Financial Forum April 2023
Market Commentary – Cracks Beginning to Emerge
Something always breaks…you just don’t know what it will be or when it will happen. This time it’s a potential banking crisis that many experts believe is traceable back to the Fed’s own actions to choke off inflation, which was running at a 40-year high last year and continues to be “sticky” in 2023. In March, the Federal Reserve continued its most aggressive rate hiking effort, raising the federal funds rate to the 4.75%-5% range. In doing so, it finally caused enough stress in the financial system to trigger the first major bank failures since the subprime mortgage crisis, as regulators took over both Silicon Valley Bank and Signature Bank. Additionally, in hopes of stopping a bank run, California-based First Republic received an injection of $30 billion from a consortium of large banks led by JP Morgan. Also, the Federal Reserve provided over $160 billion to banks through various credit facilities, including a new Bank Term Funding Program which allows banks to borrow against securities that have dropped in value.
The crisis was not just limited to the U.S. In Switzerland, UBS Group took over rival Credit Suisse as regulators and the Swiss government brokered an emergency weekend deal. And in Germany, Deutsche Bank entered the spotlight as the cost to insure itself against default hit its highest level since 2018, according to Reuters.
While each banking crisis has its own unique fingerprint, one commonality is that they typically follow periods of Fed tightening. In 2007, it was too much leverage with banks holding subprime mortgage derivatives and other toxic investments; this time it was supposedly safe Treasury and mortgage-backed securities that lost value as interest rates skyrocketed (rates go up, bonds go down). With short-term rates much higher than longer rates, an exodus of deposits occurred, as investors moved monies from stingy bank accounts, still yielding next to nothing, to higher-yielding Treasuries and outside money market accounts. This exodus of bank deposits caused some banks to sell assets, at big losses, in order to meet their liquidity needs. It also crimped their ability to make loans, which will affect future economic growth, bank profits, and eventually, inflation.
The Fed is now caught between a rock and a hard place. The central bank has two problems, each of which suggests an equal and opposite solution. On the one hand, the Fed is facing inflation that remains, to use their own words, "too high." Consumer prices rose 6% over the prior year in February, which is still three times higher than the Fed's 2% target. For central bankers, higher inflation has a clear response: raise interest rates. On the other hand, the Fed is facing a banking crisis that could continue and/or spread to other areas of the economy. The normal response to a crisis like this is to lower rates and provide as much liquidity as needed to the broken area of the economy. And there lies the rub. Raise rates to fight inflation but hurt the banking sector and the economy; or lower rates to help the banks but risk inflation continuing at unacceptably high levels. For now, the Fed has signaled that, although its work is almost done, policy will remain tighter. Unless more things “break,” the Fed still believes the greater risk on the inflation front, is doing too little, not too much.
Bottom Line: Stay tuned. Debt and liquidity crises don’t typically end in a couple of weeks. Cracks in the financial sector could keep emerging in other areas that have high levels of leverage. With the inverted yield curve, smaller banks that borrow at short-term rates (higher rates) and lend at longer-term rates (lower rates) are in a tenable position. Also, commercial real estate and private equity investments are all levered investments in a rising rate environment. According to Capital Economics, commercial property accounts for 40% of all loans made by smaller banks. If customers get concerned about the health of their bank, a vicious downward cycle could occur, as deposits leave, thereby making the bank even weaker which, in turn, will cause more capital to leave. It’s what economists call a self-fulfilling prophecy.
Wealth Management – Rolling a 529 Plan to a Roth IRA
A common question families ask regarding their child’s college fund is how much is enough? They want to know what options are available for excess funds, should that be the case. There have always been options, but thanks to the SECURE 2.0 Act, there’s another, and it’s big. Beginning January 1, 2024, beneficiaries may be eligible to roll over funds from their 529 plan into a Roth IRA. By doing so, this avoids the income tax and tax penalties you incur when you withdrawal funds for nonqualified, noneducational expenses. It’s a form of a back-door Roth conversion families are adding to their strategy.
Let’s take a deeper look into the rules. There are some limitations.
- Beneficiaries are permitted to rollover up to $35,000 of their 529 plan funds to a Roth IRA over the course of their lifetime.
- These rollovers are subject to Roth IRA annual limits, just like regular Roth IRA contributions. In 2023, the limit is $6,500 for people under 50, and $7,500 for people over 50. Also, the beneficiary must have earned income that is equal or greater to the conversion amount.
- The 529 plan must have been open for over 15 years to be eligible for the rollover to a Roth IRA, and it must be the beneficiary’s name.
- One point that has not been clarified by the IRS is the impact of changing a beneficiary… Will it start a new 15-year clock? Will it make the rollover ineligible? This we must wait on.
- And finally, contributions made within the last five years cannot be rolled over to a Roth IRA.
Quarterly thought…Voltaire
Voltaire once wrote, “Doubt is not a pleasant condition, but certainty is absurd.” I wonder if he was referring to the stock market…
Have a great week and look next month for our new monthly scribe called “Pinnacle – On Point.” A quick one-page newsletter about musings from the world of wealth management.
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