Deep Impact: What really happens when banks fail?

The recent misfortunes of the Silicon Valley and Signature Banks are being identified as echoes from the financial crisis of 2008. Fears of a lasting economic downturn, impending stock market crashes, a debt crisis and government bailouts have investors worried whether the worst is still to come. Shareholders and depositors in the two banks in question have raised pertinent questions on the regulatory bodies like the FDIC and the auditory capabilities of the Federal Reserve. Not only has this sudden collapse affected a range of asset classes, but market leaders are suggesting that this could be the first of many more collapses in the months to come. To fully understand how a collapse like this affects the economy and individual investors one must revisit the crisis of 2008 and draw lessons from that dark period.
The Great Financial Crisis of 2008
The crisis of 2008, which had far-reaching effects around the globe, was triggered by a combination of factors, including the housing bubble, the proliferation of subprime mortgages and the use of complex financial instruments, such as mortgage-backed securities, that were not well understood or regulated. The overextension of credit by banks would be the first step in this crisis. Banks offered subprime mortgages to borrowers with poor credit histories, often with adjustable interest rates that could lead to payment shock when rates rose. As the housing market began to decline, many borrowers defaulted on their mortgages, leading to significant losses for banks and investors. The collapse of the subprime mortgage market triggered a broader financial crisis, as it undermined confidence in the banking sector and led to a credit crunch. The interconnectedness of the banking sector played a major role in the crisis, as the failure of one bank had a ripple effect throughout the system. The failure of Lehman Brothers was the significant event that sparked a global financial panic. The fallout from that event led to an economic downturn that lasted for several years. The crisis caused a sharp decline in housing prices, a rise in foreclosures and bankruptcies, and a contraction in credit markets. Many businesses failed and unemployment rates increased in many countries. The years after 2008 were replete with stock market declines, banking system failures (including Lehman Brothers, Washington Mutual and Bear Stearns) and supremely controversial government bailouts. Finally, there were far-reaching sovereign debt crises in several countries, including Greece, Ireland and Spain. These crises had significant impacts on these countries’ economies, leading to major austerity measures and political unrest. The banking sector’s excessive risk-taking and reliance on complex financial instruments played a pivotal role in the financial crisis of 2008. Opinion makers then stated that this crisis highlighted the need for better regulation of the banking sector to prevent similar events in the future.
Silicon Valley Bank: A brief history of prosperity and the sudden collapse
Silicon Valley Bank (SVB) is a commercial bank founded in 1986 and is based in Santa Clara, California. It primarily serves the technology, life science and venture capital industries. SVB operates across the United States, China, India, the United Kingdom and other countries. In addition, SVB has been recognized as one of the top banks in the United States and has received numerous awards for its banking services and commitment to innovation. SVB’s collapse came all too suddenly as depositors sought to withdraw their deposits from the bank during a frantic 48 hours after learning the bank was in trouble after interest hikes by the Federal Reserve. Like many other banks, SVB had plowed billions into US government bonds during the era of near-zero interest rates. As the Federal Reserve hiked interest rates aggressively to tame inflation during 2022, the lagged impact of these hikes hit the startup-friendly bank really hard. When interest rates rise, bond prices fall. SVB’s portfolio yielded an average 1.79% return last week, far below the 10-year Treasury yield of around 3.9%. With the Federal Reserve’s hiking spree seeing no end in the near term, tech startups had to channel more cash toward repaying debt. They were also struggling to raise new venture capital funding. This forced these companies to draw down on deposits held by SVB to fund their operations and growth. With this flurry of withdrawal requests, the bank quickly ran out of funds to service these requests. SVB’s stock plummeted 60% in one day and dragged other bank shares down with it, causing investors to panic. SVB’s collapse could create systemic risks to the broader financial system, as the interconnectedness of the banking sector means that the failure of one bank can have ripple effects throughout the system. Some of these effects may include:
  1. Lack of Access to Capital: SVB provides funding to early-stage and emerging technology and life sciences companies. The collapse of the bank would reduce the available capital for these companies and may limit their growth potential.
  2. Slowdown in Innovation: The loss of funding and support from SVB could lead to a decrease in innovation and technological advancement.
  3. Job Losses: The technology and life sciences sectors are significant employers in the United States. Job losses in these sectors could follow, which would have a ripple effect throughout the economy.
  4. Economic Slowdown: The sectors that the bank supports are key drivers of economic growth. A decline in these sectors could lead to an economic slowdown or worse, a recession.
  5. Disruption in the Banking Industry: The collapse could lead to a loss of confidence in the banking system. This could have negative impacts on other banks and financial institutions, leading to a broader economic impact.
  6. Forced Bailout: The US government has previously bailed out large financial institutions, such as Citigroup and Bank of America, during the 2008 financial crisis. However, these bailouts were controversial, faced widespread criticism and decelerated overall growth. A bailout would only put more pressure on the tax system and invite the general public’s ire.
Note:SVB is not classified as a Systemically Important Financial Institution (SIFI) by the Financial Stability Oversight Council (FSOC), which means it is not subject to the same level of regulatory oversight and government support as SIFIs.
Finding a way back to prosperity
The need of the hour currently is to avoid a recession induced by this collapse. The Federal Reserve and Washington have a range of tools and policies at their disposal to help prevent another financial crisis like the one in 2008. Some tested ways to reduce the likelihood of another crisis include:
  1. Transparent government intervention: The government took significant steps to stabilize the financial system by providing bailouts to major financial institutions such as AIG, Fannie Mae and Freddie Mac in 2008. The Troubled Asset Relief Program (TARP) provided financial support to banks, and the Federal Reserve implemented quantitative easing policies to increase liquidity in the markets. If things were to get worse and the banking sector reaches the brink of collapse, such intervention could help avoid the worst outcome just about in time.
  2. Flexible fiscal policy: The government could take a flexible approach to fiscal policies to stimulate economic growth. The American Recovery and Reinvestment Act of 2009 provided funds for infrastructure projects, job creation and tax incentives for businesses that eventually helped get the economy back on track after a torrid year. However, in the current economic scenario, the large-scale spending bills (like the Inflation Reduction Act) already in place and inflation wreaking havoc on the economy, having a flexible approach might be more difficult.
  3. Investing in building consumer confidence: Winning over consumers is the most assured way to create a sustained recovery path for any economy. If consumer confidence improves, so will their spending and investing habits. As consumers power the economic machinery, it could be the platform needed for further government spending to support the ailing sectors.
  4. Seeking international support: The American financial and banking system does not operate in isolation from the rest of the world. Even now, the impact of SVB’s collapse has had far-reaching effects across geographic boundaries. Seeking international cooperation and support could help to stabilize the affected sectors and in turn, the economy. In 2008, the G20 countries worked together to implement policies that stimulated growth on a global level. Investing efforts in this route during dire circumstances wouldn’t be a bad idea.



Inflation Cooling, But Is The Fed’s Work Done?

On a short and intermediate-term basis, the HCM-BuyLine® has turned positive and investors should start to look for opportunities. The longer-term trend is still negative, so caution and prudence are still advised. Biotech, technology, basic materials, and transportation all look to be gaining momentum. (EA) Electronic Arts looks to be on the verge of breaking out of a triangle pattern. (ADM) Archer-Daniels-Midland and (CVX) Chevron are starting to break out of resistance and could have some nice follow through.
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The most recent labor market and inflation data support a downshift in Fed rate hikes, and we now expect a 50-basis point rate rise in December. However, the risk of a severe recession still exists as the latest data shows the global economy contracted for a third straight month in October. After last week’s rally following better than expected news on inflation, we expect reduced volatility and for markets to settle into a range. 
  1. Both CPI and core CPI rose less than expected in October
  2. October payrolls were stronger than expected, but wage growth moderated.
  3. This is supportive of a downshift in Fed rate hikes. We expect a 50-basis point rate rise in December.
The S&P Global Flash U.S. Composite PMI fell 1.9 points in November to 46.3, below the break-even level of 50 for the fifth consecutive month, indicating continued weakness in private sector business activity in 2H 2022. Both manufacturing and services activity contracted this month, weighed down by rising interest rates and economic uncertainty. The Flash Manufacturing PMI dropped 2.8 points to 47.6, below the consensus of 50, and indicating contraction for the first time since June 2020. Output and new orders both fell, with the latter sinking at the quickest rate since May 2020. Delivery times for inputs shortened, reflecting improvement in supplier performance but also weaker demand. As a result, order backlogs fell sharply. Employment growth moderated. Nevertheless, optimism about the output growth outlook over the coming year improved from the prior month, driven by expectations of firmer client demand and shorted input delivery times. Price pressures, both for inputs and output, eased significantly. The Flash Services PMI fell 1.7 points to 46.1, also below the consensus of 48.0, and in contraction territory for the fifth consecutive month. Service providers pointed to rising interest rates and inflation cutting into disposable income as the main culprits for weaker demand and activity. New orders declined for the second consecutive month and at the fastest rate since May 2020. Backlogs fell, while employment grew only marginally. But optimism about the year-ahead outlook for growth picked up from the prior month. Similar to manufacturing, price pressures in services continued to ease.

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