The
failure last week of Silicon Valley Bank (SVB), the second largest bank failure
in U.S. history, left me with an eerie feeling of déjà vu. It has troubling parallels to the chain of events
that launched us into the Great Recession nearly sixteen years ago. This is particularly unsettling since the
government supposedly passed tighter regulations to ensure we had no repeat of
that period of our recent history.
So
what happened?
SVB
had significantly grown its deposits over the last year or so. Ordinarily a bank can brag about that. But SVB served a clientele that included many
start-up tech companies that sometimes need to have ready access to their
deposits for their everyday expenses, especially when their business income
starts to drop. And in case you haven’t
noticed, the tech sector has been laying people off, even while other sectors
of the economy continue to add to payrolls.
So with income dropping, the tech companies needed more of their
deposited money back.
But
like most any other bank, SVB had invested in bonds in order to make some profit
from their depositors’ cash. When the
depositors came calling for their money, SVB had to start selling those
bonds—at a loss—in order to cover the withdrawals. The bank tried to raise money by other means,
but when news of that leaked, it spooked other depositors into asking for their
money back, even if they didn’t need it right away. SVB couldn’t meet the demand, and this led to
its failure.
I’ve
said for years (since the Great Recession) that financial regulations are great
for preventing the LAST recession. That
is, we examine what happened to cause the most recent downturn and then craft
regulations to prevent it from happening again.
Unfortunately, the knuckleball that knocks the economy down typically
comes out of left field, from something unanticipated. But this was nothing but an old-fashion run
on the bank, a 1930’s-type problem. And
yes, regulations are meant to prevent that, and there is the Federal Deposit
Insurance Corporation (FDIC) to guarantee deposits. But there are already murmurings about bank
regulators failing at their job when it came to overseeing SVB’s
operation. There were said to be some
red flags in SVB’s quarterly reporting leading up to last week’s events. I’m sure there will be lots of
finger-pointing in the weeks ahead. And
as for the FDIC insurance, that covers only $250,000 for each account. These tech companies had millions of dollars
on deposit.
I
relate that story here to illustrate a couple of points relating to personal
finance.
Banks
are not the only entities invested in bonds.
Many, or perhaps even most investors in the stock market have some
exposure to bonds. A bond, simply put,
is an IOU issued by a company or by a government. You buy a bond for, say, $1000, with the
understanding that you will be paid a certain percentage in interest while the
“loan” is outstanding. At the end of the
term, you get the $1000 back.
The
risks of a bond are mostly twofold: the company or government might “go under”
and they either can’t pay you the interest they promised and/or they can’t even
pay the loan back. Or more commonly, the
risk is that you tie up your money in a bond that is earning very low interest
while newly issued bonds are promising much higher interest payments. If you kept the bond until it matured (six
months, one year, one decade, or even 30 years later, depending on the bond’s
term) you would still get all your money back; you will have just not made as
much in interest payments compared to what else was available. But what if you needed the money earlier,
before the bond matured? In that case
you would have to sell it on the secondary market, and who will want to
purchase your older, low-interest bond when they can purchase a new one that
pays out much more in interest? If you
are in a pinch and need the money quickly, you will have to sell the bond for
less than it cost you, just to entice a buyer into taking it off your
hands. You would, of course, be losing
money. That is what happened to
SVB. Interest rates are going up currently;
SVB was stuck with some lower-rate bonds and had to unload them at a loss to
raise the cash to pay depositors. They
could not sustain the losses.
As
an investor, you can buy individual bonds.
To mitigate the risk of default, invest in U.S. Treasury securities or
in very stable, highly rated companies. But
you are still subject to the interest rate risk. As the rule of thumb states, “When interest
rates go up, bond prices go down.”
But
you can also invest in bond funds, similar to stock funds. These mutual funds hold the bonds of dozens
or even hundreds of different governments and corporations. This guards against the failure of any one
company having too large an impact on the investor. But bond funds are also subject to interest
rate risk. And the longer out the
average maturity date is for that fund’s bonds, the more susceptible it is to
interest rate risk and the resulting drop in the bonds’ value.
Bonds
have long been touted as a balance against the risk of owning stocks. Interest due to lenders (holders of bonds)
must be paid before dividends can be paid to stockholders, for example. And bond prices are less volatile than stock
prices and can provide a steady income stream.
Or so we are told. Last year was
a bloodbath for BOTH stock and bond funds.
This surprised some people, but it shouldn’t. The same happened during the Great
Recession.
So
now we face a potentially severe bear market.
Is the long-anticipated recession in our near future? What should you do to protect yourself
against it? I have some thoughts on
that….
First,
check your bank account balances to ensure you are fully covered within the
FDIC coverage limits. If you have any
questions, call your bank. Yes, the
President has said the FDIC will cover all SVB’s depositors for their full
balances. I’m sure that is to soothe the
nerves of the public. Don’t expect that
it could do the same for every potential bank failure if the dominoes start to
fall. And unfortunately, this kind of
extraordinary bailout (though the administration is loath to call it that) could
encourage further risky behavior by some banks.
Second,
don’t become desperate. Panic begets
panic. If the money you need to pay
bills is in the bank and fully insured, that should put you more at ease. And if your investments in stocks and bonds
are way down, again, don’t panic.
Realize it may get worse before it gets better because I expect a bear
market to develop/continue. Ideally, if
you are retired or otherwise in a situation where you need to withdraw money
from a 401(k) or IRA, you hopefully stowed at least some of it in a cash
equivalent account, like a money market fund.
That way you don’t have to sell stocks or bonds after they’ve lost value
in order to raise the needed cash. You
can afford to wait until they recover their value.
I’ve
been saying for three years now that a recession is coming. (I’ve GOT to be right one of these
days!). So I’ve kept a significant share
of my retirement savings in a government money market fund. The idea was that I would have that to draw
from when stocks were down, PLUS I’d have some cash available to buy some of
those greatly devalued stocks and bonds with the expectation they would go way
up again. That money market fund was
basically making only pennies in interest for me but is suddenly making over 4%
because interest rates are going up. But
now may be the time to pull money OUT of the account and buy some of the cheap
stocks and bonds that will become available.
It’s counterintuitive, but that’s how the great investors succeed: they
go against the crowd; they do the unexpected; they don’t panic. It’s not a bad model to follow.
Everyone’s
situation is different. Consult a financial
advisor for ideas for securing your own future.
If you are fortunate enough to be invested in a company-sponsored 401(k)
plan, you likely have free access to an advisor. It’s going to be a volatile market for a
while, but that could portend some great opportunities for those positioned to
take advantage of them.
Until next
time,
Roger
“The thing
that hath been, it is that which shall be; and that which is done is that which
shall be done: and there is no new thing under the sun.” Ecclesiastes 1:9
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