Broker Check

One of These is not Like the Others.

March 24, 2023

Banks failing left and right. Governments bailing out others on the brink. Healthier banks taking out rivals at pennies on the dollar. It’s hard to deny that a lot of what’s happening right now seems eerily similar to the early innings of the financial crisis in 2008. But while this may feel like déjà vu all over again, there are five reasons why nothing could be further from the truth.

First, the “toxic assets” owned by troubled banks in 2008 were a mix of low-grade bonds sliced and diced so many times that few had any idea what they owned. Today, troubled banks mostly own risk-free and almost risk-free bonds. They’re as high quality as bonds get. The mistake banks like Silicon Valley Bank (SVB) made was not protecting themselves against rising interest rates.

It's common practice for banks to buy U.S. Treasury bonds because there is zero risk of default. In many ways, they’re better than making loans that may never get paid back. But the standard operating procedure is to “hedge” risk by buying insurance to protect against an unexpected rise in interest rates. It’s similar to having car insurance lined up before taking that new car off the lot.

Some may argue that not hedging is the same as owning toxic assets - the motivation for both is bigger profits. But Treasury bonds are not toxic, and they trade easily. There is almost no chance that the bonds in question today would default or deliver a loss to anyone holding them to maturity. Back in 2008, few buyers were out there because the risk of those toxic bonds defaulting was very real. Within this context, it's apples and oranges.

Second, the government response has been night and day (so far). Back in 2008, Uncle Sam took way too long to respond, and when they did, they haphazardly bailed out some companies while letting others fail. There was no apparent logic or reasoning behind who was saved, and this uncertainty created massive panic.

Today, their response has been swift and decisive. They’ve told investors and depositors precisely what it takes to receive support, and this clarity appears to be restoring confidence to the system.

Third, the megabanks today have never been healthier. Back in 2008, banks that are now deemed “too big to fail” were playing with fire in more ways than just owning toxic assets, and they were subjected to clinically insane accounting rules that have since been changed.

Arguably the biggest risk banks took back then was the amount of leverage they pursued. Leverage ratios are used to assess the health of a bank’s balance sheet. Today, for every $10 in deposits, most megabanks will loan out $9 and put $1 into “reserves.” This is cash that banks keep aside to facilitate withdrawals. Reserves also contribute to a bank’s strength.

Here, the leverage ratio is 10:1, or 10%.  This is right around where regulators require megabanks to be today, and most megabanks are below this threshold1. Back in 2008, leverage ratios were closer to 40:1. As in, for every $40 deposited, some banks would only reserve $1. Roughly speaking, a pebble could take out a bank at 40:1, but at 10:1, you’d need a meteor.

Furthermore, the quality of loan books today is materially higher. In 2008, mortgages and small business loans were given away to anyone with a heartbeat. Today, borrowers go through the wringer just to get a car loan. The upside to the pain of being a borrower these days is that higher-quality loans tend to lead to fewer defaults for the lender.

Fourth, megabanks today are subject to a regulatory framework that didn’t exist in 2008. Any bank above $250 billion in deposits is now subject to the Dodd-Frank Act, which effectively prohibits the banks from doing anything that even resembles what got SVB into trouble. They are also subjected to annual stress tests by the Federal Reserve, and management teams that fail these tests rarely earn bonuses and/or keep their jobs.

Fifth, this current “crisis” has likely benefitted megabanks rather than hurt them. Size didn’t matter back in 2008 because so many banks shared the same problems. Today, megabanks are raking in billions from depositors fleeing the smaller rivals. For example, Bank of America reportedly brought in $15 billion in new deposits in two days after Silicon Valley Bank was shut down2. That’s fresh capital that BofA can put to work, and they didn’t have to pay anything to attract it.


The bottom line

Jamie Dimon, CEO of J.P. Morgan, was once asked by his daughter, “What is a financial crisis?” He responded, “Well, it’s the kind of thing that happens every seven to ten years”3.

If Mr. Dimon’s math is correct, and history would argue it is, then we’re long overdue for the next crisis. It’s been 14 years since the last one, so maybe this is it. If so, there are two reasons to be optimistic. First, it’s been a lot longer than 7-10 years, and second, the depth of this “crisis” relative to ones in the past has been relatively shallow. Perhaps these imply that the financial system is getting stronger.

That’s good because banks are different. When a manufacturing company goes under, they go to bankruptcy court, and the entire process tends to be orderly. Companies fail all the time, and it's rarely a big deal.

But banks hold a critically important role in the global economy. When they go down, their tentacles can create problems that aren’t even known until it’s too late. This can impact more than rich venture capitalists with millions sitting in a bank. Payrolls may not get processed, and jobs can disappear in hours. So far, none of these negative externalities seem to be happening (except to the executives at the failed banks).

Hence, while banks may be stronger today than ever, they’re not off the hook. Bailing out depositors comes at a price, and regulators will almost certainly increase tighten the screws on these regional and smaller banks. Governments hate messes like these, and they will try to do whatever they can to avoid another.

The bottom line is that a few small banks made a big mistake, and they’re paying the price. The financial crisis in 2008 was widespread and systemic. It’s not the same.









This material has been prepared for informational purposes only and should not be construed as a solicitation to effect, or attempt to effect, either transactions in securities or the rendering of personalized investment advice. This material is not intended to provide, and should not be relied on for tax, legal, investment, accounting, or other financial advice. Richard W. Paul & Associates does not provide tax, legal, investment, or accounting advice. You should consult your own tax, legal, financial, and accounting advisors before engaging in any transaction. Asset allocation and diversification do not guarantee a profit or protect against a loss. All references to potential future developments or outcomes are strictly the views and opinions of Richard W. Paul & Associates and in no way promise, guarantee, or seek to predict with any certainty what may or may not occur in various economies and investment markets. Past performance is not necessarily indicative of future performance.