A Critical Stock Market Risk Is Back – Deteriorating Trust In The U.S. Banking System

Four weeks ago, it looked like a new bull stock market was emerging. Then came the revelations that a couple of large banks were suffering depositor runs. To prevent a spread of doubt and fear throughout the banking system, the Federal Reserve and FDIC decided to insure all deposits for both banks. With fingers crossed, they suggested the problem was solved.

Last week, the stock market see-sawed between “it’s all good” and “oh, oh!” So, what’s it going to be? Examining the balance sheets of the two banks and the others that Wall Street has jumped on reveals the common problem: Too many deposits at risk of running with too little liquidity to meet the outflow. The picture includes some or all of three risks:

• First, large amounts of uninsured deposits. The organizations and wealthy individuals behind these are the depositors most likely to jump ship at the sign of trouble. This is the major risk that the Fed and FDIC are attempting to control.
• Second, large amounts of assets invested in longer-term bonds. The prices of these dropped significantly as interest rates rose. Since banks often classify these longer-term bonds as “hold-for-maturity,” they are carried on the books at cost, not their actual, lower market values. Therefore, reclassifying them as “available-for-sale” (or simply selling them) means having to take a large loss.
• Third, large amounts of loans and leases that are not readily marketable. This is the business of banks, so it’s normally not a problem. However, when the first two issues exist, these illiquid assets mean the liquid-assets-to-deposits ratio is that much smaller.

The element of surprise is working against the Fed’s and FDIC’s hopes

Looking at the balance sheet of Silicon Valley Bank, the primary first hit, reveals a huge hole in Wall Street’s bank analytical process. The bank’s large deposit growth and participation in the technology and venture capital areas produced an aura of success. Add to that the complacency shown by the largest depositors (like Roku’s enormous deposit of almost one-half billion dollars). Then, when the initial deposit outflow started, the three risks became exposed and the run quickly gathered speed (a run is always speedy). The bank attempted to have Goldman Sachs help find others who would provide needed funds, but no luck – who wants to climb aboard a sinking ship?

So, the Fed and FDIC insure everybody to try to keep depositors reassured. Will it work? No. Why would it? In all the other banks that don’t have that blanket “insurance,” the $250,000 limit is a strong incentive for the uninsured depositors to find alternatives.

Then, there is the other shoe waiting to drop. Wall Street analysts are busy recalculating risk, and we can see their results in both the decline in bank stock prices generally and the large differences in the declines bank-by-bank.

Then, there is this disturbing truth

Banks periodically board the same train, powered by a popular strategy. Then, when the strategy jumps the tracks, many (most?) banks are injured, albeit by different amounts. That could well be what we are seeing now – an undermining of the strategies developed during the Federal Reserve’s near-0% interest rate policy. The previously accepted actions of attracting large depositors, pursuing minuscule yields on longer-term bond holdings (presuming the Fed’s low rates were here to stay), and building a large loan and lease portfolio with the increased deposits.

As a result, banks are trying to figure out how to retain large uninsured deposits and how to rebuild liquidity. Selling the longer-term bonds in the held-to-maturity category means taking large losses that could harm their capital ratios, produce low or negative earnings, resulting in their boards nixing dividend payments until things straighten out.

Meanwhile depositors are getting educated, once again, in how banks are not always trustworthy.

The bottom line: Cash is king – once again

Now looks to be the time to return to cash. Bond risk is back up because of yields being back down. The Federal Reserve is unlikely to drop their inflation fighting with a decrease in interest rates.

As to stocks – they are the canaries in the mine, and they are coughing again. So, it’s back to sitting on the sidelines and seeing how this bank mess gets cleared up. In the past, when a general bank strategy came undone (e.g., previous fads regarding leases, commercial real estate, residential real estate, and derivatives), it took a while. The bank stocks first declined to “value” pricing, then dropped further to “avoid them” bottoms.

Disclosure: Author sold stock holdings and now holds 100% cash reserves.