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Talk about Déjà vu… this week’s market activity brought back memories of the 2008 Financial Crisis in spades. We are referring to a potential bank failure and the potential domino effect it could have on other financial institutions. At least that is what it looked like on Wednesday and Thursday. In the last financial crisis, you may recall, toxic debt from shady mortgage back securities nearly crippled the banking system. To understand how it happened, we need to break down the operations of a bank.

At the most basic level, a bank takes in deposits in the form of savings/chequing accounts plus term deposits and pays their customers a set rate of interest. Governments require the banks to hold a certain amount of that money on reserve and then takes the rest and either loan’s it to third parties at a higher interest rate (think mortgages and car loans) or invests the balance in safe, liquid assets. Notice we say safe, liquid assets. Back in 2007, Wall Street managed to create the illusion of safe and liquid by turning junk mortgages in to “investment grade” securities and then sold them to every financial institution looking for a better return than T-Bills or Treasury bonds. Unfortunately, when mortgages started defaulting on masse, the value of the “investment grade” securities suddenly went to zero leaving banks with no assets to convert to cash in the event customers wanted their money back aka they became insolvent overnight.

The six most common words on Wall Street are “trust me it’s different this time” usually means something bad is going to happen again, and this week it almost did but for a very different reason. Remember two years ago when governments were handing out billions of dollars in cheques to anyone who said they needed money? Well, a lot of that money ended up in banks, especially ones that had a second line of business financing fast growing corporations that could be taken public and creating instant millionaires and in some cases billionaires overnight, regardless of whether the underlying companies actually made a profit. These banks earned huge fees along with added benefits like options that could be exercised shortly after their IPO. Their coffers were full of cash waiting to be deployed, but to keep it safe, they also bought huge quantities of government treasury bonds. Why not, interest rates were near zero and what could go wrong holding government bonds. At least they paid something.

Fast forward to the back half of 2022 and suddenly all those companies that were taken public and had huge buckets of cash, were burning through it like a California wildfire. Strike one. The banks relying on corporate finance fees suddenly found Wall Street closing the door to new offerings. Strike two. Interest rates skyrocketed and as everyone knows, as interest rates go up, the value of a bond goes down. Strike 3. Finally, just a whisper of financial distress for any reason usually results in a stampede of assets out the door. Just ask Credit Suisse. A month ago, the company announced net cash outflows of $149 Billion US in 2022. They will need massive injections of capital and new shareholders to keep it solvent. In this case, Qatar has stepped in with a big equity stake, but that is no guarantee it won’t be chopped up and sold to other global banks.

Closer to home (California) we have SVB Financial and its subsidiary Silicon Valley Bank. After receiving billions in deposits in 2020-2021, their investment banking revenue dried up and so did their savings and chequing account balances. And that is when the government treasury bonds came into play. As depositors took their money elsewhere, SVB had to start selling its bond holdings. Everybody thought those holdings were risk free because they are issued by governments, and they are… if you hold them to maturity. If you are forced to liquidate them early, you run the risk of capital losses and with short term interest rising at the fastest pace since 1980, foreclosures can occur, and it is why the California State regulators stepped in to prevent its collapse. Just prior to that, its parent company released statements that it was forced to sell $21 billion of securities and incurred a $1.8 billion dollar loss.

It also almost created a mini stampede this week as traders and speculators raced to reduce or sell off other bank holdings who might be in the same boat. Now sure you might be thinking that is crazy, US banks have been undergoing annual stress tests to ensure their financial strength can withstand another financial crisis and they have been passing with flying colors. But that did not stop investors from fleeing banks large and small this week. JP Morgan for example fell as much as $12 this week or roughly $35 billion in market cap and Citigroup fell just under $31 billion.

We do not feel this will create a financial contagion that spreads from one bank to the next, but it probably won’t be the only one. We forgot to mention another crypto bank (Silvergate Capital Corp) filed for liquidation after seeing $8 billion in deposits fly out the proverbial door. But both certainly highlight a potential vulnerability to consumer confidence and the rapid nature of collapse should depositors flee simultaneously. On the other hand, crisis also present opportunities as the whole sector goes on sale.

To make matters more interesting, part of the market sell off this week was the dawning realization that Jay Powell at the US Federal Reserve is focused on achieving a 2% inflation rate regardless of the consequences to short term stock prices. We were fortunate enough to see a slight blip up in unemployment despite 311,000 jobs being added to the US economy in February. It still caused US markets to fall a further 1% today, but it could have been worse. We think investors could continue to sell if next week’s inflation data comes in hotter than expected.

Cross your fingers.

Stay safe.

Steve Bokor and the Ocean Wealth Team.