It’s too bad there’s not a live-mapping app for navigating financial-sector turmoil. US policymakers could sure use one now, as they try to make their way around the road hazards and breakdowns hitting the country’s regional banks. Without one, they’re forced to rely on dusty road maps left over from their previous journeys, with no guarantee they’ll get where they’re hoping to go. Here’s how they’ve been maneuvering, the two big threats ahead for banks, and what it all might mean for your portfolio…

OK, so what’s the road ahead?

The Federal Reserve (the Fed) has approved a rescue package for Silicon Valley Bank (SVB) that includes an offer to absorb government debt and mortgage-backed bonds at above-market prices. It’s a solution that looks a lot like those deployed in the past.

Deutsche Bank has called the plan just a new form of quantitative easing (QE) – i.e., the same-old central bank ploy of buying up financial assets in order to stimulate economic activity. JPMorgan, similarly, has called it a stealth form of QE, and has said it could see the Fed increasing the size of the move to around $2 trillion. And, hey, maybe it is QE. Like they say: if it looks like QE, and if it sparks a rally in stocks like QE, then it probably is QE.

Already, the Fed’s balance sheet (white line) has seen a sharp move higher, to $8.6 trillion from $8.3 trillion. And that’s happened despite the Fed’s ongoing plan to shrink the size of its balance sheet, by roughly $90 billion each month, in a program that’s known as quantitative tightening (QT).

Fed’s balance sheet (white), the discount interest rate (blue), and the S&P 500 (orange). Source: Bloomberg.

And that shift, from QT to where we are now, is already having an impact. See, when the Fed increases the size of its balance sheet, it tends to boost asset prices. Last week, while banks and financial stocks struggled, the tech-heavy Nasdaq index rallied 4.4%. We’ve traveled this particular road before.

On Wednesday, the Fed is expected to make its next interest rate announcement, and more and more people are expecting the Fed to hold rates steady, rather than hike them, as it’s previously warned. The Fed’s been hiking interest rates for a year, seeking to stomp down high inflation. But the banking turmoil has thrown a wrench into all that.

Over the weekend, meanwhile, the Fed and five other major central banks announced they’d made a coordinated move to boost liquidity in US dollar swap arrangements – a move that’s generally taken only during times of extreme market stress.

So, is all of that likely to steer us out of a crisis?

It seems unlikely. First Republic Bank (FRC) looks like the next potential car crash. Like SVB, which collapsed about 10 days ago after a spectacular run on deposits, First Republic has found itself targeted by the same rapid outflows.

A $30 billion plan for the bigger, safer banks – JPMorgan, Citigroup, Bank of America, and Wells Fargo – to “recycle deposits” from First Republic back to First Republic, in an attempt to help restore confidence, doesn’t look like it’s going to pan out. On Monday, First Republic’s share price fell another 47%, leaving the it down roughly 90% since the start of the year.

Until market confidence is restored in the banks, the market is likely to remain on tenterhooks.

Regional Bank Index and the big four bank share prices. Source: Bloomberg.

The issue, as hedge fund manager Bill Ackman recently tweeted, is that bringing in the big banks to bail out the First Republic Bank, puts them potentially at risk if the situation escalates.

See, these regional banks don’t have just one problem: they have at least two. There could even be more lurking under the surface.

What are the two risks for regional banks then?

The first is that they could suffer a huge outflow of deposits, causing further disruptions in the financial system. Let’s face it, there’s no downside in shifting your funds to a safer bank if your business or personal funds are higher than the current Federal Deposit Insurance Corporation (FDIC) $250,000 guarantee. So a request has been made by smaller banks and some lawmakers to provide a temporary guarantee for all depositors at all banks, regardless of size. And, in effect, that could put a stop to the potential for deposit runs.

Now, regional banks are important: they make up 30% of bank-held assets and roughly 40% of all lending in the US. And, ultimately, they’re going to face increased regulation and capital requirements to make their balance sheets more secure. Along with their already depleted cash reserves – as depositors have withdrawn funds – smaller and mid-sized regional banks will become less willing (and less able) to lend. That’s going to lower future returns, earnings potential, valuations, share prices, and economic growth.

Apollo Global Management estimated that the Fed’s key rate, the fed funds rate, was pushed an astonishing 1.5 percentage points higher last week because of the bank worries and the more stringent financial conditions and lending standards they prompted.

What's more, last week, new economic data pointed to the increased likelihood of a recession. US Leading Economic Indicators for February showed that eight of the index’s ten components showed growth that was flat – or negative – compared to the year before. And that was before the latest banking turmoil.

The annual growth rate of US Leading Economic indicators. Source: The Conference Board.

The second big risk for regional banks is their commercial real estate exposure. There’s been massive growth in “work from home” and hybrid working arrangements since the start of the pandemic, and smaller banks are the country’s primary lenders for commercial real estate loans. According to real estate services firm Cushman & Wakefield, commercial mortgage loans maturing in 2023 and 2024 total around $1.1 trillion. And with the rise in interest rates, refinancing those loans is going to be a lot more expensive. Many office leases are expected not to be renewed, elevated vacancy rates are expected to move even higher, and rent growth is expected to decelerate further. With all that, there’s also a real risk of an explosion of bad loans. And a deeper recession would only increase the risk of more real-estate-related losses for the banks.

So, what’s the opportunity then?

With this crisis moving so fast, it’s impossible to know what might happen next. After the Fed’s long string of aggressive interest rate hikes, the good news is that policymakers once again have room to slash interest rates, if warranted. But with inflation still much higher than the long-term 2% target (it rose 5.5% in February), they’ll be reluctant to do so. In fact, some investors still expect another rate increase – albeit a smallish one – on Wednesday.

For the Fed, there’s no easy GPS-guided path toward calming inflation and bank turmoil all at the same time.

Continued interest rate hikes raise the possibility of a hard landing for the economy – in other words, a recession. And while that would likely bring inflation down, it’d also likely bring down employment and stock prices too.

A turn toward more quantitative easing, meanwhile, could put markets back on the path toward buying quality growth and tech shares again. But it won't help bring down inflation.

Reports over the weekend suggested that billionaire investor Warren Buffett might be considering buying shares in some regional banks, in an effort to help prop them up. But the “Oracle of Omaha” hasn’t confirmed those reports, so if you’re thinking of following his lead, you might want to hold off, at least for now. In the meantime, you might consider another of Buffett’s recent moves: Berkshire Hathaway announced an $800 million increase in its stake in Occidental Petroleum (OXY), a move aimed at taking advantage of the recent fall in its share price. If you decide to invest in Occidental, dollar-cost averaging – or buying a set amount of the stock at set intervals – can help you add to your position, while limiting your price risk. And that’s an especially good idea now, with stock market volatility so high.

As for regional banks, you’re likely best to steer clear, unless you’ve got the stomach to handle some extreme levels of volatility. Until this crisis of confidence is cleared, buying their shares may be like trying to catch a falling knife.