GW&K Investment Review 1Q 2023
In one way or another, this banking crisis has affected us all. With multiple explanations from talking heads, I think it is important to understand the basic facts in simpler terms. Banks have a straightforward task: pay interest on the deposits made by customers and extend loans to folks who need to borrow.
Very simple. Take money in and lend money out. The amount of interest paid to depositors should be less than the rate charged to borrowers. The resulting spread goes toward the earnings of the bank. What can go wrong? Well, in the 2008 banking crisis, the big problem was poor-quality loans — particularly subprime mortgages — and the damage was intensified by counterparty exposure across the entire global banking system. That is not the issue this time around. Today’s loan portfolios are, for the most part, very solid.
A better comparison would be the Savings & Loan Crisis of the 1980s and 1990s, when a sharp rise in interest rates created a severe imbalance between funding costs and asset values, leading to the collapse of over a thousand thrift banks. The banks that failed in March got caught in a similar trap — they took in deposits and bought long-dated bonds to enhance the spread between what they were lending money for and what they could earn on their deposits. Their reasoning was simple — buy mostly safe, government-backed bonds, but juice the return by investing in longer duration (i.e., higher returning) maturities. As long as the securities were held to maturity, very little could go wrong. As we all know, however, the Federal Reserve began to aggressively raise short-term interest rates in an attempt to slow inflation. In response, the long end of the bond market sustained large mark-to-market losses. This had nothing to do with credit quality — when long rates rise, prices of all existing debt fall in value.
It didn’t matter that banks were allowed to carry bonds at cost. Depositors focused on the fair value disclosed in the footnotes and grew concerned by what they saw. And in this era of instant communication, an interconnected customer base quickly magnified the growing anxiety. Silicon Valley Bank lost more than $40 billion in a single day after depositors concluded that its portfolio of bonds had depreciated so much that its available capital would be unable to meet withdrawal demand. In the end, the Fed’s full-throttle tightening campaign transformed weak asset liability management into a full-blown banking crisis.
Even though the weaker banks had fabulous franchises, the big banks did not step in and rescue them. Why not? Because in the consolidation and rescue mission that took place during the global financial crisis, the “good” banks were dragged before Congress and had their heads taken off and, in some cases, had to pay fines for past transgressions of their acquisitions.
I hate to make this comparison, but I believe it is worth noting. Being responsible often leads to demise. If Muammar Gaddafi hadn’t given up Libya’s nuclear capacity, he likely would have remained in office. If Ukraine still had their nuclear bombs, Russia would not have invaded. Simple lesson — don’t give up your nuclear arsenal. No country with nuclear weapons has ever been invaded.
Why do I speak about a financial crisis and nuclear weapons in the same letter? Because scrutiny of those who try to act in good faith can often backfire. No bank today wants to spend months in Congressional hearings and have their decision to do the “right” thing examined under a microscope. So, while the big banks may be willing to lend to other banks, they do not want to buy. Like the nuclear umbrella that allows governments to stay in power, keeping your business isolated from failing institutions, even at the risk of further systemic fallout, is considered a rational choice.
Banking crises have been a part of the landscape my whole career. Whether caused by bad loans and excessive lending practices, as in 2008, or healthy but temporarily underwater asset values, as was the case this time around, there is always a Black Swan lingering out there. I was reminded of this when watching the recent Bernie Madoff series on Netflix, which details the roots of his Ponzi scheme. It was interesting to see how many “crises” have occurred since the early 1960s when Madoff began his efforts. We have good times and then we come crashing down and then we have good times again. Maybe that’s the story of capitalism. It works until it doesn’t. Abusive policies, both private and governmental, create difficult periods. Eventually, we recover and expand again. It goes to my unwavering conviction that both this country and the economy bends, but does not break. Once again, we will find a way out of this mess.
Capitalism and democracy certainly have flaws, but there is a self-adjusting mechanism to both. Twenty years from now, people will refer to these as “the good old days,” like we now say about yesteryear. But we all know those past years were full of fear and controversy. It is, it just is.
Harold G. Kotler, CFA
Founder-Chairman, Chief Investment Officer