Interest Rate Policy, Banking System, and Fiat Currencies
March 15, 2023
Silicon Valley Bank (SVB) collapsed on Friday, March 10, 2023, followed shortly by Signature Bridge Bank.
Based on historical FDIC online resources, 2023 has already become the second-worst year for bankrupt banks’ assets since 2001 with $319 billion vs. $373 billion in 2008.
However, SVB’s balance sheet appeared superficially healthy, even hours before it collapsed. Its risk-based capital ratios exceeded by a significant margin all regulatory requirements. Its $216 billion assets included $70 billion in loans—the vast majority of which were performing—and its $91 billion of held-to-maturity bonds, which had not defaulted either, were mostly MBSs, CMOs, and CMBSs (i.e., agency-issued mortgage-backed securities). The current default rate on mortgage-related securities is lower than 2%.
So, what went wrong? One has to look into its held-to-maturity (HTM) bonds—typically medium- to long-term assets of relatively high rating that are supposed to be kept until maturity (i.e., whose mark-to-market, or fair value, is ignored on the basis that, at maturity, these bonds will return their principal). They are thus reported at net carry value, their value at redemption.
As per its February 28, 2023, published account, the difference between its HTM bonds’ consolidated fair value and net carry value was negative $15 billion, equivalent to 16% of these assets’ book value. At the same time, the bank’s common stockholders’ equity was worth $12.5 billion.
What that means was that SVB was insolvent, provided that all of its depositors wanted their money back, which is exactly what happened on Friday, March 10, 2023.
Was SVB the only bank in that situation? Probably not. The overall US banking system’s HTM fair value is currently about $2 trillion lower than its net carry value or book value. This is why the US government scrambled to find a solution by Sunday.
Let’s now look at JPMorgan Chase, the largest US bank. Its regulatory capital ratios are actually very close to those of SVB. However, its HTM assets are worth only $425 billion as of Q4/2022. This is about 12% of its overall balance sheet vs. more than 40% for SVB. The unrealized losses (i.e., the difference between market and book value) stood at almost $37 billion, a relative loss of about 9%. The bank’s net post-tax income for 2022 reached $14.8 billion, with a market capitalization close to $400 billion. At the same time, the bank holds $3.349 trillion in interest-earnings assets, the vast majority of them accounted at book value, with an average yield of 2.78%. As 10-year treasuries pay now 3.6%, mortgage rates average 6.5%, and credit card debt is a lot more lucrative even, one gets a sense that even JPMorgan has piled-up a lot of these low-yields securities, and that its sustainability relies on its massive deposit base, on which it pays virtually no interest. With so many other financial institutions casually offering between 2.5% and 3.5% for their savings accounts, how long is this sustainable?
All of this says two things: JPMorgan held under the form of HTM securities a much lower proportion of its assets than SVB, and its unrealized losses were relatively lower within this asset class. However, even in this much less risky case, JPMorgan’s unrealized losses equate three times its annual net revenue for 2022. This does not threaten the bank’s existence, but its impact is not negligible either. At the same time, because of its low yields on assets, its business model looks more fragile than it seems.
Behind this analysis lies the Fed’s monetary policy. For the better part of the last 22 years, the Fed kept its interest rates at very low levels. This began in 2001, in the wake of the implosion of the dotcom bubble. When the Fed tried to tighten its policy in 2006–2007, as the commodity and other markets entered overvalued territory, it led to the mortgage implosion of 2008: a bubble that had been the result of its previously lax policy. The banks were bailed out, while the homeowners were left to go bankrupt. Rates remained near 0% during the next 10 years, something which has no historical precedent since the 1930s.
These two decades of mostly super-low rates and financial repression have led to a desperate hunt for yield across the investment world, while pushing all assets and all valuations to unseen levels, from stocks to real estate, rare watches, art, collectable coins, and finally dubious ventures of all sorts.
With more than $50 trillion of outstanding fixed-income securities in the US, and annual issuance close to $8 trillion, it is probably a safe estimate that $30–40 trillion of outstanding bonds return minimal yields today. When short rates jumped finally from almost 0% to 5% in the span of about one year in 2022–2023, all of these assets were pushed into the red. A 1% coupon 10-year bond loses almost 10% when yields increase by 1%.
To simplify, around $10–$15 trillion of sometimes unreported losses have been erased from the bond market over the past year. Most fixed-income funds lost about 25% in 2022, as the long-term yields increased by ca. 3%. Significant losses are borne by those pension plans owned by future retirees, which will depress their future income. Another chunk is located within the Fed’s own balance sheet, unofficially adding to the public debt; around $2 trillion within the banking system, mostly invisible.
Those banks that have been more aggressive in their hunt for yields now display weak balance sheets with negative or barely positive net assets. Larger, more diversified, and more conservative institutions fare better.
The most recent crisis has probably been addressed in the short term by the quasi-State guarantee that was announced on Sunday, March 12, 2023, even though it is now spreading to Europe, where the same causes produce the same effects.
At that point, as these events are still unfolding, several paradoxes should be noted. First of all, the monetary authorities that are addressing the crisis are ultimately the ones responsible for its very occurrence. Then, moral hazard is implemented once more, albeit in a different form. Shareholders and bondholders are not protected this time, but the large depositors are. Very few middle-class people maintain cash accounts over $250k in any single bank. Then, if all banking deposits become effectively state-guaranteed, this increases the incentive for extreme risk exposure among bank’s managerial teams, leveraging on deposits whose owners do not care anymore—unless regulators weigh in. Furthermore, the central banks lose their capacity to fight inflation. Yields won’t rise as much as needed. The Fed’s balance sheet may inflate again. Finally, these trillions of low-yield assets will remain among us for a good number of years, putting pressure on financial institutions’ returns, and hampering their funding capacity toward the global economy.
We might be moving toward a quasi-nationalization of the entire banking sector via depositors’ State guarantee and much-increased oversight and regulations. None of this says anything very good in terms of financial markets’ efficiency, future inflation, and fiat currencies’ credibility. No wonder Bitcoin rose by about 20% between March 10 and 15, and gold by 5%.