Serious threat to USA’s banking system
Facts about American Banks (Source FDIC data)
· There are currently 4,951 insured commercial banks & savings institutions as of the end of 2021.
· There are 4,001 community banks (with less than $10 billion in assets) with 27,511 branches and 134 regional banks (with total assets between $10 billion and $100 billion) with 13,109 branches across the US. Savings and loan associations and savings banks specialize in real estate lending. (December 2022)
· There are 31 banks categorized as large financial institutions (assets of $100 billion or more), with 30,570 branches nationwide. Largest 10 banks in the United States- JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs, U.S. Bank , PNC, Truist, Capital One & TD Bank.
· Community banks control $3.2 trillion in assets (about $811 million per bank), while Regional banks control just under $3.1 trillion in total assets (about $29.7 billion per bank). Large financial institutions control over $16 trillion in assets, roughly $500 billion per bank in this category.
· It is estimated that banking assets were equal to 56 % of the U.S. economy
· Confidence in the world’s largest banking system (American) is shaken and this could spread as there are concerns about Asset Liability mismatch. Many of these Regional, small banks are holding securities. Many of these holdings have lost value since interest rates have risen at a sharp clip. Many
· U.S. banks may be on the brink of collapse due to these factors with $7 trillion in uninsured bank deposits lying with them. Even if only half of uninsured depositors decide to withdraw, almost 190 banks are at a potential risk of impairment to insured depositors, with potentially $300 billion of insured deposits at risk. If uninsured deposit withdrawals cause even small fire sales, substantially more banks are at risk. Overall, these calculations suggest that recent declines in bank asset values very significantly increased the fragility of the US banking system to uninsured depositor runs.
What does this mean for the U.S. banking system, and what are the implications for depositors and the broader financial system?
$7 trillion in uninsured bank deposits in America
Ø This is roughly about equal to 30% of U.S. GDP & 40% of all bank deposits
Ø Bank of New York (BNY) Mellon and State Street Bank are the active banks with the highest levels of uninsured deposits. They are the 2 largest custodian banks in the U.S., followed by JP Morgan. Both BNY Mellon and State Street are considered “systemically important” banks.
Ø Held-to-maturity securities pose a greater risk to banks. Many of these holdings have lost value since interest rates have risen at a sharp clip. This presents interest-rate risks to banks.
Ø Considering how the value of long-term U.S. Treasury’s declined by about 30% in 2022, if banks sell these assets before they mature, they take a steep loss.
Ø 11 banks have loans and held-to-maturity assets that are over 90% of their total value of deposits
Ø US mid-cap banks are ‘full of’ bad commercial property loans worth $ 5.6 trillion.
Ø In March 2020, interest rates were so low that the Treasury Department sold some 10-year Treasury notes at yields as low as 0.08%.
Ø The reason that USA going to have so many failures is because the Fed kept interest rates so low for so long. That’s what enabled these banks to load up on overpriced US Treasuries and mortgages
Ø But interest rates have increased so much since then; the 10-year Treasury yield was more than 4%. And this is an enormous difference.
Ø US Federal funds rate is currently 5.00% to 5.25%.
Ø Valued at over $51 trillion, the U.S. has the largest bond market globally.
What does this mean for the U.S. banking system, and what are the implications for depositors and the broader financial system?
U.S. Banks are sitting on $1.7 trillion unrealized losses
Ø According to FDIC, there were $620 billion of such unrealized (or paper) losses sitting on U.S. bank balance sheets in early March. In a recent note, (Fed) estimated banks’ unrealized losses on loans & securities at about $1.75 trillion
Ø However, some experts believe the figure is understated, with 2 recent estimates suggesting the outstanding losses could be as much as $1.7 trillion
Ø A study shows that many banks' assets lost 10% of their value this year due to rising interest rates
Ø It introduces new risk into the system. If market participants expect the Fed to always come to the rescue, they will likely make less prudent decisions
Ø The ultra-low interest rate environment not only made banks more sensitive to interest-rate risk as rates went up, but it also lowered the cost of risk-taking
Ø For custodian banks, retail deposits can make up a smaller portion of total deposits while operational deposits comprise a larger share. These types of deposits hold large amounts of funds for other banks for the purposes of custody or clearing and cash management, among other functions. For this reason, they are often considered more stable forms of deposits.
Rating alert
Rating Agency Rating
Standard & Poor's AA+
Moody's Investors Service Aaa
Fitch Ratings AAA
DBRS AA
Ø Moody's cuts (14 March 2023) outlook on U.S. banking system to “negative” citing “rapidly deteriorating operating environment
Ø Moody's reviewing further downgrade due to ongoing Debt ceiling issues
Moody's downgrade:
Ø Entire US banking system downgraded after Silicon Valley Bank chaos
Ø “Due to extended period of low rates combined with Covid pandemic-related fiscal and monetary stimulus, have complicated bank operations”.
Ø Rating have changed to negative from stable their outlook on the US banking system
Ø “Banks with substantial unrealized securities losses and with non-retail and uninsured US depositors may still be more sensitive to depositor competition or ultimate flight, with adverse effects on funding, liquidity, earnings and capital,”
Ø The outlook for the US banking system is "negative" after a "rapid deterioration" in conditions for the institutions.
Ø "rapid and substantial decline in bank depositor and investor confidence precipitating this action starkly highlight risks in US banks’ asset-liability management".
The moves are important because they could impact credit ratings and thus borrowing costs for the sector.
How USA Banks got here:
1. The Fed printed insane and historically unprecedented levels of money during the COVID-19 crisis, and kept interest rates near zero, all while repeatedly insisting that doing so would not create inflation.
2. All that sudden liquidity had to go somewhere, and much of it ended up in banks. Said another way, bank deposits skyrocketed.
3. Deposits rose so quickly that many banks couldn’t loan out the money quickly enough. So what did they do with the excess? They chased yields and bought billions and billions and billions of mid-to-long term bonds. In short, they engaged in a “carry trade”.
4. The Fed actively encouraged this bond buying by repeatedly promising banks and the markets (via its formal guidance) that it wouldn’t start raising rates until at least 2024 (rising rates are bad for bondholders, so this promise was a material inducement for banks to buy bonds). Powell even said explicitly that rising inflation alone wouldn’t be sufficient to cause the Fed to raise rates in this environment.
5. All that money printing combined with totally predictable supply chain disruptions caused inflation to spike to levels higher than the 1980s.
6. Panicking, Democrats persuaded the Fed in early 2022 to go “all in” to reduce inflation before the elections. Hence, the Fed broke its promise and started draining liquidity (money) out of the system, fully 2 years before it promised.
7. It drain money out of the system at the fastest rate in history via a combination of (1) selling billions of its assets for cash (which it then took out of circulation) and (2) raising interest rates at the fastest pace in history. Fed also promised that it would not stop raising rates until inflation was tamed.
8. Rates rising at the fastest pace in history had a devastating effect on bondholders who had previously relied on the Fed’s guidance, most especially the banks who were induced to purchase all those bonds. The losses were staggering
10. Hence, many banks simply characterized a large part of their bond portfolios from marketable securities to securities intended to be “held to maturity”. This accounting gimmick kept banks looking wildly profitable even though they were actually (in some cases) taking huge losses.
11. The banks looked wildly profitable because, in addition to not having to book all those massive losses on their bond portfolios, they were earning interest rates on their loan portfolios that were many %age points higher than what they were paying on deposits, one of the widest spreads in history.
12. And then, big money started moving money out of banks (which refused to raise their rates and in some cases couldn’t afford to) and into money market accounts or other instruments that offered significantly higher yields. This outflow was large and growing. So large, in fact, that many banks had to sell some their bond portfolios to cover these outflows. Thus, selling the bonds triggers recognition of any previously disguised/ignored/unrecognized losses
13. Bond market losses in 2022 were the worst in history! According to the Barclay’s U.S. Aggregate Bond Index, 2022 was the worst year in since they started recording in 1976 for bonds. Last year, 2022, was historically bad – down 13%. So for example if you own a bond paying a flat 2% and the current interest rate, which is what new bond issues are based on, are at 5%, why would anyone buy the 2% bond? They would buy it only when offered at a discount. “Even if you go back 250 years, you can’t find a worse year than 2022,” The longest U.S. government bonds have a maturity of 30 years. Such long-dated U.S. notes lost 39.2% in 2022.
It’s impossible to know what’s in store for 2023
14. Now, Big Money finally recognized that the Fed had entirely destroyed the business model of these regional banks and are fleeing.
15. Fed agreed for the first time in history to make unsecured loans to banks so that they can cover these outflows without having to sell their bond portfolios and trigger loss recognition. And that effectively means that the Fed has resumed money printing.
16. Which means…more inflation is coming
US government bonds are the new “toxic security”-Case study from SVB incident
a) SVB was a banker to the Silicon Valley VCs & start-ups. SVB (16th largest bank of America) was the biggest American bank to fail since the collapse of Washington Mutual in 2008, at the height of the global financial crisis.
b) Lehman bet almost ALL of its balance sheet on those risky mortgage bonds, SVB actually had a surprisingly conservative balance sheet SVB had $173 billion in customer deposits, yet “only” $74 billion in loans, parked the majority of their depositors’ money ($119.9 billion) in US government bonds, whose value have fallen sharply in 2022 & 2023. Banks typically loan out MOST of their depositors’ money.
c) Wells Fargo has made loans with nearly 70% of its customer’s money, while SVB had a more “conservative Loan-to-Deposit ratio” of 42%.
d) Silicon Valley Bank failure is a text-book case of an asset liability mismatch. Its roots are in poor risk management practices that zero interest rate decade in the US triggered. SVB was not holding dodgy assets or crypto coins that went bust — it simply used short-term money to buy long-dated US Treasuries in the expectation that interest rates will remain low.
e) US government bonds are supposed to be the safest, most ‘risk free’ asset in the world. But that’s totally untrue, because even government bonds can lose value. And that’s exactly what happened.
f) Most of SVB’s portfolio was in long-term government bonds, like 10-year Treasury notes and these have been extremely volatile.
g) SVB loaded up on long-term government bonds when interest rates were much lower; the average weighted yield in their bond portfolio was just 1.78%. But interest rates have been rising rapidly. The same now yield between 3.5% and 5%, meaning that SVB was sitting on steep losses.
h) SVB’s 2022 annual report, showed about $15 billion in ‘unrealized losses’ on their government bonds whereas, SVB only had about $16 billion in total capital.
i) SVB passed its stress tests with flying colors. It also passed its FDIC examinations, its financial audits, and its state regulatory audits
j) SVB was also followed by dozens of Wall Street analysts, many of whom had previously issued emphatic BUY ratings on the stock after analyzing its financial statements. But the greatest testament to this absurdity was the SVB stock price in late January
k) SVB published its 2022 annual financial report, where they posted $15 billion in unrealized losses which effectively wiped out the bank’s capital. SVB stock closed at $291.44
l) In other words, despite SVB management disclosing that their entire bank capital was effectively wiped out, ‘expert’ Wall Street investors excitedly bought the stock and bid the price up by 16%. The stock continued to soar, reaching a high of $333.50 a few days later on February 1st. In short, all the warning signs were there. But the experts failed again.
m) The FDIC saw Silicon Valley Bank’s dismal condition and did nothing. The Federal Reserve did nothing. Investors cheered
If SVB is insolvent, so are many other banks
Ø Wells Fargo recently reported $50 billion in unrealized losses on its bond portfolio. That’s a HUGE chunk of the bank’s capital, and it doesn’t include potential derivative losses either.
Ø Anyone who has purchased long-term government bonds-- banks, brokerages, large corporations, state and local governments, foreign institutions-- are all sitting on enormous losses right now.
Ø The FDIC (the Federal Deposit Insurance Corporation), i.e. the primary banking regulator in the United States) estimates unrealized losses among US banks at roughly $650 billion, this is similar in size to the total subprime losses in USA back in 2008; and if interest rates keep rising, the losses will continue to increase.
Ø In fact they manage a special fund called Deposit Insurance Fund’s (DIF)’ balance right now is only around $128 billion vs. $650 billion (and growing) unrealized lossesin the banking system. DIF invest that $128 billion? In US government bonds, which is fast loosing value?
So even the FDIC is suffering from unrealized losses, which is supposed to bail out banks
What about Fed?
Now there’s one bank that is incredibly exposed to major losses in its bond portfolio. In fact last year this bank reported ‘unrealized losses’ of more than $330 billion against just $42 billion in capital making this bank completely and totally insolvent. It’s about the Federal Reserve, the most important central bank in the world. It’s hopelessly insolvent, and far more broke than Silicon Valley Bank
Lessons from History, Lehman moment
1) The unraveling can happen in an instant. A week ago, everything was still fine. Then, within a matter of days, SVB’s stock price plunged, depositors pulled their money, and the bank failed. The same thing happened with Lehman Brothers in 2008.
2) This phenomena may keep happening (bank failures & instability in the financial system)
3) When inflation shot up in 2021 and peaked in mid-2022 at 9.1% from a near-zero level in 2020, the Fed carried out a brutal 450 basis point rate hike in 12 months.
4) There is an inverse relation of interest rates with bond prices. Investors holding the low-interest bonds saw the bond price fall sharply. But, US regulation allows smaller banks to not mark the bond portfolios to market, but to value them as if they are held to maturity. This strategy works if the bonds are held to maturity or interest rates fall (the bond prices will rise, giving a profit if these bonds are sold).
5) Fed was creating a financial meltdown by raising interest rates quickly as they have to choose between a rock and a hard place, i.e. higher inflation versus financial catastrophe.
6) There might be other casualties-- not just in banks, but money market funds, insurance companies, and even businesses.
7) Foreigners (mainly Central Banks, sovereign wealth funds & Financial Institutions) who bought US government bonds are suffering tough losses, and could accelerate their losses by holding on. Why would anyone want to continue with this insanity?
8) Foreigners dumping their holdings due to losses & lack of confidence have negative implications on the US dollar’s reserve status as they may decide to avoid investment in US government bond & reduce current holdings.
9) US national debt is outrageously high and inflation is high beyond their tolerance level.
10) Official narrative is “Banking System is safe”, remaining in state of denial. “Americans can rest assured that our banking system is safe,” Biden
11) But the Federal Reserve-- which is the ringleader of this sad circus seems to act at the behest of political masters whose priority is winning elections (every 2 years) and doesn’t act according to rule book. They appear totally out of touch with what’s really happening in the economy.
12) In a recent note, we (Fed) estimated banks’ unrealized losses on loans and securities at about $1.75 trillion. We argued they are at least partly offset by gains on the deposit franchise.
13) The US Fed itself resembles SVB.
14) In Sept 22 its MTM loss was already > $1.2 TRILLION. Wait for the March 23 figure.
15) U.S. banking system’s market value of assets is $2.2 trillion lower than suggested by their book value of assets accounting for loan portfolios held to maturity. Marked-to-market bank assets have declined by an average of 10% across all the banks, with the bottom 5% are experiencing a decline of 20%. Most of these asset declines were not hedged by banks with use of interest rate derivatives.
(Source: SSRN Papers Research)
US bank system is more fragile than you’d think
a) US banks are ‘full of’ bad commercial property loans, as U.S. commercial property market is in trouble while about $ 5.6 trillion in commercial real estate loans are held by mid-cap banks. Concerns remain about a commercial real estate crash resulting from a rate hike, which would further escalate the collapse of regional banks. The U.S. national office space vacancy rate was 19 % in the first quarter, an all-time high in 31 years, and even institutional investors failed to pay off their office mortgages.
b) About half of U.S. banks may be on the brink of collapse due to these factors.
c) Amit Seru, professor of finance at Stanford Graduate School, estimated that almost half of America’s 4,800 banks are “burning through their capital buffers” and “potentially on the brink of collapse.
d) “In the worst-case scenario, if all uninsured depositors withdrew all their money from U.S. banks, more than 1,600 banks would be left without enough funds to cover their insured deposits,” Professor Seru’s paper calculated.
e) 10 % of banks have larger unrecognized losses than those at SVB. Nor was SVB the worst capitalized bank, with 10 % of banks having lower capitalization than SVB.
f) Prior to the recent asset declines all US banks had positive bank capitalization. However, after the recent decrease in value of bank assets, 2,315 banks accounting for $11 trillion of aggregate assets have negative capitalization.
g) Check out this difference between US and China banks, Its crazy casino capitalists versus sensible socialists
i. Looking at the top 4 American and Chinese banks, here are their assets and derivatives:
ii. US: 20x more derivatives than assets! China: 2x more ASSETS than derivatives! (And Chinese assets are also 2.4 xs larger than US assets)
h) US government doesn’t have any money. Where does the US government get the money?
i) From the Fed & the Fed just prints the money. That’s where the FDIC gets the money, which is why everybody is going to lose. The mainstream pundits, central bankers, and politicians all claim the banking system is sound but you had better worry even more about your money.
Vulnerabilities of NBFC
According to the Financial Stability Board (FSB), a body of global regulators and government officials, non-banks had about $239 trillion (That's up from 42% in 2008) on their books in 2021 (accounted for 49% of all global financial assets in 2021), accounting for just under half of the world’s total financial assets. Non-banks that provide credit are known as “shadow banks,”although the term is often used imprecisely to mean all non-banks. It is this type of institution that is worrying the investors. NBFCs operate without the same level of regulatory oversight and transparency as banks.
Expert’s take:
Ø There is far too much money floating around. Stimulus checks and Fed bond buying filled up bank accounts and boosted corporate profits, and it hasn’t all gone away. One sign of the spare cash is that money-market funds have banked $2.2 trillion at the Fed, via its reverse-repurchase facility. Some, of course, was wasted on meme stocks, bitcoin and exercise bikes, but plenty is invested, helping hold up share prices, junk bond prices and Treasury prices—and so hold down yields. Excess money shoved into stocks shows up as an elevated valuation, even as Wall Street wakes up to the risk of a hit to profits by lowering earnings forecasts.
Ø Raghuram Rajan foresees fresh trouble for banking sector after US crisis and opined that a decade of easy money and a flood of liquidity from central banks has caused an “addiction" and a fragility within the financial system as policy makers tighten policy. “This sense that the spillover effects of monetary policy are huge and aren’t dealt with by ordinary supervision has just escaped our consciousness over the last so many years," Rajan said. He said banks are vulnerable to unwinding after central banks “flooded the system with liquidity."
Ø What about banks hedging? I.e. some banks would have "insured" their int. rate risk? If the most insolvent banks have hedged the most, but if the best banks have hedged this risk - quite likely - risk of bank failures remains unaltered.
Ø The inescapable conclusion is that fiscal profligacy during Covid is costing the U.S. now. This is Long-term pain for short-term gain. India chose the reverse: short-term pain for long-term gain.
Ø The SVB story, the reaction of Silicon Valley’s VCs, usually dismissive of the government, screaming for a deposit guarantee from the Fed, think of this famous line: Sharp suits want capitalism on the way up, but socialism on the way down.
Ø Ray Dalio on Banking crisis post SVB: I think that it is a very classic event in the very classic bubble-bursting part of the short-term debt cycle (which lasts about seven years, give or take about three) in which the tight money to curtail credit growth and inflation leads to a self-reinforcing debt-credit contraction that takes place via a domino-falling-like contagion process that continues until central banks create easy money that negates the debt-credit contraction, thus producing more new credit and debt, which creates the seeds for the next big debt problem until these short-term cycles build up the debt assets and liabilities to the point that they are unsustainable and the whole thing collapses in a debt restructuring and debt monetization (which typically happens about once every 75 years, give or take about 25 years).
Ø “The way the world is, the government had no alternative but to back all deposits. Or we would have had the biggest goddamn bunch of bank runs you ever saw.”-Charles Munger
Ø “A healthy Banking system is one of the vital parts of a nation's foundation.” ― Hendrith Smith
Can this happen in India?
India has: 12 PSU Banks, 21 Pvt. Banks, 43 RRBs, 12 Small Banks, 6 Payment Banks, 34 State Co Op Banks, 53 Urban Co Op Banks, total 181 Banks with population of 1/4th to that of USA. Both RBI and the SEBI have been pushing banks and mutual funds to mark their portfolios to market — which means that if there are unrealised losses due to a change in the bond price, these need to be accounted for. This means that banks today will be sitting on mark-to-market losses on account of their bond portfolios as RBI has been raising rates, but it also means that a sudden event will not catch them off guard and cause a sudden deterioration of their asset values. SEBI has progressively made rules tougher for debt funds. Hence no major shocks expected in India.
CA Harshad Shah, Mumbai harshadshah1953@yahoo.com