In the last update, I discussed the various economic observations that go either against or in favor of a recession being declared in the near future. That was written a few days before the two recent regional bank failures, Silicon Valley Bank in California and Signature Bank in New York. These bank failures increase the odds of a recession. Let me explain.
These two banks will probably not cause other banks to fail due to “contagion” since they are smaller and more specialized than most large banks. However, the circumstances that lead to their demise are likely occurring throughout the banking industry, putting other banks at risk of failure.
When a bank takes in deposits, it only keeps about 10% available to service withdrawals. The rest of the money is invested and held as assets. They loan money out as mortgages and car loans and buy U.S. Treasuries. The bank makes money from the interest rate earned on those loans and treasuries.
Interest rates have increased dramatically in the past year due to the Federal Reserve raising the federal funds rate in an effort to curtail rising inflation. On longer-term treasuries, using a 5-10 year duration as an example, as the interest rate increases, the value of the underlying treasury or mortgage decreases. If the owner of the treasury waits the full 5 or 10 years, they will get the entire investment back. However, if they are forced to sell a treasury that they bought with a 2% yield when the going yield now on the same duration is 4%, they would have to lower the price significantly of the treasury they own so that the new owner gets the same yield.
This is what occurred with these two failed banks. A few years ago, when the economy was great and many individuals and businesses were making deposits and borrowing money at low rates, the banks purchased many treasuries. They bought treasuries and made loans at meager rates. Remember that the 10-year note yielded <1% just a few years ago.
Flash to today, the 10-year rate is just under 4%. People and businesses are withdrawing more money than they are depositing, as explained by the following. Start-ups and other businesses borrow less now because venture capital firms are not loaning out as liberally. Interest rates are much higher, and companies cannot afford to borrow as much. Items cost more due to inflation. For these reasons, bank customers are dipping into their savings to pay bills, pulling money out of the bank. More is being withdrawn from these banks than is being deposited.
There is another factor causing bank withdrawals. People and businesses have recently realized that they can buy government treasuries yielding 4-5%, much greater than what banks are offering for interest on savings accounts. More money gets pulled from bank accounts and goes into buying government treasuries.
The banks are experiencing withdrawals at a much greater pace than deposits. They must then cash in their assets before they mature in order to honor the withdrawals. This means they have to sell treasuries before they hit their maturity date. If the bank bought a $1,000,000 10-year treasury yielding 2%, and the yield is now 4% on a similar treasury note, they will have to sell it for much less than $1,000,000, losing several hundred thousand dollars. When people in the community hear about this, many will withdraw money from the bank and move it to a place they perceive as safer. The cycle repeats itself and gets increasingly out of control. This is an old-fashioned run on the bank.
This partly explains what recently happened at Silicon Valley Bank. The day before the bank was shut down, money was being withdrawn at the speed of $1,000,000 per minute. People no longer have to stand in line to make a run on the bank. This can be done with a click on the phone. Word gets out on social media, and everything happens much faster than it used to. This explains why the President of the U.S., the Federal Reserve, the U.S. Treasury, and the FDIC had to get out in front of this issue as quickly as they did.
After analyzing the news, I think these two bank failures are “canaries in the coal mine.” They are probably small enough not to cause a contagious event themselves. Still, the circumstances that caused loss of deposits and then material loss of income by forced selling of treasuries are likely being experienced by large and small banks across the country.
This problem was triggered by the Federal Reserve raising interest rates at the fastest pace in the history of the Fed. They now have to decide whether to keep raising rates to fight off the inflation we are all feeling or to pause, or even reverse and decrease rates, to prevent more banks and businesses from failing. Either way, we are heading toward a recession.
If the Fed continues to increase rates, everything we have to borrow money for (mortgages, car loans, and credit, etc.) costs more, forcing people to spend less elsewhere. That tactic should help bring inflation down but is most likely causing a recession, driving more banks and businesses to fail, and increasing unemployment. Alternatively, fewer businesses will fail if the Fed opts to reverse course and lower rates. Inflation could get further out of control, leading to a recession as people/businesses have to put more of their income into paying for necessities like food and shelter and cannot spend elsewhere.
The Federal Reserve is stuck between the proverbial “rock and a hard place.” They meet next week to figure out what to do with rates. They will likely take a pause or increase by 25 basis points.
What can you do with this information? Don’t panic. Don’t lose sleep over this. We know that is easier said than done, but your bank deposits are guaranteed by the FDIC up to $250,000. The government assured all deposits with Signature and Silicon Valley Banks last week above the $250,000 amount. What you can do is prepare yourself and take control of the things you can.
Prepare for the recession that we predict is on the way.
- Cut expenses to just the necessities for now.
- Spend less than you earn
- Generate some extra income to build financial resiliency
Use the MoneyWellth app to track your budget. Connect your accounts so you can see all of your accounts in one place—view areas to reduce top spending and find categories to lower expenses.