Think Nothing to See here Folks; The Economy is Perfect, RIGHT?

The financial sector remains under pressure following the collapse of Silicon Valley Bank and Signature Bank. Remember, these represent the second and third largest bank failures in U.S. history. Now that we know what happened, more important questions are being asked. Is your bank under pressure? What is the BTFP? What does this mean for the economy, interest rates, and of course, what does it mean for stocks? I'll answer those questions and a lot more. Stay tuned.

Welcome to another edition of We're Talking Money. I'm Phil Clark, and today we are working through implications that for some reason are not being discussed. One of the more important, perhaps, is the moral hazard. This term has been tossed around a lot. What does it mean? In simple terms, if you know there is a safety net, well, you're likely to take greater risk. If there's no repercussions, you will take excessive risk. That's human nature. The problem is it doesn't feel like excessive risk because you know the net is just below.

For example, interest rates were so low for so long they became the norm. People's behavior changed. Consumers were buying more than they could afford under normal conditions, and businesses were doing deals that probably were not very prudent under normal conditions. Silicon Valley Bank comes to mind. We can all agree low rates, they invited record amounts of venture capital to every party, which of course caused record deposits for banks like Silicon Valley. When times are good and money is cheap, common sense and business basics, somehow they just get left out of the equation.

Now, we don't have time to talk about why rates stayed at zero for so long, but I can tell you how they got there, and it goes back to 2010. The Federal Reserve, then under Ben Bernanke, pushed rates all the way to zero using quantitative easing, or QE. At its peak, the Fed was buying 120 billion dollars of U.S. bonds every month. That was driving down yields. Now, you might be asking, how can the Fed purchase its own paper? Most of us call that legerdemain, or in simple terms, cooking the books. Keep listening. I'll explain in just a few minutes what all of that means.

Anyway, given this catastrophic failure of late, should you be worried about systemic risk across the financial system? Well, President Biden and Janet Yellen just stepped up and said no harm, no foul. They did that to stem fear. In other words, they just enabled moral hazard. Why would they do this? No risk, folks, step right up, get your money, not one cent will be the responsibility of taxpayers. Are you kidding me? The government is funded by taxpayers, so how can anything they spend not be a taxpayer expense? Someone please help me understand that.

Turn the page, and we suddenly have the creation of something called the Bank Term Funding Program, or BTFP. This was to serve, or is serving, as an additional backstop with a maximum, keep in mind a maximum, of 25 billion dollars. Now, that sounds like a lot, right? Well, First Republic, which almost failed but is still solvent, so to speak, they almost met the same fate as SVB. They needed 30 billion dollars to stay afloat. That deal was brokered by guess who? That's right, Janet Yellen and company, and she was able to do a deal with big banks who have stepped in to save First Republic.

But why would those highly competitive heavyweights do such a thing? Example: the Fed can't afford to save everyone, and bank runs are more likely if another domino falls. In fact, some reports are suggesting nearly 200 banks are at risk, with uninsured deposits of some 300 billion dollars. Suffice it to say, the BTFP is another Band-Aid. Then again, our government's been kicking the can since 2010.

So what does this BTFP do exactly? Well, in simple terms, it lends money to banks that need cash to meet withdrawal demand that exceeds what the bank has on hand. In other words, it keeps a bank from being forced to sell its bonds at a huge loss like Silicon Valley Bank. Now, banks will have to use their bonds as collateral to participate in this program. Herein lies another problem. The BTFP is a lending program that says banks pledge their securities, borrow money to pay depositors, and pay back the loan within one year. The idea is their bonds will regain value before the end of the 12-month term. If so, voila, no problem. If bonds do not regain their value, this plan is dead on arrival.

I urge everyone to consider there could be broader implications for the financial sector, and your bank could be at risk. Why? Well, the depth of two banks collapsing and a third being bailed out by Wall Street, it brings to light the fact that banks have been paying depositors much less than competing short-term vehicles do. Banks are generally at the moment paying about a half percent or so on deposits, compared with four and a half percent on the average for money markets, and treasuries at least temporarily have exceeded five percent. How long will depositors accept this disparity? Only time will tell.

For my review, banks need to regain consumer confidence. It has been lost quickly. They will have to start competing for deposits, partly by paying higher rates. But paying higher rates means deposits could eat into net interest margins, which will impact significantly the profitability of banks. If banks are less profitable, the risk increases on several fronts, including the entire financial sector. If banks refuse to pay higher rates, depositors are more likely to withdraw their money in search of better performance and maybe safety. Hence, the potential for bank runs is not over, not even close.

So even though SVB may not lead to systemic type risk, lasting repercussions for the financial sector, in my opinion, are probable. And we haven't even mentioned Credit Suisse. They are a huge threat because they're much more than just a bank with deposits. They are interconnected with far-reaching derivatives, credit swaps and other risky assets.

Now let's talk about potential implications for the Fed's rate hike cycle. As I said in last week's show, the Fed usually keeps raising rates until something breaks. Back in 2007 and eight, it was subprime mortgages. Today it's SVB and Signature Bank. There is a lot for Jerome Powell to consider. This is the smack of being between a rock and a hard place. He will be speaking on Tuesday and Wednesday, March 21 and 22, and we're going to soon learn if more rate hikes are imminent. SVB and the creation of the BTFP could very well mark the breaking point for this Fed cycle, or the Fed will not waver from wrestling inflation down to its target of two percent. You can bet whichever way he goes, there will be implications for the valuation of all assets, including stocks.

On the one hand, inflation remains too high and employment is at multi-decade lows. Now, both of those suggest more rate hikes. But now the Fed needs to create a liquidity backstop to solve a problem that is very much a byproduct of the rate hike cycle. What happened at SVB speaks to the overall asset liability mismatch, we talked about that last week, that is now happening for many institutions.

Remember, banks borrow from depositors, that's you and me, at the short-term end of the yield curve, and they lend, making loans at the long-term end of the yield curve. Now, under normal conditions, short-term rates are lower than long-term rates, so banks keep the difference between the short-term rates they pay and the long-term rates they earn on those loans. That's called the spread. But currently, as you probably know, the yield curve is inverted, with short-term rates significantly higher than long-term rates. This inversion is one hundred percent Fed induced.

Remember a few minutes ago I mentioned cooking the books? The Fed's constant money printing after 2010, taking money out of the left pocket, printing, and putting it in the right pocket, buying its own bonds, that drove down rates. And closing an economy during COVID, followed by extreme free money campaigns, all of that created relentless inflation. Thus the byproduct: rate hikes like we haven't seen in decades. In turn, banks are underwater with bonds that are severely undervalued. And there is one more potential asset that no one's talking about. Many banks today are holding cryptocurrency, and cryptocurrency is down some 60 to 70 percent in the last 12 months. What I'm saying is bonds are just one problem for banks.

Now we'll close with how this may affect investors and stock portfolios. Zooming out, the macroeconomic argument has to be considered. The stock market and bond market for much of 22 moved down in lockstep. This was a clear change of character for stocks and bonds. The Fed's tightening cycle was ripping through risk-on and risk-off assets, signaling the end of easy money. And boy, it has been easy since the Great Recession. We've enjoyed that cheap money for a long time, but now we might have to pay the price. Inflation remains stubbornly high, and now we have a banking crisis that makes the Fed's decision even more important. This could be the beginning of a much more ominous outlook.

Just a few months ago, we were focused on models that supported a new bull market. On the other hand, many are in the camp that believes 2022 represents another viable long-term dip, like 2016 and 2018. Moreover, this camp assumes that the Fed will pivot now and hopefully reduce further market volatility or downside.

Let me put it this way: there is risk in either scenario. Continuing to raise rates will likely get the Fed to its target inflation number of two percent. This is good for consumers because everyone's wallet needs a break. Remember, a few weeks ago we talked about consumer savings being down and credit card use continuing to increase to record levels, and wage growth is below that of inflation. The flip side is, however, continuing to raise rates is probably not good for the stock market.

Now, if the Fed pivots and they start lowering rates, the outcome is different but not necessarily better. First, inflation could easily start heading higher. In fact, we saw this in the February CPI report, where inflation was down year over year but up month over month. This means consumers could continue digging themselves into a deeper hole with lower savings, higher credit balances. Stocks, however, would probably get a boost, and the yield curve would have a chance of normalizing naturally. This would be welcome news for underwater banks. Jerome Powell at this juncture must decide: is he fighting inflation or saving banks?

For now, we believe the downside risks are greater than the upside. If you are a long-term investor and don't plan to use your investments in the near term, you might not need to make any changes. On the other hand, if your horizon is shorter and you're reaching retirement, or maybe the distribution phase of your portfolio, it might be smart to speak with your advisor. If you don't have one, talk to one of our advisors. We have a Second Opinion Solution that's been very helpful for many investors who simply want to be sure. They want that second opinion. It will either reiterate that what you're doing is right, or it will illuminate blind spots so that you better know where, or better understand where, weaknesses might exist. You can then make adjustments.

Now, I hope this edition of We're Talking Money provided you with some information that's useful and inspiration to take a closer look at your situation. If you enjoyed the content, please like, share, and consider subscribing to our channel, and don't forget, ring that bell so you never miss an episode. I wish you a blessed day, and I'll see you next time on We're Talking Money.

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