Why many US banks may be in trouble

 

One can say, with a certain amount of truth, that the Federal Reserve's fiscal policies have created the problem currently confronting US banks.  Here's why.

One of the biggest problems facing banks is the rapid devaluation of their bond portfolios.

Banks were incentivized to load up on high-priced, low-yield bonds thinking that the Fed would keep interest rates low forever. As the Fed jacked up interest rates to fight price inflation, it decimated the bond market. (Bond prices and interest rates are inversely correlated. As interest rates rise, bond prices fall.) With interest rates rising so quickly, banks have not been able to adjust their bond holdings. As a result, many banks have become undercapitalized on paper as the value of the bond portfolios shrinks. The banking sector was buried under some $620 billion in unrealized losses on securities at the end of last year, according to the Federal Deposit Insurance Corp.

As the Washington Post reported, this means banks would face unprecedented losses if they were forced to liquidate their bond portfolios. In fact, that is exactly what doomed Silicon Valley Bank. The plan was to sell the longer-term, lower-interest-rate bonds and reinvest the money into shorter-duration bonds with a higher yield. Instead, the sale dented the bank’s balance sheet and caused worried depositors to pull funds out of the bank.

According to the Post, the total capital buffer in the US banking system totals $2.2 trillion. Meanwhile, total unrealized losses in the system based on a pair of academic papers is between $1.7 and $2 trillion.

Gojon explains how the big banks have dealt with this problem.

Many big banks in the United States have substantially increased their use of an accounting technique that allows them to avoid marking certain assets at their current market value, instead using the face value in their balance sheet calculations. This accounting technique consists of announcing that they intend to hold such assets to maturity.”

In other words, this accounting trick makes the bank look far more solvent than it actually is.

At the end of 2022, Charles Schwab had the largest amount of assets marked as “held to maturity” relative to capital. According to data cited by Gojon, Schwab had over $173 billion in assets marked as “held to maturity,” while its capital (assets minus liabilities) stood at under $37 billion. At that time, the difference between the market value and face value of assets held to maturity was over $14 billion.

If the accounting technique had not been used the capital would have stood at around $23 billion. This amount is under half the $56 billion Charles Schwab had in capital at the end of 2021. This is also under 15 percent of the amount of assets held to maturity, under 10 percent of securities, and under 5 percent of total assets. An asset ten years from maturity is reduced in present value by 15 percent with a 3 percent increase in the interest rate. An asset twenty years from maturity is reduced in present value by 15 percent with a 1.5 percent increase in the interest rate.”

Other banks that may be close to effective insolvency include the Bank of Hawaii and the Banco Popular de Puerto Rico (BPPR). According to Gojon, the Bank of Hawaii, BPPR, and Charles Schwab have lost between one-third and one-half of their market capitalization over the last month.

Gojon concedes that it’s hard to know how this will play out, but he said there is clearly a large amount of risk in the banking system.

It is difficult to say with certainty whether they are indeed secretly close to insolvency as they may have some form of insurance that could absorb some of the impact from a loss of value in their assets, but if this were the case it is not clear why they would need to employ this questionable accounting technique so heavily. The risk of insolvency is currently the highest it’s been in over a decade.”

Gojon said the Fed can solve liquidity problems even as it continues to raise interest rates to fight inflation. That’s the whole point of the bank bailout program. But he said the Fed can’t fix solvency problems without pivoting to loser monetary policy or through more blatant bank bailouts. Those scenarios would both raise inflation expectations.

The bottom line is that despite Janet Yellen’s constant assurances, the banking system is not sound. It is a house of cards that could fall down at any time.

There's more at the link.

It's a logical sequence of events.

1. The Fed dictates that US banks must hold a proportion of their reserves in "approved" investments such as government bonds.
2. The banks obediently invest their money in those bonds at then-prevailing prices and interest rates.
3. After a time, interest rates go up, because nobody is willing to buy the bonds at an interest rate (i.e. a return on investment) that's lower than inflation and/or doesn't adequately compensate for the risks involved.
4. The rise in interest rates drives down the low-interest bonds' current market value, so that they're now worth less on the open market than they were when the banks purchased them.
5. The banks dare not sell them and take the loss, because that might reduce their cash reserves below the proportions required by law;  therefore, they announce that they'll hold the bonds until their redemption date, regardless of whether their present value is lower than it will be at that time.  This - on paper - effectively revalues the bonds upward.
6. However, if the bank hits serious problems and has to sell its bonds to raise liquid capital (e.g. if there's a run on the bank), it will still get less for its bonds than it paid for them, and will have to reflect that loss on its balance sheet.  This might render it technically bankrupt according to US law, and may not raise enough liquid capital to meet all its obligations.

The banks are between a rock and a hard place, made worse by the fact that smaller banks are more exposed to this risk than larger ones (because the former have fewer reserves than the latter, and are therefore more affected by fluctuations in bond prices).  As a result, when a smaller bank goes belly up, the bigger banks - to compensate them for taking on the "risks" involved in buying the technically-insolvent smaller bank - are allowed to do so for much lower prices than other investors would pay, making them an instant and often exorbitant profit.

It's not only a logical sequence, it's a vicious circle too - and it's been created by Federal Reserve policies that banks are obliged to follow.

All we can be sure of is that the fat-cats, the oligarchs, and the politicians and bureaucrats they control, won't lose money.  They've got theirs.  Sucks to be us.

Peter