Nearly half of America’s 4,800 banks have already burned through their capital buffers and the Fed has chosen not to help them.
Crashes in the commercial real estate sector and the US bond market collided with $9 trillion in uninsured deposits in the US banking system.
The second and third largest bank failures in US history followed in quick succession. The US Treasury and Federal Reserve want us to believe they are "idiosyncratic."
Nearly half of America’s 4,800 banks have already burned through their capital buffers. They may not have to mark all losses on the market under US accounting rules, but that doesn’t make them creditworthy. Let’s not pretend it’s just Silicon Valley Bank and First Republic. Much of the US banking system is potentially insolvent. A Hoover Institution report by Prof. Seru and a panel of experts calculated that more than 2,315 US banks are currently sitting on assets worth less than their liabilities. The market value of their loan portfolios is $2 trillion lower than their reported book value.
One of the 10 most vulnerable banks is a global systemic entity with assets of over $1 trillion.
The US Treasury and Federal Deposit Insurance Corporation (FDIC) thought they had stemmed the crisis by bailing out uninsured depositors at Silicon Valley Bank and Signature Bank with a "systemic risk-free" after these lenders collapsed in March.
The White House declined to provide a blank check for all deposits. Additionally, the FDIC has just $127 billion in assets and may eventually need its own bailout.
The authorities preferred to leave the matter vague, hoping to reassure depositors. The bet failed. Depositors fled First Republic Bank, despite an earlier $30 billion inflow from more established banks.
White Knights investigating a possible takeover of First Republic Bank backed off once they reviewed the books and discovered the extent of real estate losses. The FDIC had to seize the bank, wiping out both shareholders and bondholders. It took a $13 billion grant and $50 billion in loans to entice JP Morgan to pick up the pieces.
US authorities can contain the immediate liquidity crisis by temporarily guaranteeing all deposits. But that doesn’t address the major solvency crisis.
The Treasury and the FDIC are unwilling to take responsibility. They blame bankruptcies on reckless borrowing, mismanagement, and overreliance on uninsured depositors. This is exactly the same approach used when Bear Stearns collapsed in 2008.
Rates have risen 400 to 500 basis points in one year and the financial markets have shut down almost completely. Goldman Sachs says there are about four to five trillion dollars of commercial debt. Of these, about a trillion matures over the next 12-18 months.
Bonds secured by a portfolio of commercial mortgages (CMBS) are typically short-term and need to be refinanced every two to three years. They exploded during the pandemic when the Fed flooded the liquidity system. That debt will now need to be refinanced in late 2023 and 2024.
Could the losses be as significant as during the subprime crisis? Probably. The US residential property investment bubble peaked at 6.5% of GDP in 2007. For comparison, commercial properties are today valued at 2.6%. Nevertheless, the threat is not trivial. Commercial real estate prices in the US have decreased by 4-5%. But a 22% drop is expected. This will pressure regional banks which account for 70% of all commercial real estate financing.
Silicon Valley Bank’s problems were different. Its original sin was parking excess deposits in what is supposed to be the safest financial asset in the world: US Treasuries. It was encouraged to do so under the Basel regulators’ risk weighting rules.
Some of these debt securities have lost 20% on long maturities.
US authorities say the bank should have protected this Treasury debt with interest rate derivatives. But hedging simply transfers losses from one bank to another. The counterparty that signs the hedge contract takes the hit instead.
The root cause of this bond and banking crisis lies in the erratic behavior and perverse incentives created by the Fed and the US Treasury over many years. First, they created “interest rate risk” on a global scale: now they are detonating the time bomb they themselves set off.
The banking crisis will continue to spread until the Fed reverses its monetary policies and cuts rates by 100 basis points.
The Fed has no plans to back down, continuing to reduce the US money supply at a record pace with $95 billion of quantitative easing each month.
The truth is, the US has to choose to capitulate on inflation or let a banking crisis reach systemic proportions.
Apparently, it chose a banking crisis.