March 20, 2023

Dear Clients and Friends:
Investing is a unique pursuit and one that depends on the goals of the investor.  There are many investments to choose from, but no matter what they are, there are risks that should always be considered. Each investment carries its own risks and risks differ depending on the investment type. Real estate carries liability and market risks. Investment in securities carry individual issuer risk; the risk associated with where the securities are custodied; interest rate risk; market risk; and potentially others.  Princeton Professor Malkiel’s famous book, A Random Walk Down Wallstreet, identified many investment risks and how they could be mitigated with proper portfolio construction. Over long periods of time, history suggests a well diversified portfolio of equity securities does well.   Furthermore, fixed income investments with government backing may be considered riskless if held to maturity, but what if cash is needed now. It is commonly said, “cash is king” and for a reason.  Cash carries custodial risk, in a sense similar to the custodial risk associated with investment securities, which was discussed by us in our most recent Fall 2022 Client Update on page 5:


Custodial risk depends on what happens to your assets if the custodian were to become insolvent and fail. Are your assets at risk, or are they independent of the institution’s balance sheet assets? Also, what risk is there in getting your assets back? Depending on where custodied, there can be a difference, which our Fall 2022 note above addressed.  It was also addressed in a note written by us in 2009, in reaction to the mortgage crisis and The Great Recession:

Custodial risk of cash and securities are similar, but not completely. True cash is generally held at banking institutions, as opposed to broker dealers.  Financial crisis is often a result of runs on cash, where institutional liquidity becomes a concern as cash is drained. As Berkshire’s Warren Buffett famously quoted, “ It’s only when the tide goes out that you learn who has been swimming naked.” Whether someone is swimming naked of liquidity, does not necessarily mean they are insolvent, particularly if time permits their assets to mature in value. The most notable bank runs in American history occurred during The Great Depression, but with the  2nd and 3rd  largest failures occurring this month, March 2023, when Silicon Valley Bank and Signature Bank failed to meet depositor demands for withdrawal.  Cash management has always been important but it has become more important as interest rates have risen. Bank deposit withdrawal demand has been increasing with the rise of interest rates, where individuals and businesses seeking to capture higher interest rates have removed deposits from banks in order to invest in money market funds and short term Treasuries.  It hadn’t mattered much when interest rates were low. Inflation and money supply exacerbated the problem, which can be seen in bank balance sheets. Interest rates are decreasing the present value of bank long term assets (such as mortgages and long term bonds), but only if “marked-to-market,” while demand deposits (current on demand liabilities) have significantly grown. Five mega cap tech companies alone- Apple, Microsoft, Alphabet, Amazon, and Meta- hold more than  $500 billion worth of cash and marketable securities. This recent demand for high returns on cash, that were absent during our recent low rate history, coupled with large relative cash positions as a result of substantial government subsidy during the Covid pandemic, started the recent bank run, but it was accelerated as some banks were identified as being at risk by bank investors and bank insiders. Both began to sell their investment securities in the banks and to remove deposits. Friends and family followed.

Custodial risk of a particular bank is not necessarily easy to find, but everything is easy once you know how to do it.  Insider trading of securities is reported to the SEC and many watch for signs of selling , in order to sell,  and buying, in order to buy. Insider buying and selling are not always determinative of the investment performance direction of a particular security. Bank securities are not regulated in the same manner by the SEC, but rather are reported to the Federal Deposit Insurance Corporation (“FDIC”). Studies have concluded that the market does not react in a similar way to the more readily available disclosures filed with the SEC.  Similarly, it is not always easy to understand whether a portfolio of bank loans are correlated because of business and other relationships, which seems to have been a problem with Silicon Valley Bank.

Federal deposit insurance (FDIC coverage) became effective on January 1, 1934, providing depositors with $2,500 in coverage. Today, the FDIC insures cash in banks generally up to $250,000 per account owner.  Historically, if the owner of a trust were involved, you could count the beneficiaries of a trust as unique owners to multiply the $250,000 amount of coverage. Recently, the FDIC changed this rule and applied a maximum of $1,250,000 to revocable and irrevocable trusts.  This new rule, however, is not effective until April, 2024. See,  Double counting of beneficiaries and owners is prohibited at the same bank, but can be duplicated by opening other accounts at other institutions.

The Securities Investor Protection Corporation (“SIPC”), is similar to FDIC but extends protections to securities held with broker-dealers. It covers the first $500,000 of a customer’s portfolio of securities, with a $250,000 limit on cash.  There is excess coverage in some institutions and regulations associated with posting collateral under the Customer Protection rules, which were explained in our Fall 2022, Client Update on page 5:

Cash risk is often minimized by investing in U.S. Treasury bills, notes, and bonds of various durations. Treasury securities are backed by the full faith of the United States and said to be without risk of loss. Nevertheless, their market value can fluctuate depending on interest rates. With rising interest rates, their market values decrease.  Simultaneous, with rising interest rates, many bank depositors have sought to move their cash into Treasury securities at broker-dealer firms to capture these higher rates and gain safety.  At the same time, banks held long term Treasuries, mortgages, and other fixed income investments that were intended to be held to maturity without a need to mark their values to present market values on balance sheets. But, as a result of recent bank deposit withdrawal demand to capture rising rates, they were forced to sell these long term securities and mortgages at a loss, in a sense being forced to mark it to present value.  Thus, the Federal Reserve’s war against inflation indirectly exacerbated the problem with some banks that failed to diversify their portfolios into shorter term investment in order to confront a spike in deposit withdrawal demand. As of this writing, 186 banks in America have been identified as risking insolvency if 50% of their deposits were requested to be withdrawn.

We are pleased to be of service. If there are any questions or comments, please feel free to write or call.

Joseph C. Kempe, Esq., LL.M.

Scroll to Top