Posted March 18, 2023
By Zach Scheidt
How Did the Banking Crisis Actually Happen?
"Hey Zach, can you explain this whole banking crisis in a way normal people can understand?"
At lunch with my dad and brother yesterday, we mostly focused on watching the NCAA basketball tournament, a family tradition.
But our conversation briefly touched on the banking crisis that’s been making headlines this week.
My dad was a bit frustrated. The reports he saw on the news were overly complicated as the talking heads explained the details of our banking system.
"It's all so confusing!" he told me. And he's right; the media has made this story far too complex. So today I want to give you a clearer picture of what's happening.
The Root of the Problem
Bond prices are at the root of today’s bank crisis. More specifically, it’s tied to how bonds trade in relation to interest rates.
When interest rates rise, the price of a bond moves lower. Here's an analogy that may help you better understand how this works.
Let's say you’re a trail runner like me and decide to train on mountain trails. Today you want to finish at the top of a mountain that’s 10,000 feet tall.
(Now stick with me. I promise this relates to the banking crisis.)
If you wanted to climb 2,000 feet on your run, you'll need to start at a point that’s 8,000 feet above sea level. That way you can climb 2,000 feet during your run.
But let's say you have a big race coming up and you need to climb more, like 5,000 feet.
In this case, you would need to start at a much lower elevation, like in a valley at 5,000 feet above sea level. That way you can climb a full 5,000 feet before reaching the top.
How does this relate to bonds?
Well, most bonds pay investors $10,000 when they mature. So basically that's like hitting the 10,000-foot level at the end of your run.
When interest rates are at 2%, you'll pay about $9,800 for a bond. And then over the next year, that bond will trade 2% higher and finish at $10,000.
But when interest rates move higher, today's price for a bond has to start at a lower level. (Think of the current market price as the starting point for your investment.)
So thanks to higher interest rates, today's bond prices must trade lower today.
That way they can climb further over the duration of the bond, giving today's investors a higher interest rate on their way to $10,000.
Here's an extra point to consider. Bonds that mature 5, 10, or even 20 years from now have to move much further down the mountain (or much lower in price).
That's because when interest rates are at 5%, the bonds will have to generate 5% each year to get to the final $10,000 level.
So longer-term bonds trade much lower when interest rates pick up.
The Banks’ Bonds Are Worth Less (But Not Worthless)
Banks traditionally take deposits from savers, like you and me, and invest those deposits by lending to different borrowers.
In today's economy, many banks lend a large portion of their deposits to companies, mortgage borrowers, or the U.S. government.
This is done more efficiently by purchasing bonds, which will eventually be paid back at the standard $10,000 per bond (like in our mountain running example).
Thanks to aggressive Fed rate hikes, many of these bonds have traded sharply lower.
The bonds are still eventually going to be worth $10,000. But if the banks were to sell the bonds today, they would be worth far less. And that's where the problems arise.
Several regional banks like SVB have depositors who have pulled their money out. To pay those depositors, the banks needed to sell their bonds.
But now that the bonds are trading lower, banks aren't receiving enough from selling their bonds to pay back depositors.
As depositors start to worry about this problem, more have started to pull money out of their accounts, triggering a good old-fashioned bank run.
Fortunately, the Fed is stepping in to backstop banks in most cases.
The Fed has agreed to let banks borrow the full cost of what they paid for these bonds. Then once the bonds mature, the banks can pay back the Fed.
This way, banks can still pay back their depositors. And hopefully, depositors feel safe enough to keep cash in the bank.
This situation continues to evolve, and we’ll certainly see ripple effects throughout the economy over the next several weeks.
But the good news for you and me is that the U.S. financial system will still be operational. You'll still be able to pull cash out of your bank account.
And the short-term pullback in the stock market gives you a great opportunity to buy dividend stocks at a discount like we talked about yesterday.
I'll be back to you next week with more ideas to grow and protect your retirement wealth. In the meantime, I hope you have a wonderful weekend!