There’s been a lot of bad news coming out of the financial sector of the economy these past few weeks. Amidst all these dark clouds, there may be a silver lining. First, let’s recap what happened recently.
For the last ten days, the banking sector has looked like it went back to 2008 all over again. Some banks have gone under, and others have been bailed out by the government and their bigger competitors. Poor leadership in these failed banks is, once again, the main culprit. But, this time, it’s a little different.
Back during the great recession, banks had a lot of bad loans and other sketchy assets on the books. When those loans couldn’t be paid back, all hell broke loose, and banks failed. Today, banks have much more solid balance sheets, with a big chunk of their deposits invested in long-term U.S. Treasury bonds. However, this became a problem for banks when interest rates began rising rapidly last fall. When interest rates go up, bond prices go down and long-maturity bonds are affected the most.
Subsequently, these long-term bonds that the banks held went down in price (lost value). Word got out about this and depositors wanted to get their money out of those banks, also known as a run on the banks. As you may or may not know, banks are required to keep a small percentage of total deposits on hand in cash at any one time to cover normal withdrawals by depositors. This works fine until there is a run on the banks, like what happened these past few weeks. So, banks had to sell those long-term bonds at a loss to raise cash, causing their balance sheets to implode. Now we have an idea of how these bank failures happened. Here’s where there might be some good news that comes out of all of this mess.
The Federal Reserve knows that there has to be many other banks that hold long-term bonds on their asset sheets and could suffer the same fate as the banks who have already fallen. So, this could be as good a time as any for them to pause raising interest rates. This would cause bond prices to go up and help stabilize the bond assets of banks, hopefully preventing more bank failures. Not to mention, it might help them from overshooting their inflation target and sending the economy into a recession, but that’s a discussion for another day. In any event, we will find out what they’re thinking this Wednesday afternoon when they conclude their next meeting. This is going to be an interesting week for the financial industry, to say the least!
Please comment or send an email if you have any questions. Thanks!
Joe Baker, CFP®
Baker Asset Management, LLC
