Bank Failure, Recession – What Is Happening

 

        I am composing this blog while listening to 5 songs, playing loudly, Living the Dream by Foreigner, Demolition Man by Sting, Bang a Drum by Jon Bon Jovie, Wheel in the Sky by Journey, and Dr. Heckyll & Mr. Jive by Men at Work. Mainly because they sound good loud, better louder, especially with more bass. The lyrics are a good mix of some of my feelings regarding the economy, economic policy and the people playing the various roles in this current economic play (especially Bang a Drum).

                I haven’t said anything for a few weeks as I was waiting for the news noise to settle down and we can pick through the points in a more reasoned manner.  The Associated Press article titled Fed raises key rate by quarter-point despite bank turmoil by Christopher Rugaber (3/22/23) is a good summary of the past several weeks and may hold some insight into future activities. I have put a link to the article at the end of this post.

                First, bank failures. The problem is 3-fold. One, with the Fed raising the Fed Funds rates and attempting to dry out the economy by removing money from the economy, all borrowing costs have increased as well as interest rates on all new debt instruments. Treasury rates have changed wildly and are higher across the board. Don’t worry about short term vs. long term differences, just know all rates are up, up a lot. The purpose is to remove money from the overall economy so that too much money is not chasing too few goods (one of the basic definitions of inflation). The higher rates affect you in many ways but especially if you have old bonds (bonds at old, lower rates) and you need to get the principal before the bonds naturally mature. Remember, interest rates and principal value are inversely related. If rates go up principal value goes down. However, this only happens if the bonds are sold before their maturity date. If the bonds don’t need to be sold early then no foul, no harm. When they talk about bonds losing or gaining value it only relates to having to sell them before maturity. It’s only a paper change based on current conditions. It is a way of looking at current opportunities vs. what was spent / invested previously. If you have an existing, older mortgage you are saying, boy what I deal I got. If you are looking at invested funds you are saying I wish I had my money free right now because I could earn a lot more if I invested now. You don’t owe any more interest on your mortgage or have fewer dollars coming in from your invested bonds. Now, if you need to borrow new money or invest some current excess funds then the current rates will apply. That is where you will see the impact of higher rates, on any new debt you want to acquire or new investments which will give you more earnings. If, however, you need to get the money out of your current investments you will have a problem which is what all the current news is talking about as lost money. Remember, there is an inverse relationship between rates and principal, as rates increase, principal decreases and vise-versa. In order for you to get your money back early (i.e., sell your current debt/bond) someone else will have to buy it and they are not going to want your old interest rate bond because it has a lower interest earnings rate than what that person can get if they were to take their money into the market today and buy a new debt instrument. In order to make it attractive to the new investor you need to make your old debt equal to the current debt they can get. Debt is equal to the value of the stream of remaining interest payments plus the principal payment. So if the interest payments are lower than current interest payments you have to take less principal to make up the difference (not quite that simple because compounding is also included). So, if current interest rates are higher and you have to sell your old debt then you will get less than the stated principal to make up the difference. If you were counting on that total principal amount you now have less.

                That leads to the second part of the bank failure problem. Banks make money by lending out their deposits and funds to borrowers (no problem). Banks learned a long time ago that they can’t lend all their deposit as they need some funds to cover regular transactions. If people can’t get their money in a timely fashion they won’t invest in the bank. The Fed has set various rules for how much banks must maintain in cash and cash equivalents to meet short term demand. (A discussion for another time is why does the Fed have to set the rules thus removing the need for banks to be their own monitors. That is why we have too big to fail banks and other problems, banks aren’t responsible for their poor decisions because the Fed picks up the responsibility, and cost.) One of the cash equivalents allowed by the Fed is the bank can hold Treasury bonds and high quality municipal debt (bonds). The bank should always be monitoring the impact of changing rates and if rates are moving then what is the value of the principal if the debt has to be sold immediately (can’t wait for maturity). Usually the bank will “hedge” the debt meaning they have various financial products that will allow them to cover the loss in having to sell before maturity. These instruments are not perfect and can have problems themselves.

                The third part of the bank failure. Silicon Valley  and Signature Bank had depositors that included venture capitalists and other very sophisticated investors. The investors realized that the bank was either not hedging their funds properly or had lent out too much in relation to what they needed to cover their short term needs. The investors fairly quietly started taking their deposits back. Problem is many watch venture capitalists very closely. It took only a few days for a run to start on the bank meaning not just a few but lots of people want their money back, now. The bank had to sell their cash equivalent funds (because they didn’t have enough cash) which were in treasury bonds, considered very safe (and they are because the federal government will always pay what they owe) but they had to sell in a rising interest rate market. Investors won’t pay the full principal amount because interest rates are higher than the rates on the bonds. Hence, less principal coming back. The bank sold something like $21 billion in securities and lost $1.8 billion. They needed to make up the difference and tried to sell new stock to raise it. That sent more shockwaves through bank customers which led to a run on the bank. No one wanted to buy the stock. The bank was overwhelmed by withdrawals and couldn’t meet the demand. The Fed stepped in and closed the bank.

                Many are suggesting that the Fed’s interest rate policy led to the bank failures. High interest rates certainly caused the problem of the lost principal when the bank was forced to sell before maturity. The bank was supposed to be monitoring such things. According to reports, the bank’s mix of securities and cash was substantially different (worse) from industry averages.

The Fed this week increased the Fed Funds Rate by only 25 basis points, recently it was expected to be 50 basis points. There is news noise that the Fed should stop, increase, change. There are calls for Congress to do something (more regulation), again news noise. There may well be new regulations but let it sit a bit before you start looking / commenting. Previous Federal policies and regulations made much of this mess, they may or may not be able to do some good. I am not particularly hopeful but one never knows. There is much noise around the Treasury and Federal Reserve’s move that guaranteed all deposits not just those of $250,000 or less (FDIC insured) at the failed banks. That move was to keep the bank runs from spreading to other banks. It seems to have worked at this point but things are still dicey in the banking sector. Questions are being asked about what other banks may have similar situations to SVB and Signature bank. There have been rumblings in other parts of the country. We have had many public officials making official public announcements. Remember news noise, we don’t know yet in spite of all the words. Back to the guaranteeing of all deposits. That releases all responsibility of the banks and the big depositors. The system wasn’t designed to cover those types of costs. Biden and Yellen have promised that taxpayers won’t cover this cost. There isn’t enough money in the FDIC funds to cover the cost of insuring those uninsured deposits. The insurance premiums are collected from bank fees to all banks. You and I pay those fees. I don’t see how we aren’t going to pay the costs. Unless public officials come up with some other plan, we can hope they will. Now we have another precedence set for banks to rely on the Federal government to bail them out, tying them closer still to the government.

                A recession is still very much on the table. The Fed needs to balance the problems caused by tighter policy (higher rates) with the expected problems generated by those policies, yes expected (the problems aren’t new). They also include stalled growth (which is needed but how long might it last), increasing unemployment, higher borrowing costs. Markets really, really hate, loth, fear, you name it, all this uncertainty. They don’t like it and tend to rebel (do things that the Fed isn’t expecting or prepared for – like bank failures). Expect to see this continue. It’s all part of the process. Remember, we have survived this sort of thing before (recession). It is NOT the end of the world as we know it. It is NOT going to go on forever. The sky is NOT falling. (Things you will hear in the news noise.) It is part of the process of getting the economy back on track and working better. It is going to work, it has worked before and it will work again. Hang in there. Remember what is important and that important things are NOT found in news noise. They are found in friends, family, loved ones and enjoying life. It is doing things together and learning new things. It is in seeing all the beauty around us and enjoying that. It is found in loving and caring more.

            I am now stepping off my soapbox and turning down the music volume.

AP news article -

https://apnews.com/article/federal-reserve-inflation-banks-interest-rates-jobs-91a9185ebce972bbf5ab1f46654f1a53

Hang On For A Rough Ride

                  As the old saying goes, hang on, things are likely to get a bit rough. I have pulled financial news articles from the past week or so. Financial thinking has been fairly consistent for the past weeks and the most recent 10 days have been fairly typical. By consistent I mean, lots of uncertainty, markets and thinking are moving up, down and sideways most all of the time. Nobody really knows much of anything but there is lots of noise.

First, a good article from Think Advisor (10/24/22) concerning the annual meeting of the Securities Industry and Financial Markets Association (SIFMA), an organization I subscribe to and is very much an industry standard. The meeting is attended by many big wigs from finance and government. Janet Yellen, secretary of the Treasury, spoke at the meeting (more on that later). One of the panel discussions included several business economists discussing inflation and recession among other things. Several are now predicting that there will be a recession in 2023. The participants listed several factors supporting their conclusion. The factors are the same as have been discussed before, inflation being the 800 lbs. gorilla in the room. The article gives some good comments and supports for their conclusions. Much of the current discussion involves estimating and second guessing the Fed and its inflation response. Since the 1970s and Alan Greenspan’s solution to inflation the Fed has been terrified of any type of uncontrolled inflation. The solution in the 1970s just about destroyed the US economy before it corrected itself. Corrected itself is also correct, Alan Greenspan and the Fed did not fix the 1970s economy but they made it possible for it (the economy) to rebalance itself – governments and individuals don’t control economies in spite of what they say, economies control governments and people. The Greenspan solution was one that worked or at least that was what governmental and financial think tank gurus came up with that worked, and it did work. Governmental officials and politicians ever since then will do just about anything to avoid that situation again. The problem is that much of the fiscal and governmental policies of the past 20 years have been such that it supports inflationary growth. Then the loose money supply accompanied with artificially low interest rates (yes, dear reader, rates have been artificially low for 20 years, held down by direct intervention from the Fed which allowed government to pursue its various expansionary agendas) got away from the governmental people as it had to do. The low interest rates and expanding money supply couldn’t go on forever but for 20 years governmental types have been kicking that can down the road until now. That is why the current administration is howling that the current inflation isn’t their fault but they are willing to add to the problem by increasing governmental spending by unprecedented amounts which is very inflationary. Hence, trying to kick the can down the road again but the financial system has reached its limit. Goods and services are not able to absorb the excess funds without adjusting and that means prices have to go up, in this case way up, way fast (the basic definition of inflation) as we have seen in the last 8 months. That is why the big concern. This looks a lot like the inflation rates of the 1970s. The cure is of course, recession, the rapid deceleration of spending and the removal of the excess money from the system. It would really help shorten the recession and cause it to be less severe if government curtailed spending, reduced governmental needs and did not fund new programs without also including revenue sources (net funding). All of which the current administration refuses to consider but instead is increasing spending and unfunded programs. We have to wait for price increases to begin to slow or stop (in spite of the governmental spending headwinds) as supply and demand are brought into closer alignment, i.e. demand does not outstrip supply and so prices are normalized and we don’t have too many dollars chasing too few goods. We have to weather inflation as price and supply try to find some sort of new equilibrium. I am afraid inflation hits very unevenly in these situations. It is inherently unfair, unjust and unkind. 

                Again, the mechanism to get inflation under control or rather, under more control is to dry out the excess money from the economy and that is done by making money more difficult or expensive to acquire and use. It has to cost more. The interest rates we pay is the control mechanism. Hence, the Fed Funds Rate helps increase or decrease what it costs to borrow and use money. In the second article by Reuters (10-24-22), Yellen is trying to make the point that the Treasury is aware of the problems of drying out the economy and at least in the area she has some control over is attempting to assure the financial system that the government is willing and able to keep one of the major secondary problems caused by inflation at bay. The problem is that as the cheap money (low borrowing costs, relatively speaking, caused by very low interest rates) dries up, investors become unwilling to speculate and began to draw their funds out of banks and financial institutions and put it in safer places such as Treasury instruments or cash (again safer is relative). Banks and financial institutions use leverage to earn additional profits by using borrowed money to invest. You take your money, they have to go find money somewhere on a short basis to cover your withdrawals. In the great recession of 2008 there wasn’t enough liquid funds available to meet the withdrawal needs and the government bailed out many financial institutions by printing more money among other things and almost wasn’t fast enough in responding (TARP if anyone remembers). Several big financial firms didn’t survive or were absorbed. Yellen is trying to tell the markets she is aware of the situation and it is under control which may or may not be accurate but we can hope.

                The Bloomberg article of 10-21-22 is a discussion of what Fed Funds Rates may be and why or why not. There is some speculation that Fed Funds rates may need to be as high as 4.75% - 5.0%. The Fed is trying to give the impression of controlling inflation and the financial institutions are trying to act like the Fed has some control. Both are incorrect. The Fed can’t “control” inflation and financial institutions are not really supporting the Fed but trying to find any place to hide away from the train wreck that is coming. As an aside, the financial economists are having a heyday because they can predict just about anything and there is a pretty good chance they will be correct at some point, for a change. Watch to see who claims they got the forecast right and what part of the forecast in the next 18 months or so. I need to flog a dead horse again. The Fed can not control inflation with any kind of fine tuning. Watch and see, at the very most they can nudge the inflation rate around. The Fed will get this whole process wrong (as measured by various financial institutions, markets and money gurus). But they may be able to influence inflation to some extent. According to the people in the know (don’t trust the people in the know), the Fed started raising the Fed Funds Rate to late or too early, they will not raise it fast enough or they will raise it too fast, and they will overshoot how high and for how long rates need to stay up and they will either not decrease rates fast enough or too fast on the back side of things. They will not be able to stop the inflation rate from gyrating all over the place, both up and down and they will likely completely miss their target inflation rate of 2.0% by a wide margin. The final solution to the last point will be that the Fed will change the target inflation rate to something other than 2.0%. In two years the Fed will declare that they beat inflation and it is now tame again at whatever rate they decide on. Again, not accurate (notice I didn’t say not true) as the Fed never has really been able to control inflation but rather sets a rate (for the last several years, 2.0%) that somewhat matches the ongoing economic activities. There will be more articles about the Fed and its “fine tuning” the Fed Funds Rate in the coming months. Don’t be fooled by the noise.

                The final article is a bit of fluff about the resignation of Prime Minster Liz Truss (Britain) after just 44 days in office. She has the distinction of being the shortest serving prime minster in history. Many of her problems were caused by very aggressive economic policies that were considered too radical for the times. Just a reminder why governments tend to be slow and ponderous in their decisions and a good example of why we have had 20+ years of expansion in this country. It is too politically difficult to change things and who wants to rock the boat, even if it needs it until there is some kind of popular uprising that is consistent with the political leaders thinking. A good example is the case of Ronald Regan and the then new thinking of supply side economics which was a good thing.

 

Articles referenced;

https://www.thinkadvisor.com/2022/10/24/bofa-economist-i-dont-see-how-we-avoid-a-recession/

https://www.reuters.com/markets/us/yellen-says-taking-steps-enhance-treasury-market-funds-resilience-2022-10-24/

https://www.bloomberg.com/news/articles/2022-10-21/fed-officials-expect-debate-on-rate-peak-and-when-to-slow-hikes

https://www.bnnbloomberg.ca/markets-are-calling-the-shots-uk-traders-react-to-truss-exit-1.1835289

What is your risk level (part 4)

Government is designed not to lose & Risk summary

             Now think about a typical government department or function. How is success measured for government functions? What constitutes doing a good job? How does one do a great job? What is likely to happen if an individual tries something new and fails? As you think about government functions are they graded on how much money is made or is it on how much money is not lost. I believe that for government functions the goal is not to make money but to not lose it. A typical government function is not graded on succeeding but on not failing. It tends to not matter how many things go right but how many things go wrong. One failure can wipe out a multitude of successes. Think of government as a defensive function not an offensive innovation. If one is trying to win a battle are all the soldiers given shields (government) or are they given swords (private sector)? The army with swords may lose some men but will likely win the battle. The army with shields will not have the ability to win, only possibly not to lose. In government there will not likely be innovation, improvement, or  profit motivations. There will be support for status quo, minimization of failures, and entrenchment (defensive positions). I believe governmental officials tend not to be rewarded for taking risks (swords) but for not failing (shields).

             This underlying philosophy has serious implications. In general, innovation, new products and wealth generation come from the private sector not from government. Why, because innovation generally involves risk taking and the very nature of government is to avoid risks.

             As a general review, we discussed risk averse and risk tolerance and some ideas that show that the magnitude of the impact of an outcome can affect or view of the results. Many small impacts may not bother us as much as a few large impacts, especially negative changes. We looked at some evidence which supports the observed phenomena of the diminished capacity of the adolescent male brain as it approaches the 12 to 13 age range (which seems to reverse itself in most cases by the early 20s). The risk  that one does not know they don’t know can have significant ramifications. We looked at some examples of risk as it applies to specific outcomes and risk as it applies to ranges of activities or outcomes. We observed the distinction between private sector and public sector (governmental) risk taking and its possible impact.

            It was suggested that risk tolerance or avoidance could be used in character and story line development. Probability, the risks of uncertainty and of the unknown unknown could also apply to character and story line plots but may also be applied to world building and back story development. Such risks can be used to shape societies, cultures and even species or races. Can societies change their risk perception? Does a society by its nature lock in risk levels or understandings so that the individual must struggle to break free of norms expected behavior? Are risk traits inherited or learned, by an individual,  group or race. Does environment effect risk perception and action?

             Let me know your thoughts and ideas.

What is your risk level (part 3) update

There are different types of winning …. and losing

              Let us start with a quick review of how we perceive risk from part 1 and expand on the concept. Risk can be related to volatility. High risk can imply great or high volatility in relation to expected outcomes or solutions. Suppose a desired outcome is winning exactly $5,000, what is the likelihood of getting our desired outcome if the possible range of outcomes could be from $10,000 to -$10,000 with an equal chance of any integer on a single draw. Low risk suggests predictability or stability in the expected outcomes or solutions i.e. if our desired outcome is 1, what is the likelihood of drawing 1 (on a single draw) if the values available are between 2 and 0. In our first example, if we need to get $5,000 we will be very disappointed because the risk is so great that we will not get $5,000 (the odds are 1 in 20,000). However our upside potential (risk of getting equal to or more than $5,000) is much better. Our odds have improved to 5,000 in 20,000 or 1 in 4. We may be disappointed with the selection but not unhappy with the outcome.

             Risk can also relate to a specific outcome and the probability of that outcome. Assume option 1 has a 25% probability (1 in 4 chance) of making $1,000 and a 75% probability (3 in 4 chance) of making $0. Assume it costs $250 to participate. Remember, in business, finance and especially in investing there is always a cost to participate, if someone tells you there is no cost keep looking until you find it (I will get off my soapbox now). Option 2 has the same cost to participate but the probabilities are reversed. Now it is a 75% probability of making $1,000 and only 25% probability of making $0. Option 1 is substantially more risky than option 2. The risk is not in earning an amount different than the desired outcome ($1,000) but the likelihood of realizing or getting the desired outcome.

             Many business risks deal with a range of possible outcomes from very successful to significant lose. However, the payout or benefit of a successful outcome may be so great that the risk may be considered acceptable. Conversely, the cost of failure may be relatively small so that any lose is not particularly damaging. A business may be able to sustain a number of relatively small losses if the occasional success is great enough. In that case a risky venture, meaning a venture with significant volatility, may be not only acceptable but quite profitable. If one is accurate in predicting the probability (likelihood) of the possible outcomes then the risk of the unknown happening is greatly reduced. If one is uncertain of the possible outcomes then the exposure to risk can become enormous.

             We generally see that in order to generate the maximum possible wealth a certain amount of risk is usually involved. The very definition of increased risk as we discussed earlier, that results vary significantly from expected outcomes, suggests that there is likely a large element of the unknown or even unknowable in such situations. By 1985 Steve Jobs was cofounder, chairman and CEO of  Apple Inc. However in that year he was booted from the company. Many at the time may have thought that Jobs was done or finished. But by 1997 he was de facto chief of Apple Inc. again. In between 1985 and 1997 he had started another firm, NeXT, and acquired the computer graphics division of Lucasfilm which he spun off as Pixar. After returning to Apple in 1996 he is credited with helping engineer the turnaround of Apple and creating new products and innovations that made it the most valuable publicly traded company in 2011. Jobs must have been exposed to an innumerable number of risks. Many of them were likely negative but several were positive or upside risks.

          Next we will look at government and risk perception and some final thoughts.