Is The Banking System Safe?

Over the past few weeks, we have had the second and third-largest bank failures in our history. As this crisis unfolds, we are repeatedly told by officials that it is localized to these particular banks, that the banking system is sound, and there is not a systemic risk to those with money on deposit in banks.

One interesting commentary is from the journalist Kim Iverson, who suggests the failures are basically a raid to take down cryptocurrencies as if they needed any help in their demise.  See the video archives.

We have long felt government cannot tolerate crypto or anything else that threatens its monopoly on money.  However, we are skeptical of Iverson’s thesis because other explanations appear compelling and not so esoteric.  The Biden inflation, followed by the sharpest rise in rates in history, is damaging banks everywhere.  This includes the Federal Reserve itself, which may soon have negative equity.  This seems to us to satisfy the notion of “systemic.”

Others point to the systemic build-up of government debt at an unprecedented and unsustainable rate.

To be sure, inflation, high-interest rates, are all connected to excessive government spending and borrowing.  It is a wonder to us that we could go years with this kind of fiscal abuse without serious consequences.  Globalization, shrinking demographics, and other factors might simply have delayed the problem.  Whatever.  Now we must deal with the consequences.

For the investor, if one believes the problem is localized, there is no particular action to be taken. Odds are, your bank is safe. Or if it is not, it will be rescued.

If on the other hand, this is a systemic issue in the banking system, then there are some protective steps investors and depositors should consider. There is not enough money in the FDIC insurance fund to cover systemic risk in the banking system.

At the risk of cynicism, just because the same people making you comfortable with the banks are the same that told you that WMD existed in Iraq, that Covid came from a wet market, that Donald Trump was a Russian pawn, that Hunter’s laptop was Russian “disinformation”, that Covid vaccines work, that inflation was transitory and that men can have babies,(we could go on like this)…is not necessarily a reason they are wrong about the banks.

Then again, they could be lying again. Our government seems to do that rather frequently and thus has poor credibility and has not earned our trust. Besides, how could we know if they are lying before the fact? Moreover, the government as the ultimate guarantor of FDIC, has a vested interest in keeping us calm and our deposits in the banks, right?

Here are some reasons besides their past lying why you just might want to be suspicious.

The financial system is much like a chain. One bank has a claim on another. One financial institution has a claim on another. One institution’s asset is another institution’s liability. If you fail on the liability, you destroy someone else’s asset. In short, the system is only as strong as the weakest link in the chain. It is clear some of the links are breaking, because of this interlocking relationship, there is simply no way of knowing how far the rot has spread.

Localized stress should be just that…local. But we learn for example that the Swedish national pension system was a depositor in Silicon Valley Bank. Sweden? That does not sound very local, does it?

Nor does the failure of Credit Suisse and now the rumors swirling around Deutsche Bank sound localized. Why would giant Swiss and German banks be in trouble if a bank in California is having difficulty? Does that sound local to you?

It would appear that most banks, and many other types of financial institutions, have been victims of government policy in several ways. As such, everyone is affected.

Years of ultra-low interest rates created a “zeal for yield.” This zeal encouraged many to take excessive risks and use excessive financial leverage to try to get decent rates of return. Thus, ultra-low interest rates spread this desperation for return likely far and wide. Not just banks, but many businesses, grew used to almost zero cost for capital and zero costs to borrow. But now they must roll their debt forward to much higher rates and their business models may no longer be profitable.

The government supervises these institutions and once again, we find their supervision did not stop banks from failing. Sleeping at the switch seems to be a trite understatement. Didn’t we just have a financial crisis and they fixed things?

Excessive government spending and the Covid lockdown came after a long string of large deficits and have destabilized the economy. This was not a local issue either. Rather, it is systemic. It caused system-wide inflation, which in turn triggered system-wide sharp increases in interest rates to fight that inflation, which drove down the value of bank assets.

Moreover, the recent blowout budget proposed by the Biden Administration indicates they have no clue how excessive their spending has been, or they do understand and are proceeding anyway. Either way, you slice it they seem to have no plan to dampen excessive spending.

When government acts, it is by nature systemic. The government orders banks to invest in long-dated bonds and mortgages, and then by raising rates very quickly, it has caused the banks to lose a lot of money on what the government forced them to buy. Who escaped this conundrum? We suspect few did and most did not, hence it looks more like systemic risk.

While there is a modest amount of money in the FDIC, it is intended to support isolated banking failure. But the insurance fund is spread even thinner when the government extends deposit insurance beyond the $250,000 account size. Right now, the government is expanding the deposits to be covered without expanding the number of reserves to insure them.

Treasury Secretary Janet Yellen has purportedly insured more deposits in a gambit to calm depositors, but at the same time, by spreading a limited base of capital over far more deposits, she actually has weakened the system. Will her attempts at calming the situation work or did her haste to extend coverage signal there is a greater problem than what we currently appreciate? There is ambiguity about what is insured and what is not. As the Wall Street Journal recently pointed out, “the Administration’s mixed signals are becoming another threat to the financial system.”

It is a confidence game we would rather not play.

Because of all the unknowns and the lack of credibility in government officials, we suggest you treat the current crisis as a systemic risk, not a risk isolated to just a few banks. Assume more pain is to come and act proactively.  There is no risk to yield, credit quality, liquidity, or safety.  There might be some inconvenience but that seems like a small price to pay.

What steps can you take to protect yourself?

If you have money in a bank beyond the $250,000 limit, move the money around between banks and stay under the limit in any given institution.

Get extra cash out of the bank and store it safely at home. Yes, we mean physical bills. Even if FDIC can weather the storm, sometimes audits have to be conducted and other procedures might delay your access to cash. It is good to have some physical currency outside of the banking system.

Since FDIC can only be “saved” up by the government, you might as well own direct obligations of the US government, not indirect ones. Besides, the yields on US Treasury bills can be higher in yield than bank deposits. Move excess cash directly to treasuries.

If the Federal Reserve is forced to reverse on Quantitative Tightening (and there is evidence they are) or reverts to overt money printing to inject “liquidity “into the system, that will aggravate an already difficult inflation problem and possibly create an upward spiral in interest rates. Bank borrowing from the FED already exceeds that of the 2008 Financial Crisis. Where did all the money come from to lend to the banks? How is this substantially different than Quantitative Easing?

Historically, if forced to choose between inflation and deflation, the government opts for inflation. Why?  Mostly because debtors are really punished by deflation. They have to pay back their debt with more valuable dollars than they borrowed.

Since the government itself is the biggest of all debtors, they would prefer inflation because they get to pay off their debt with dollars worth a lot less than the dollars they borrowed.

Sometimes, however, deflation gets out of control regardless of government desires and during that condition, there is a widespread failure among borrowers of all kinds, including sovereign government default.

We suggest that investors own at least a modest hedge position in gold bullion coins.  Check out our long-term advertiser American Precious Metals which specializes in the physical delivery of gold coins.  For security purposes, not for speculation, these coins should be in your possession. A home safe or private depository is likely better than a safety deposit box.

While there are many flavors of “paper gold” from Exchange Traded Funds that hold bullion to gold mining shares, the entire reason for owning gold and having it in your possession is not to take further “promises” from the banking system or the government. Paper gold might be fine for speculation but not for basic safety against bank runs.

Others suggest you own some cryptocurrencies as well. We have been critics of cryptocurrencies from the beginning and remain unconvinced. Candidly, we don’t understand them and thus prefer not to invest in things we don’t thoroughly understand. Moreover, we have long felt government will not give up its monopoly to issue money to private parties and hence will come after cryptocurrencies.

As for the stock market, as we have mentioned before, we don’t think the bear market in equities is yet over. While we have been impressed by the way the market shook off the last rate hike and the news of banking problems, the trend still remains downward. Remember whatever you buy and presently own, will likely feel the gravitational pull downward of the bear market in stocks and if we go into recession later this year. Our view still is that if our fate is a recession, the first beneficiary will be the bond market, not the stock market.

Banking problems may make banks both reluctant or unable to extend credit.  Tighter credit conditions on top or rising rates simply raise the odds of a recession in our opinion.  That remains a substantial negative for the stock market.

Certainly, you may own stocks but we would keep the risk down by limiting exposure of the portfolio to below-normal levels for your age and risk tolerance. Hold extra cash in the form of T-bills or short-term Treasury bonds.  See the video on the subject of how to buy them or talk to your broker/financial advisor if you have one.

You may also wish to revisit our “barbell strategy.”

Notice we have stayed away from mentioning amounts or percentages. More specific advice requires much greater detail into a reader’s financial condition, something we simply can’t do.

Consult a qualified financial advisor and be sure you do your own due diligence.

What we are suggesting is that you take a few concrete moves to protect yourself in the event things get uglier than they already are.

As stated before, there simply is no way to know for sure, but given the excesses of the recent era, we would er on the side of safety. Now is one of those times when the return OF your money is more important than the return ON your money.