The twin crashes in US commercial real estate and the US bond market have collided with $9 trillion uninsured deposits in the American banking system. Such deposits can vanish in an afternoon in the cyber age.
The second and third biggest bank failures in US history have followed in quick succession. The US Treasury and Federal Reserve would like us to believe that they are “idiosyncratic”. That is a dangerous evasion.
Almost half of America’s 4,800 banks are already burning through their capital buffers. They may not have to mark all losses to market under US accounting rules but that does not make them solvent. Somebody will take those losses.
“It’s spooky. Thousands of banks are underwater,” said Professor Amit Seru, a banking expert at Stanford University. “Let’s not pretend that this is just about Silicon Valley Bank and First Republic. A lot of the US banking system is potentially insolvent.”
The full shock of monetary tightening by the Fed has yet to hit. A great edifice of debt faces a refinancing cliff-edge over the next six quarters. Only then will we learn whether the US financial system can safely deflate the excess leverage induced by extreme monetary stimulus during the pandemic.
A Hoover Institution report by Prof Seru and a group of banking experts calculates 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 the stated book value.
These lenders include big beasts. One of the 10 most vulnerable banks is a globally systemic entity with assets of over $1 trillion. Three others are large banks. “It is not just a problem for banks under $250bn that didn’t have to pass stress tests,” he said.
The US Treasury and the Federal Deposit Insurance Corporation (FDIC) thought they had stemmed the crisis by bailing out uninsured depositors of Silicon Valley Bank and Signature Bank with a “systemic risk exemption” after these lenders collapsed in March.
The White House baulked at a blanket guarantee for all deposits because that would look like social welfare for the rich. Besides, the FDIC has only $127bn of assets (and less very soon) and may ultimately require its own bailout.
The authorities preferred to leave the matter vague, hoping that depositors would discern an implicit guarantee. The gamble failed. Depositors fled First Republic Bank at a fast and furious pace last week despite an earlier infusion of $30bn from a group of big banks.
White knights probing a possible takeover of First Republic recoiled once they examined the books and discovered the scale of real estate damage. The FDIC had to seize the bank, wiping out both shareholders and bondholders. It took a $13bn subsidy along with $50bn of loans to entice JP Morgan to pick up the pieces.
“No buyer would take First Republic without a public subsidy,” said Krishna Guha from Evercore ISI. He warns that hundreds of small and mid-sized banks will batten down the hatches and curb lending to avoid the same fate. This is how a credit crunch begins.
The share price of PacWest, the next on the sick list, fell 11pc in late trading on Monday. That will be the bellwether of what happens next.
The US authorities can contain the immediate liquidity crisis by guaranteeing all deposits temporarily. But that does not address the greater solvency crisis.
The Treasury and the FDIC are still in the denial phase. They blame the failures on reckless lending, bad management, and over-reliance on foot-loose uninsured depositors by a handful of banks. This has a familiar ring. “They said the same thing when Bear Stearns went down in 2008. Everything was going to be alright,” said Prof Seru.
First Republic lends to technology start-ups, but it chiefly came unstuck on commercial real estate. It will not be the last on that score. Office blocks and industrial property are in the early stage of a deep slump. “Where we stand today is a nearly perfect storm,” said Jeff Fine, real estate guru at Goldman Sachs.
“Rates have gone up 400 to 500 basis points in a year, and financing markets have almost completely shut down. We estimate there’s four to five trillion dollars of debt in the commercial (property) sectors, of which about a trillion is maturing in the next 12 to 18 months,” he said.
Packages of commercial property loans (CMBS) are typically on short maturities and have to be refinanced every two to three years. Borrowing exploded during the pandemic when the Fed flooded the system with liquidity. That debt comes due in late 2023 and 2024.
Could the losses be as bad as the subprime crisis? Probably not. Capital Economics says the investment bubble in US residential property peaked at 6.5pc of GDP in 2007. The comparable figure for commercial property today is 2.6pc.
But the threat is not trivial either. US commercial property prices have so far fallen by just 4pc to 5pc. Capital Economics expects a peak to trough decline of 22pc. This will wreak further havoc on the loan portfolios of the regional banks that account for 70pc of all commercial property financing.
“In a worst case scenario, it could create a ‘doom loop’ which accelerates a real estate downturn that then feeds back into the banking system,” said Neil Shearing, the group’s chief economist.
Silicon Valley Bank’s travails were different. Its sin was to park 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 risk-weighting rules of the Basel regulators.
Some of these debt securities have lost 20pc on long maturities – a theoretical paper loss only until you have to sell them to cover deposit flight.
The US authorities say the bank should have hedged this Treasury debt with interest rate derivatives. But as the Hoover paper makes clear, hedging merely transfers losses from one bank to another bank. The counterparty that underwrites the hedge contract takes the hit instead.
The root cause of this bond and banking crisis lies in the erratic behaviour and perverse incentives created by the Fed and the US Treasury over many years, culminating in the violent lurch from ultra-easy money to ultra-tight money now underway. They first created “interest rate risk” on a galactic scale: now they are detonating the delayed timebomb of their own creation.
Chris Whalen from Institutional Risk Analyst said we should be wary of a false narrative that pins all blame on miscreant banks. “The Fed’s excessive open market intervention from 2019 through 2022 was the primary cause of the failure of First Republic as well as Silicon Valley Bank,” he said.
Mr Whalen said US banks and bond investors (i.e. pension funds and insurance companies) are “holding the bag” on $5 trillion of implicit losses left by the final blow-off phase of the Fed’s QE experiment. “Since US banks only have about $2 trillion in tangible equity capital, we have a problem,” he said.
He predicts that the banking crisis will keep moving up the food chain from the original outliers to mainstream banks until the Fed backs off and slashes rates by 100 basis points.
The Fed has no intention of backing off. It plans to raise rates further. It continues to shrink the US money supply at a record pace with $95bn of quantitative tightening each month.
The horrible truth is that the world’s superpower central bank has made such a mess of affairs that it has to pick between two poisons: either it capitulates on inflation; or it lets a banking crisis reach systemic proportions. It has chosen a banking crisis.
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