THE LOCATION STRATEGY TOP 10

"CRISIS IN THE BANKING SECTOR"

THIS WEEK'S SPECIAL EDITION OF THE TOP TEN WILL COVER WHAT'S BEHIND RECENT BANKING COLLAPSES, WHAT TO EXPECT THE EFFECT OF BANKING CHALLENGES IS LIKELY TO BE, AND HOW TO SPOT AN IMPEDING RUN ON BANKS. OR, HOW THE FEDERAL RESERVE CREATED A PERPETUAL MOTION MACHINE WHERE RISING RATES ARE FUELING BANK RUNS THAT ARE BEING RESOLVED BY THE FED'S OWN EMERGENCY RESCUE PROGRAMS.

On March 6 FDIC Chairman Martin Gruenberg gave a speech at the Institute of International Bankers, saying that banks had $620 billion of unrealized losses from long-dated bonds:

The Financial Times reported on Wednesday (3/15/23) about a study that shows the losses may be even greater:

Silicon Valley Bank (SVB) was particularly explicit about these problems, announcing on March 9th the bank had incurred massive losses on its investments, and its CEO held a "Don't Panic" call with depositors on March 10. The run began the next day. It was only so severe because SVB was such an outlier; the bank had unusually high percentages of hold-to-maturity securities (which cannot be sold) and uninsured deposits.

One of the next shoes to drop was First Republic, a large regional bank basically serving east and west coast customers. This time Treasury Secretary Yellen and Fed Chair Jerome Powell organized a $30 billion "bailout" from six of the largest banks in the country. So if you are one of the millions of bank customers who fled community and regional banks for the perceived safety of a large, national bank: Surprise! Yellen and Powell just pushed you right back in.

If you think the team is coming to save your smaller regional or community bank, I'd encourage you to watch this exchange between Treasury Secretary Janet Yellen and Oklahoma Senator James Lankford:

Despite the media focus on US banks, this is a worldwide problem. Credit Suisse, for example had a market capitalization of about $8.4 billion borrowed more than $54 billion from the Swiss Government.

What turned mortgage bonds toxic?  The same story we have seen again and again: incompetence and mismanagement of the government's response to the pandemic. From the Wall Street Journal:

These banks are going under because they are holding mortgage-backed securities (bought when rates were low) in a high-rate environment. Because of the increase in mortgage rates, those securities are at least worth less than what they paid for them. Californians may not have been able to spot this problem, but it should be readily apparent to Texans who lived through the 1980s - it's very similar to the problems that brought down S&Ls, where at its core institutions were paying depositors more than they were receiving from borrowers.

Stimulus created by the Fed's 40% increase in money supply in 2020-2021 had to go somewhere; banks then bought bonds and mortgage-backed securities while the Fed Chairman, the Treasury Secretary, and the President told everyone who would listen that the excess cash wasn’t inflationary. If inflation came it would be “transitory.” 

There are a number of well-known spurious correlations, like the 67% correlation between deaths by drowning and number of films starring Nicolas Cage, or the 95% correlation between per capita cheese consumption and the number of people who are strangled by their bedsheets. I guess the Fed would have us non-bankers and non-economists believe the correlation between Fed Funds rate increases and unrealized losses on bank balance sheets is another one of these.

This situation means the Fed is back to hiking rates, tightening its balance sheet while also injecting funds back into the markets. I used to work for a company who's motto was "we're building the plane while we're flying it." It's no way to run a company and no way to run a country, either.

Fed Funds Rate Increases Always Break Something. This time it seems like the Fed is on a collision course with the banking system itself.

The scale of losses is larger than most people imagine: In total banks needed to borrow close to $550bn over the past week to Wednesday, slightly above $300bn from the Fed and slightly below $250bn from FHLB. This implies that US banks lost even more than the $460bn estimated based on the uninsured deposits at the six US banks with the highest ratio of uninsured to total deposits in last Wednesday’s Flows & Liquidity. If banks experienced losses of that scale that means banks realized almost 25% of total universe of estimated investment losses in just the last week.

WHAT DOES THIS MEAN?

Firstly small banks will likely dry up as a source of funding generally because their reserves are as low as they can get:

Where are the defaults taking place? Office buildings and apartments. There have already been a few notable defaults in the office sector, like this one, this one, and this one; but challenges in this space are limiting the ability of banks to continue lending. Values are down 8-10%, because people still haven't come back to work. It's worth noting most of these defaults are on the east and west coast, and Texas should remain isolated from the worst of these events.

Because of this, we are at risk of a vicious cycle of spiraling liquidity.



As macroeconomic conditions continue to weigh on operating performance and constrain liquidity, the leveraged loan default rate could rise to 2.5% by December 2023 (from 0.85% in January 2023) amid persistently challenging credit conditions

Tightened liquidity, increased defaults along with an imbalance in investment losses means many banks will have to reorganize their balance sheets. Every bank to the right of SVB will likely need to do this.

Whether we realize it or not, when we think of a bank run we imagine Frank Capra's classic It's A Wonderful Life. Like Capra's fictional cop Bert, I've never seen one, and I suspect banking doesn't really even work that way. Even if it did, but the time you saw people lining up outside it's probably too late.

There is some potential risk; it only took about 10% withdrawals to bring down SVB, and the Fed contributes to that by setting up a perpetual motion machine. It raises rates devaluing securities and provoking defaults, which encourages runs on small banks - who then clandestinely receive financial support from the Fed to stay alive.

I don't really think we will see more bank runs; but if we did, what would those look like? We turned to some analysis from Goldman and here's what they look for to identify a bank run. I've eliminated a few technical measurements, but the rest can be easily found.

ISo the first place Goldman recommends to find a potential bank run is to look at deposit rates. Climbing rates could be an indication that institutions are struggling to retain deposits. 

A second place to look is the Fed’s H.8 release. The H.8 release reports total deposits at small banks, defined as those outside the top 25, with a week-and-a-half lag. Large time deposits (Exhibit 1, left) might provide a clearer and earlier signal than other deposits (Exhibit 1, right) because they capture depositors more attuned to issues such as interest rates or concerns about bank stress. A limitation of the H.8 data is that the two banks that have failed were categorized as large, so the small vs. large split does not align perfectly with vulnerability to stress.

The Federal Home Loan Banks (FHLB) system is seen as a less stigmatizing alternative to the discount window for commercial banks and other members to obtain funding. The FHLB has been increasing the amount of funds it has on hand, which suggests a surge in demand for dollars and a potential increase in deposit runs.

The FHLB recently raised an unprecedented $88.7 billion through floating-rate notes, followed by another $19 billion on Tuesday, and has also raised $22.87 billion via term discount notes. The FHLB's total amount of advances to members more than doubled to $819 billion last year, and this latest episode may push them higher still. While the FHLB system provides a clean tracker of the amount of deposits smaller banks have lost in recent days, this data comes out only once a quarter.  

The last place Goldman recommends is following the stock price if the company is publicly traded.

Those are our thoughts on the banking sector this week. Have a great weekend.

Scott Davis

LOCATION STRATEGY, LLC

1302 Waugh Drive #178

Houston, Texas 77019

832.304.DIRT (3478)

www.locationstrategyllc.com