Here’s the Real Banking Crisis (It’s Just Getting Started)

Shah Gilani Mar 23, 2023

Regulators are trying to calm depositors and bank equity investors, talking about potentially backstopping all uninsured depositors. They’re talking about how banks can borrow from the Federal Reserve’s Discount Window and get FHLB (Federal Home Loan Bank) advances to meet withdrawals. They’re even talking about how unwarranted it is for people to panic over losses on banks’ safe-asset Treasuries that are being marked down.

But here’s something no one is talking about: loans.

No one’s talking about how loans comprise almost twice the amount banks hold in Treasuries and other bonds. No one’s talking about how exposed banks are to loan repayment risk if the economy falls into recession. And most frighteningly, no one’s talking about how loan values drop just like bonds when rates rise, but aren’t marked-to-market… which means no one knows how impaired these assets are or how much more capital banks need to remain liquid and solvent.

No one but me, that is.

So, hold onto your hats, people. You’re not going to hear about this on CNBC or read it in The New York Times. But there’s a perfect storm developing right now that could send us into another round of depositor flight – SVB all over again, or potentially worse.

But don’t worry, I’ve got your back. You know what I always say – where other people see crisis, I see opportunity. And there is a great way to protect yourself and make money on what’s coming down the road.

So let’s get into it – here’s how bad loan losses could be, how they’re hidden, why they aren’t being talked about, and what you need to do about it.

The Problem with Banks’ Loan Books

By now everyone should know what happened at Silicon Valley Bank. How the bank doubled its deposits during the Pandemic, invested some of those “liabilities” in “assets” like long-term Treasuries for their piddling yields, how rising rates forced mark-downs of fixed-income assets, and that depositors and equity investors fled when they heard the bank had a sudden $1.85 billion “hole in its balance sheet” from selling a portfolio of bonds at a loss.

That same scenario is happening at banks all around the country, in case you didn’t know.

But what’s really scary is no-one knows how impaired banks’ other giant pool of assets are, the loans they have outstanding.

At the beginning of 2022, U.S. banks had some $24 trillion in assets, including $6 trillion in Treasuries and other fixed-income securities, and $11.2 trillion in loans, against a deposit base of $19 trillion. Barely half of this is insured by the FDIC.

We know what’s happening to bonds on balance sheets – they’re being marked-down as rising rates knock their prices down, because investors looking to buy bonds want higher yields available on newer bonds. They’ll only buy lower yielding bonds if their prices are marked down so much that their total return equals the yield on newer bonds.

The same thing is true for loans.

There’s no economic difference between a 10-year bond with a 2% coupon and a 10-year loan with a 2% interest rate cost to the borrower. If the value of that bond falls by 15%, the economic value of that loan theoretically falls by the same amount.

According to South State’s Correspondent Division, “Each basis point increase in rates decreases the lifetime value of a fixed-rate loan to a bank. Marking loans to mark would be the same process as the AOCI (Accumulated Other Comprehensive Income) for fixed-rate securities. The longer the fixed rate, the more sensitive the loan is to negative economic adjustment.”

Using a $1 million fixed-rate loan (25 years amortization) with a fixed rate to the borrower of 5% and a commitment term of 5-years, South State calculated the loan would experience a $466 decrease in value on a one basis point hike in rates.

In case you missed it, fed funds have now risen by 500 basis points, in a year’s time.

Based on interest rate movement over the last year, South State calculated these loan AOCI adjustments on a $1 million fixed rate term loan:

  • with 2 years remaining = -$81,060
  • with 3 years remaining = -$104,574
  • with 4 years remaining = -$120,834
  • with 5 years remaining = -$139,532
  • with 10 years remaining = -$202,055
  • with 20 years remaining = -$527,370

I’ll say it again: at the start of 2022 banks had $11.2 trillion of loans outstanding. Imagine if banks had to carry those loans on a mark-to-market basis, given the rise in rates. Most of them, make that all of them, would be insolvent.

So it’s a good thing banks don’t have to M-T-M their loans. Some of that has to do with where assets are parked on balance sheets. The different buckets where stuff is parked includes places labeled Held-to-Maturity, Held-for-Trading and the in between bucket labeled Available-for-Sale, all of which have different accounting, mark requirements or none, and capital reserve and buffer parameters.

But that’s changing.

Why We May Be Headed for a Second Banking Crisis

Beginning in 2023, banks are subject to new Current Expected Credit Loss, or CECL, accounting rules. They now have to:

  1. Consider “looking forward” not just “to-date” when calculating expected losses;
  2. Consider common risk characteristics like concentrations of loan types and group exposure;
  3. Consistently report changes in CECL so auditors and partners can better stress test outcomes.

While new CECL rules are already in place, Michael Barr, Vice Chairman for Supervision on the Federal Reserve Board of Governors, is conducting a “thorough review” of the Fed’s capital standards including “knock-on” effects of concentration, interconnectedness, and loan book exposure.

If a regulatory reckoning is coming, and banks have to be more transparent about economic valuation modelling of their loan books, they’re going to need a lot more capital, a lot more.

When investors see that, they’re going to sell bank shares like they’re going out of style, and the negative feedback loop we just saw with the canary in the coal mine, SVB, will round robin all over again.

And if you think all uninsured depositors are going to be bailed out during future failures, or you think banks borrowing at the Fed’s Discount Window and taking advances from their regional Federal Home Loan Banks is the be-all-end-all fix for their problems… oh, have I got news for you.

You have no idea what’s really going on at the Discount Window, with the privately held FHLB system, or what’s in store for uninsured depositors. But that’s for next week.

In the meantime, take this opportunity to buy put option spreads on the SPDR S&P Regional Banking ETF (KRE), because any regional bank that has been beaten up and seen their stocks rebound is going back down, trust me.

And while you’re at it, buy some market protection in the form of puts on market index ETFs like the SPDR S&P 500 ETF Trust (SPY), Invesco QQQ Trust Series 1 (QQQ), and SPDR Dow Jones Industrial Average ETF Trust (DIA). Because when a few more “systemically important” banks (and they’re almost all systemically impactful now) go down, they’re going to take the market down with them.

You’ve been warned.

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