Bank failures, FDIC and our collective delusion

Silicon Valley Bank. Signature Bank. First Republic Bank. Three high-profile bank failures in the last two months. What’s going on?

A bank fails when the value of its assets is less than the value of its liabilities, the obligations the bank owes to its depositors. Each of these three banks experienced a run on deposits: clients withdrew their deposits because they feared they wouldn’t be able to get their money out, creating a snowball effect that within 24 hours decimated the banks’ reserves.

The Federal Deposit Insurance Corp stepped in and guaranteed uninsured depositors in full at the failed banks. This meant no losses for depositors with accounts above the $250,000 insurance limit, an extraordinary development that reflects the heightened level of nervousness about the U.S. banking system. But the pressure has continued, with regional banks bearing the brunt of the crisis: California-based PacWest Bancorp shares are down more than 80%, which is about one-quarter book value.

“If you are sitting there as an uninsured depositor, what you’re thinking about is whether you want to take any chances that you will be made whole in the event your bank goes into resolution. And while you probably will be made whole, there is some chance the Fed, the Treasury, and the FDIC decide not to do so” (Robert Elliott, Wall Street money manager).

In a recent press release, the FDIC considered increasing coverage for business payment accounts, but not for all accounts. A policy to treat all accounts equally would deal with bank runs, but might increase excessive risk-taking by banks. Understandably, that press release did little to ease the market’s jitters. Bank assets are primarily made up of the loans they have made and the bonds they hold (mostly government securities).

The sharp increase in interest rates has made many of the bonds worth less, and exposure to commercial real estate loans especially, has created non-performing loans and unrealized losses on the balance sheet. The more nervous investors get, the worse the psychology of patience. And once the tide turns negative, deposit withdrawals happen very quickly in today’s world of connectedness: the three failed banks' deposit accounts were drained within hours as the panic was transmitted through social media sources. Banks are now considering limiting the amount and the frequency of withdrawals, which perverse strategy in my humble opinion doesn’t do much for confidence in retrieving depositors’ money. The “collective delusion” that is the glue that keeps the system together can quickly become collective disillusionment.

For years, the banks have paid very low interest on deposits: with the interest rate increases over the past year, it became far more attractive to have your cash in money-market funds, so the Federal Reserve policies are encouraging deposit flight. All the nervousness and media coverage of course obscures the fact that many regional banks are quite sound. The reliable ones have maintained a lower loan-to-deposit ratio and kept their securities portfolios balanced and hedged. The high-profile banks that failed were focused on tech and IPO bonanzas, and when those sectors dried up so did their profitability.

Bank asset portfolios had been gorging on the federal government stimulus programs post-pandemic: they couldn’t lend enough of the stimulus money, so they held those funds as government bonds. What’s a Treasury bill paying 2% worth when interest rates are now 7%? There is also a political bias stemming from the predatory nature of the ultra-big banks to gobble up the more nimble competition, and federal regulators dreaming of monitoring only a few mega-banks, which are often as bureaucratic as the regulators are. The scrutiny of the regional banks by investors continues, with the spread for bank funding bonds and US Treasurys widening. The higher yield demanded by the market as banks shore up their balance sheets increases the regional banks' cost of doing business, which results in lower earnings estimates and ultimately, lower stock prices. If the recession the economy is in right now deepens, this will create more non-performing loans. If depositor and investor sentiment turns more negative, triggering another round of deposit outflows, that’s going to create problems for even well-run smaller banks.

Meanwhile, back in the housing sector, high-interest rates and stubbornly high home prices are killing Americans’ faith in home ownership. Just 21% of US adults say now is a good time to buy a home according to a recent Gallup poll. That’s the lowest confidence level since the survey began in 1978. The housing market has been tough this year, with interest rate increases by the Federal Reserve helping to push mortgage rates close to a 20-year-high. That has put off prospective homebuyers from entering the market, but it has also discouraged homeowners from putting their houses up for sale, creating a supply-demand imbalance that's kept affordability low. Those dynamics are compounded by tightening credit conditions, with banks pulling back on lending after the collapse of three regional lenders earlier this year. That means prospective home buyers could be locked out of getting a mortgage as banks tighten lending standards. 

With two critically important sectors of the economy experiencing so much uncertainty, this is going to be an interesting Summer! “In the end, everything is going to be alright, and if everything’s not alright, then it’s not the end.” (John Lennon) 

Raphael Barta is an associate broker with an active practice in residential, vacant land, and commercial/investment properties. He can be reached at Raphaelb@sandpoint.com.