adviser with the SEC and only conducts business in states where it is properly registered or is excluded from registration requirements. Registration is not an endorsement of the firm by securities regulators and does not mean the adviser has achieved a specific level of skill or ability.
Information presented is believed to be current. It should not be viewed as personalized investment advice. All expressions of opinion reflect the judgment of the authors on the date of publication and may change in response to market conditions. You should consult with a professional advisor before implementing any strategies discussed.
All investments and strategies have the potential for profit or loss. Different types of investments involve higher and lower levels of risk. There is no guarantee that a specific investment or strategy will be suitable or profitable for an investor’s portfolio. There are no assurances that an investor’s portfolio will match or exceed any particular benchmark.