Clear as mud

Foreword

If you haven’t been hiding under a rock for the past ~5 months, you’ll know that there has been a bit of a kerfuffle in the regional banks, leading to 3 very dramatic bank failures, and a lot of uncertainty in regional bank stocks. What gives?

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Banks, why’d it have to be banks?

If you follow me on StockClubs (1), you’ll know that I basically never buy bank stocks. There is a fairly straight-forward reason for this — banks are weird. Everything about them is weird.

Because of the nature of their business, they have very different accounting rules compared to regular companies. They are also allowed ridiculous amounts of leverage. And finally, because banks are run by, well, bankers, and bankers are really good at finance, it sometimes (frequently?) occurs that the financial statements put forth by banks are, shall we say, less than transparent.

Which is to say, a bank’s books and financial statements are clear… as mud.

And because I don’t like buying things I don’t understand (2), I generally don’t buy bank stocks.

Drama

Which brings us to the happenings since the start of the year. Or really, since around the middle of last year. As discussed in “Safest Money“, essentially all banks have been taking it on the chin on their portfolio of bonds and loans, due to the rapidly increasing interest rates. This is particularly true for regional banks, because they tend to hold the loans on their books.

Holding loans with 2-3% interest rates on your books are good when you are a bank and can get capital (via deposits or via borrowing from the Fed) for 0-1%. You pay out 0-1%, you take in 2-3%, and the difference you pocket.

Holding those loans when interest rates are at 4-5%, however, is not quite as good, as Silicon Valley Bank, then Signature Bank and, more recently, First Republic Bank found out to their detriment.

At the same time, the news outlets have been having a blast, blaring out scary headlines about the blow by blow of which banks are having trouble, what the Fed/FDIC officials are talking about behind the scene, and which banks may be next. Accordingly, the stock prices of essentially all regional banks have been behaving like the electrocardiogram of someone having multiple heart attacks, at the same time. All very not-pretty.

Banking

Throughout all this drama, it’s natural to ask — are banks safe?

My personal opinion is that, as a whole, the banking industry should be fine. Most people simply do not pull money out of banks and stuff them in their mattresses. Instead, most of the money withdrawn are, almost immediately, shoved into another bank — there simply isn’t enough physical cash in circulation for everyone to withdraw.

What about those folks who take their money to buy assets like stocks, bonds or money market funds, you ask?

Well, every transaction has a buyer and a seller. The buyer gets the asset, and gives the money to the seller. And the seller (generally) promptly puts the money into… a bank.

So, collectively, it is very hard for money to escape the banking system (3).

That said, while banks, as a whole, should be fine (4), individual banks may drop like flies as we’ve witnessed in the past few months, because…

Irrational

… the situation really isn’t about rationality anymore. If you have under $250k in a bank account, the probability of you losing money is essentially 0. Even if you have more than that, the FDIC has shown that they are willing to go to extraordinary lengths to prevent depositors from losing even $1. While that guarantee is not set in stone and they may relent at any time, it seems that providing the safety net, at least in the short term, may be the only way to prevent contagion, so short of some really dramatic changes to the circumstances, I don’t think the implicit guarantee is going away anytime soon.

Which is to say, most of the action in terms of bank deposit flight, seems to be mostly due to irrational fear.

As for banks’ stock prices, the past few days have been a whirlwind of crazy — it simply doesn’t make sense for (at least on paper) profitable banks’ stocks to drop 60% and rebound 100% in the span of 24hours; Either the sellers are wrong, or the buyers are wrong. They can’t both be right.

So, while depositors should mostly be OK (4), shareholders may find their shares of various regional banks turning into donuts overnight, and often with very little fundamental reasons.

Systemic?

The thing to watch out for, is if the situation becomes systemic. As some may remember, the 2008 Great Financial Crisis was essentially a banking crisis, and it was not pretty.

That said, be very careful about the scary headlines. It is true that the 3 banks that just went down were the 2nd, 3rd and 4th largest banking failures ever in US history. But that fact sounds more ominous than it really is. The fact of the matter is that the US banking system is dominated by 4 very, very large banks, and thousands of, well, not very large banks. According to Bankrate, Wells Fargo, the 4th largest bank is more than 3 times larger than the 3 failed banks combined, and JPMorgan Chase, the largest bank in the US, is almost twice the size of Wells Fargo.

To put it simply, while it certainly isn’t good that medium size banks are failing, the situation isn’t quite as dire as some are making it out to be.

Even more importantly, the underlying problems in 2008 were bad loans — back then, many banks made loans to folks who simply could not possibly pay back the loans. As a result, there was a serious solvency crisis, as well as a serious confidence crisis — nobody knew which loans were good or bad, so nobody knew who was going to take massive losses, and thus nobody trusted anybody, resulting in a deep freeze of the financial system.

This time around, the problematic loans in question are mostly Treasury bonds, literally the safest security on Earth. The issue isn’t one of solvency, nor one of confidence — every bank’s holding of Treasury bonds are reasonably well documented and nobody is really worried of a Treasury hard default. The issue is one of liquidity — the affected banks simply do not have enough cash on hand if there is a severe bank run.

Given that the underlying assets backing the banking system are mostly safe, the installation of new federal backstop via the BTFP, and the willingness of larger banks to scoop up rivals at a huge discount (5), the chances of a systemic crisis seems slim. Though, again, shareholders of some banks may find a lump of coal in their stockings in the next few months.

Footnotes

1. Disclaimer: I am an investor in StockClubs. Also, as of publication time, only 1 (out of 10+) of my brokerage accounts are linked to the app.
2. They make me feel inadequate.
3. There are some exceptions, for example reverse repo operations with the Fed, etc. But those are generally not available directly to retail investors. Also, according to the Fed, the amount of money parked in reverse repos hasn’t really moved that much since the start of the year.
4. To be clear — banks (collectively) should be fine as long as the current situation remains a liquidity and duration mismatch crisis borne of interest rate risks. If this morphs into a insolvency crisis because of bad loans, then things will be very different.
5. JPMorgan Chase’s CEO, Jamie Dimon, was noted to be bragging about the sweetheart deal to his shareholders.