This Week in Episodic Pivots: March 19, 2023

The cause of this financial crisis... And why we're still holding off on new positions

Crisis averted! Well… Maybe.

We sat on the sidelines last week and didn’t enter any new trades. This was the prudent thing to do as we saw how the events unfolded around the bank failures.

But the Federal Reserve has found a way to paper over this problem. To explain what’s happening, we need to first talk about what brought down Silicon Valley Bank (SIVB).

The crux of it deals with interest rates and accounting principles. I’ll keep this short and sweet so we don’t lose anyone from boredom here.

Businesses Can Account for Bonds Two Different Ways

Any business that buys bonds has two ways they can record them on their balance sheet. The first way is to classify the bonds as “available for sale.” These are bonds the business plans to sell on the market instead of holding the bond until it matures. For these bonds, the business (or bank) has to record those bonds at their market price.

But there’s another way to classify bonds. This way is called “Held to Maturity.” These are bonds the bank plans to hold until their mature and get the par value of the bond back. Because the bank knows how much they will get when they dispose of the bond, they don’t have to adjust the value of the bonds due to short-term price fluctuations.

This is perfectly legal and falls under the generally accepted accounting principles (GAAP).

And this doesn’t create any problems… Until the Federal Reserve starts raising rates at breakneck speed. Remember, bond prices move inversely to interest rates. So when interest rates go up, the value of bonds go down. And longer duration bonds, those that don’t mature for a long time, get impacted the most.

Where Silicon Valley Bank Went Wrong

That takes us to SIVB. The bank had billions of dollars of deposits from their clients. But that cash wasn’t going to just sit on their books. SIVB invested those customer funds so they could get some extra income. They didn’t get greedy or anything, they invested in “safe” US Treasuries and mortgage securities.

The problem is that they had a fair amount of long duration bonds – the bonds that just lost a lot of value. So when their customers came asking for their money, SIVB had to sell off more bonds than they planned… And took huge losses on some of the bonds they had to sell.

Eventually, as the bank run intensified, SIVB didn’t have enough assets to pay out their customers. That’s when regulators took control of the bank.

This is bad management by SVB’s treasury department. They really should have hedged out their interest rate risk. Or stock with extremely short-term T-bills. So the bank deserves the treatment it’s getting. And so does any other financial institution that didn’t manage these risks properly.

And now investors are looking more closely at all companies that have large “held to maturity” balances. And wondering if that business could be in trouble too. That’s why we haven’t seen a bounce in regional banks yet. And also why other financials like insurance companies are taking a beating. Investors fear they may have to pay out more in claims than they actually have in reserves.

The Fed Has a Plan for Banks

But the Fed has the ability to help banks through this problem. The Fed implemented a program where banks can borrow from them while putting up their long-dated bonds as collateral. And banks can borrow the full par value against those loans.

Usually I’m a critic of the Fed, but this plan makes sense. There is nothing wrong with the bonds or the underlying holdings. Bondholders will likely get the full par value when those bonds mature. They just have a short-term drawdown in the value of the bonds.

This is why we see record borrowers at the Fed’s discount window.

So we are not about to see the collapse of the traditional banking system. At least not because of this. And also, the Fed won’t let the large, too big to fail, banks go under. They will prop those banks up and insure all their deposits.

For this reason, I believe the rally in bitcoin is overdone. The narrative right now is to buy bitcoin as a hedge against TradFi (traditional finance). But that’s ludicrous. If the TradFi system goes down, it will destroy trillions of dollars’ worth of capital. And bring down all asset prices with it.

And I also want to clear up one more misconception.

This Bailout Will Not Cause Inflation to Soar

That’s right. Inflation isn’t going to soar because of this bailout. All the Fed is doing is replacing current dollars that are already in the system. They’re not printing out more money and handing businesses checks for more than they had.

It is just to cover the already existing money. So we can call this whatever we want, many are calling it quantitative easing. And maybe it is. But I would say, just like QE didn’t cause inflation (I can prove that statement), neither will this.

Remain Nimble

Anyone trading the markets now needs to remain nimble. We should expect very turbulent markets as the financial world deals with the fallout from these banks. Just today, UBS bought Credit Suisse for $3.3 billion. That’s peanuts compared to the size CS used to be.

And The Fed plus five other central banks announced they would all boost liquidity in US dollar swap arrangements to help global banks that have transaction in dollars. This is commonly done when there are stresses in the financial markets.

The authorities are doing good work to keep the crisis contained. But they are pulling out all the stops. Eventually something will happen that they can’t fix. And that’s when the real problems will begin.

It’s unknown how long that will take. Don’t forget that in 2008, Bear Stearns failed in March. Lehman didn’t fail until September. And the market didn’t bottom for another six months.

We still have a long time to watch this play out. And just like in 2008, we should expect some turbulence in the markets the rest of the year.

To combat that, I think we’re going to start to implement profit targets for our positions. And sell at least half our position when we reach the initial target. This will help us lock in some gains and prevent us from given all our gains back to a choppy market.

No New Trades Again This Week

I just relooked through all the potential setups from the past week… And once again, I didn’t like any of the charts I saw. And while many of the potential episodic pivots ended up being back, those are too risky to purchase right now. If you really want to speculate on a strong and quick recovery for the banking sector, buy the regional bank ETF (KRE). That will get you some nice, diversified bank holdings.

Until next week, happy investing.