The biggest theme in 2022 was the Federal Reserve raising interest rates. We have now seen nine interest rate hikes. The Federal Reserve is raising interest rates to combat inflation by slowing down the economy. While most people thought the biggest risk of this policy would be the potential for a recession, we found out that there was another consequence to the drastic increase in interest rates.
My first job out of college, the person before me had taped the above message to the desk. Throughout my career this has been the rule to which I evaluate opportunities. Why do I bring this up at the beginning of this newsletter? The law of unintended consequences are outcomes of a purposeful action that are not intended or foreseen. The biggest theme in 2022 was the Federal Reserve raising interest rates. We have now seen nine interest rate hikes. The Federal Reserve is raising interest rates to combat inflation by slowing down the economy. While most people thought the biggest risk of this policy would be the potential for a recession, we found out that there was another consequence to the drastic increase in interest rates. Silicon Valley Bank (SVB), at the time the 16th largest bank in the United States, failed in the first quarter creating a panic across all banks of all sizes across the globe. SVB announced the capital raise on Wednesday, the bank was closed on Friday morning. Regulators normally try to keep a bank open until Friday, this one needed to be closed during the day. The government stepped in over the weekend to “bail-out” the bank calming the markets. Over the following days and weeks news stories were published about a great deal of other banks. There are three major issues with banks, let’s discuss both and the impact on the markets.
These are U.S. Treasury bonds and agency bonds such as mortgage backed securities that the bank keeps as a percentage of their deposits to ensure liquidity and safety of the bank. When interest rates increase (as they did in 2022), bond prices decrease. However, banks are allowed a line on their balance sheet called “Held to Maturity” that are carried at their face value and not the current market value. These Treasuries are not intended to ever be sold and will mature at face value. With SVB, depositors started requesting to withdrawal the money they had on deposit at such high volume (also referred to as a “run on the bank”) that SVB would have been forced to sell their Treasuries at a steep loss, thus not having enough money. Bank deposits are insured by the FDIC up to $250,000 per depositor, per bank. SVB’s customers were mostly venture capital firms/private equity firms and not individuals. Two days after SBV was taken over by regulators, the Federal Reserve announced that it would lend banks money with their Treasuries as collateral if it is needed.
The main way banks have historically made money is by collecting deposits in the forms of savings accounts, checking accounts, CDs, etc. They typically pay very little interest on savings and checking accounts. They then lend that money to their customers as commercial loans, mortgages, HELOC’s or margin. The difference between the interest they receive and the interest they pay is their net interest margin. The unintended consequence of nine interest rate increases is that customers can withdraw the money in their savings or checking accounts and buy money market mutual funds that pay them significantly higher interest rates. The bank can’t use the money in the money market mutual funds to lend so they will make less net interest margin and potentially have lower earnings.
If banks have less deposits, they will have less they can lend. There will be approximately $270 billion of commercial real estate loans held by banks that will come due in 2023. According to an article on CNN’s website, $80 billion of those loans are office properties. As you have probably noticed, a lot of office properties have increasing vacancies as leases are expiring and workers prefer to work from home. This will continue to create weak demand and falling prices. We recently saw an entity managed by PIMCO default on nearly $2 billion in debt for seven office buildings in San Francisco, New York City, Boston and Jersey City.
After reading that, the conclusion would be the markets must be following the loss in 2022 with more losses in 2023. Quite the contrary, through the first quarter the S&P 500 was up over 7.5%, Nasdaq 100 was up over 20%, Russell 2000 was up over 2% and the Dow Jones Industrial Average was up just under 1%. The top 3 sectors in the first quarter were the 3 worst sectors in 2022. That leads to the question of whether those gains are sustainable or is it a bounce from last year’s bottom? At this point, that is not a question we can answer, many factors will affect it, including what the Federal Reserve does on future rate hikes, if inflation remains high or decreases, geo-political news events and if we dip into a recession later in the year. One of the most remarkable statistics from the first quarter is that the combination of Microsoft and Apple now make up over 13% of the market. Think about that for a minute, there are 500 names in the S&P 500 and two of them make up 13%. That can make market returns very volatile depending on what happens with those stocks.
Over the years, Paragon has gone from the traditional 60/40 model, investments made up of stocks and bonds to adding additional asset classes such as structured products, private credit, private real estate and private equity. These assets classes can decrease the overall volatility of a portfolio. Alternative investments are typically less volatile, but also are less liquid and therefore not always appropriate for every client and every account.
With Private Investments can come an unintended consequence, going back to our theme of this newsletter. With the increase in interest rates and increase in volatility in 2022, we saw a significant increase in the income we generated on our callable yield note strategy. We had many clients surprised when they received their taxes back from their accountants. As a reminder, we always evaluate fixed income products from an after-tax viewpoint. We have a long history of investing in the municipal tax-exempt bond market for clients. Those types of bonds can have Federally tax-free (sometimes State tax-free as well) income of approximately 3%-4% in today’s market. In 2022 we saw many of our alternative income investments with coupons of between 10% to as high as 18%. With coupons like those, even after paying taxes in the highest tax bracket, you are better off than with municipal bonds.
We are happy to review this with you using your specific tax brackets to show that sometimes it may not be fun to write a check to Uncle Sam, but it is in your best interest.
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