The latest inflation report contained bad news for banks. They’re deeply underwater, and still sinking – in such bad shape that even the head of the SEC doesn’t want anyone looking too closely…
The first inflation report since the Fed’s September interest rate cut begged some questions…
Since I sincerely hope most of you don’t follow these stories as closely as I do, we’ll start with a quick recap:
In August, the Fed lowered its primary interest rate by 1/2% (50 basis points) to 5%. That was the first reduction in interest rates since the Fed began raising rates from zero way back in 2022 – in an effort to tame the worst inflationary episode in over 50 years.
(Okay, 2022 wasn’t really “way back” but so much has happened since then, it feels like a decade ago.)
Official September inflation numbers showed a slight, but definitely upward, trend. This is unwelcome news, however we slice it. Just like in Canada, reducing interest rates before the inflation target is met means inflation trends back up.
It’s particularly unwelcome for banks – who are still struggling with massive unrealized losses on their reserves.
How are the banks doing?
That depends on who you ask…
According to FDIC Chairman Martin Gruenberg in his September 5 update, “The banking industry continued to show resilience in the second quarter.”
He also noted, “This is the tenth straight quarter that the industry has reported unusually high unrealized losses since the Federal Reserve began to raise interest rates in first quarter 2022.”
We all remember what happened back in 2023:
- Silicon Valley Bank became the 3rd largest bank failure in U.S. history
- That same month, two other banks collapsed: Silvergate Bank and Signature Bank (4th biggest)
- Swiss megabank Credit Suisse also failed in March
- Then in May, First Republic Bank collapsed (2nd biggest)
- Later that year, two regional banks failed: Heartland Tri-State and Citizens Bank (Iowa)
The Fed’s emergency backdoor bank lending program (BTFP) stopped making new loans in March – and I expected more trouble. One month later, Republic First Bank (different from First Republic Bank – I know, it’s confusing!) collapsed.
Since then, things have been relatively quiet on the banking front. Frankly that surprised me.
See, banks are still under a lot of pressure… Right now they’re sitting on losses nearly SEVEN times greater than during the worst of the Great Financial Crisis:
That is clearly the biggest challenge – but there’s more (quotes from Gruenberg’s September speech):
- The default rate on commercial real estate loans is “ts highest level since third quarter 2013”
- The default rate on multifamily real estate loans is “the highest since third quarter 2014”
- Banks simply gave up on ever getting paid for credit card loans at “ the highest rate reported since third quarter 2011”
- “deposits decreased $197.7 billion”
This really matters to banks!
In order to understand why, you need to understand how banks work at a very basic level…
“Banking is a confidence trick”
Famed Bloomberg columnist Matt Levine explained how modern banking works:
Banking is a confidence trick. You put money in the bank today because you are confident you can take it out tomorrow; to you, a dollar that you have deposited in the bank is just as good – just as much money – as a dollar bill in your wallet. If you show up at the ATM at any time of day or night, you expect it to give you your dollars. But the bank doesn’t just put your dollars in a box and wait for you to take them out; the bank uses its depositors’ money to make loans or buy [assets], and just keeps a little bit around for people who need cash. If everyone asked for their money back tomorrow, the bank wouldn’t have it. But everyone is confident that, if they ask for their money back tomorrow, the bank will have it. So they mostly don’t ask for it, so when they do, the bank does have it. The widespread belief that banks have the money is what makes it true.
It’s a simple problem: Banks use your money to do things you wouldn’t do.
They take depositors’ money and use it to “make loans or buy assets.”
Levine does a good job of explaining this dynamic further, including how it works:
You and I put our money in the bank because it is “money in the bank,” it is very safe, and we can use it tomorrow to pay rent or buy a sandwich. And then the bank goes around making 30-year fixed-rate mortgage loans: Homeowners could never borrow money from me for 30 years, because I might need the money for a sandwich tomorrow, but they can borrow from us collectively because the bank has diversified that liquidity risk among lots of depositors. Or the bank makes small-business loans to businesses that might go bankrupt: Those businesses could never borrow from me, because I need the money and don’t want to take the risk of losing it, but they can borrow from us collectively because the bank has diversified that credit risk among lots of depositors and also lots of borrowers.
This makes sense, right?
Like I love to say, quoting Nobel Prize-winning economist Harry Markowitz:
“Diversification is the only free lunch in investing.”
Banks lower their risk by diversifying among a variety of loans and assets.
Consider all the services provided by any single bank or credit union. They make money lots of different ways:
- Mortgages
- Home insurance
- Auto insurance
- Personal loans
- Credit cards (also known as “unsecured lending” because there’s no collateral)
- Loans on boats, RVs, maybe even motorcycles and scooters
And of course any bank wants to give you lots and lots of options for giving your cash to them:
- Checking accounts (free, interest-bearing, business, personal and even student checking accounts)
- Savings accounts of all kinds
- A checking account for your HSA
- Certificates of deposit (CDs or time deposits)
- Individual retirement accounts (IRAs)
Heck, my credit union has a special “Christmas Club Savings” account just for the holidays!
When banks are able to use our money and make loans with it, they profit from charging interest on the loans. So when interest rates go up, you’d think that would make banks happy, right?
When interest rates are higher, banks can make more profit from their loans!
Here’s the problem: Higher interest rates also mean that banks have to pay depositors more in order to attract new cash.
Higher interest rates also mean that the loans you made back when rates were low? They’re worth a whole lot less.
Half a trillion dollars in “unrealized losses”
Banks are struggling with “unrealized losses,” which is another way of saying “losses on paper.”
Over the last 20 years, when the Fed kept interest rates near zero, banks made tons of loans at a fixed interest rate. I’m lucky enough to have a 30-year mortgage at 3.3%, for example. Back in 2012, when I bought my home, this was a good deal for banks!
They didn’t need to lure depositors with high rates on savings accounts – nobody offered more than 0.25% on cash deposits. So they took the money they basically got for free and used it to fund my mortgage.
Fast forward to today: Mortgage interest rates have more than doubled since then.
What looked like a great deal to the bank in 2012 is now a bad deal. They could be making new mortgage loans and collecting 7% rather than getting stuck with my 3.3% – so obviously they don’t want my mortgage anymore.
But when they go to sell it, there’s a problem: Nobody will buy it at the price they want. The BANK is underwater on my mortgage! They’re stuck with two bad choices:
- Keep it for the full 30 years and get paid back at 3.3%
- Sell it for the best price they can and take the loss
Given the choice, they’d probably keep it. Nobody likes taking a loss!
But what if they don’t have a choice?
Unrealized losses really matter when banks are forced to sell assets (like my mortgage) to meet customer demands for deposits.
That’s exactly what happened in 2023 to SVB, Signature, Credit Suisse, First Republic and Republic First.
Could it happen again?
Let’s see what the experts say…
“…you are not making the speech because you think there is an imminent crisis”
Not long ago, Gary Gensler, Chair of the Securities and Exchange Commission, gave a speech on the importance of transparency in banking. The SEC duly published a transcript of his speech, but made a small mistake…
They accidentally included the quite revealing notes SEC staff gave Gensler on the speech. That version of the transcript wasn’t live long (here’s a fortunately archived copy) but it certainly attracted some attention.
This is a speech about the importance of transparency, my friends. He says so right at the beginning:
Adam Smith, known as the father of modern economics, noted in The Wealth of Nations more than 200 years ago that the whole economy benefits when the price of information is lowered, or information is free.
Reliable, comparable, accessible data benefits everyone.
Keep that context in mind!
Now, here’s the part of the speech that raised red flags:
History is replete with times when tremors in one corner of the financial system or at one financial institution spill out into the broader economy. When this happens, workers, families, investors, and businesses inevitably get hurt. Thus, around the globe, regulation and safeguards have been put in place to lower the risk of financial institution failures to the public.
In the aftermath of the 2008 financial crisis, there was a consensus to further enhance those regulations. Governments worked with financial institutions to create mechanisms for private sector capital market investors to bear the costs of failures, through what’s called “loss absorbing capital.” In the face of a potential failure, large financial institutions would conduct a major recapitalization. Though such a restructuring has yet to occur at any global systemically important financial institution, the goal is to protect taxpayers by having private sector investors bear the costs of the institution’s problems.
One reviewer noted:
I strongly recommend that a sentence be placed here (or soemwhere in the first part of the speech) to reassure markets that you are not making the speech because you think there is an imminent crisis. [emphasis added]
Why does this matter?
Well, when Gary Gensler speaks, people listen. Investors, of course, but also C-suite executives, regulators from around the world and so on.
It’s absolutely vital that Gensler give absolutely no indication that there’s anything wrong.
“…you are not making the speech because you think there is an imminent crisis.”
Remember what Levine said? “Banking is a confidence trick.”
Confidence tricks only work as long as there is confidence.
The moment that confidence disappears, they collapse. Levine explains in greater detail why it’s so crucial that we have absolutely no indication there’s anything wrong:
If everyone asked for their money back tomorrow, the bank wouldn’t have it. But everyone is confident that, if they ask for their money back tomorrow, the bank will have it. So they mostly don’t ask for it, so when they do, the bank does have it. The widespread belief that banks have the money is what makes it true.
Considering the half a trillion in unrealized losses U.S. banks are sitting on, I would change Levine’s last line:
“The widespread belief that banks have the money is the only thing that makes it true.”
Let me ask you a question: If an asset or an institution requires your belief simply to function, is that a good thing?
Let me put it another way: If something can’t exist without constant belief and faith (I keep thinking of Tinkerbell in the old Disney version of Peter Pan, “We believe!”), should it exist at all?
Obviously, Gensler didn’t mean to raise these questions. He only wanted to give a speech about the importance of transparency in finance and investing.
That is, so long as we don’t look too closely. “Nothing to see here! No imminent crisis, nosiree, everything’s just fine.”
Numbers don’t lie. Does everything look just fine to you?
Financial crisis, bank collapses and the role of belief
Don’t get me wrong about these matters. I think faith and trust are crucial to a healthy life. I have faith in myself. I have trust in those who’ve earned it. I do not believe that the financial crisis that began in March 2003 is over.
As you can see from the chart above, the situation has improved. A little bit. Banks remain under a historic level of financial stress. And the banks aren’t alone. One major reason banks are struggling is because everyone else is struggling, too! Commercial real estate loans going into default. Credit card bills going unpaid.
The pressure isn’t going away. It’s getting worse.
One of the reasons I love my work is because of the sheer complexity and interconnectedness of the global financial system. It’s amazing to me that a single Houthi rebel armed with a $2,000 RPG-7 can change the price I pay to fill up my car.
Here’s what you need to know about complex interconnected systems, according to Dr. Richard Cook who’s made studying them his life’s work:
- Complex systems are intrinsically hazardous
- Change introduces new forms of failure
- Catastrophe is always just around the corner
No, I don’t believe the banking crisis is over. I do agree with Gensler’s thesis that transparency is important! Transparency gives us the ability to make smart choices.
Unfortunately, there are many barriers to transparency. A lot of them are deliberate. Here’s my favorite: Did you know that the FDIC has a secret list of “Problem Banks”? (If you read this entire article, now you understand why it’s a secret…)
I believe everyone should diversify their savings with assets that don’t need your trust. Physical gold and silver don’t require your faith because you can verify their authenticity in a second. Their value isn’t destroyed by belief, or by lack of belief.
In fact, when faith and belief are in shortest supply, that’s when gold and silver shine brightest.