This Dangerous Funding Source Is Propping Up America’s Weakest Banks

Shah Gilani|August 11, 2023

You may have heard about Moody’s downgrading 10 banks this week, identifying another 6 whose ratings are under review, and 11 more they called out having “negative outlooks.”

But the rating agency, citing growing financial risks and strains that could erode banks’ profitability, didn’t address the multi-trillion-dollar elephant in the room.

Shaky banks are being propped up by funding sources that are not only expensive and “flighty” in some cases, but dangerous to the banks themselves, and worse, to the entire banking system.

They’re called brokered deposits. Brokered deposits are deposits banks pull in by offering high-yielding CDs to investors looking for yield. The so-called brokers are institutions like Fidelity, Vanguard, Morgan Stanley and other financial outfits that have lots of customers whom they sell stocks, bonds, and products to. One of those products is CDs.

Banks go to brokers and tell them how much money they want to raise and tell them how much they’ll pay in interest on the CDs they want brokers to place with their customers. That’s all there is to brokered deposits.

But brokered deposits are problematic, on lots of levels. They mask weaknesses at failing banks, and when those banks inevitably have to pay the piper, we’re going to be looking at the next phase of the banking crisis and potentially a systemic panic.

The smart move here is to set yourself up now to make money from those banks as they fall. Let me bring you up to speed on everything you need to know, then give you an easy profit play to get you started.

The 10 banks Moody’s downgraded are: Commerce Bancshares, BOK Financial Corporation, M&T Bank Corporation, Old National Bancorp, Prosperity Bancshares, Amarillo National Bancorp, Webster Financial Corporation, Fulton Financial Corporation, Pinnacle Financial Partners, and Associated Banc-Corp.

The 6 banks with ratings under review for possible downgrades, including some of the nation’s largest institutions, are: Bank of New York Mellon Corporation, Northern Trust Corporation, State Street Corporation, Cullen/Frost Bankers, Truist Financial Corporation, and U.S. Bancorp.

And the 11 banks Moody’s shifted from stable to negative outlooks are: PNC Financial Services Group, Capital One Financial Corporation, Citizens Financial Group, Fifth Third Bancorp, Huntington Bancshares, Regions Financial Corporation, Cadence Bank, F.N.B. Corporation, Simmons First National Corporation, Ally Financial, and Bank OZK.

Moody’s specifically cited something I’ve been pounding the table about for a year now, noting, “Elevated CRE (commercial real estate) exposures are a key risk given sustained high interest rates, structural declines in office demand due to remote work, and a reduction in the availability of CRE credit.”

About those sustained high interest rates…

Whether you’re looking at banks’ loans, the commercial, personal, or real estate loans and mortgages in their “loan books” or the securities, mostly U.S. Treasuries, residing on their balance sheets, both of which are assets, they’re being adversely affected by higher interest rates.

Most of the Treasuries banks hold were bought when rates were much lower. For example, the 10-year Treasury yield averaged 2.14% in 2019, averaged 0.89% in 2020, and averaged 1.45% in 2021. The Federal Reserve started raising rates in March of 2022. The yield on the 10-year Treasury bond today is 4.14%.

Since bond prices drop as yields rise, all the older lower yielding notes and bonds that banks hold have fallen in price. In other words, they’re all sitting on huge losses on their fixed income securities.

The same is true for the loans they’re sitting on, whether they’re commercial real estate loans or any other kind of fixed interest loan they made to borrowers. The economic value of those fixed-rate loans are impacted the same way fixed income securities are impacted in a rising rate environment. The bottom line is, banks’ loan books are chock full of huge losses too.

Banks fund most of those loans and securities assets with depositors’ money, and to a lesser degree with money they borrow in the credit markets. So, when depositors pull out their money banks have a problem. And now they have a huge problem.

That’s because as interest rates have risen depositors, who’ve for years gotten nothing parking their money at banks, are pulling their deposits and looking for yield in money market funds and other banks CDs (certificates of deposit).

Depositor flight is a real problem, it can kill a bank in a matter of days, as it did with Silicon Valley Bank back in March. Tens of billions of dollars were digitally withdrawn from SVB in two days when depositors, most of whom had more than $250,000 parked at SVB (the most they were insured for by the FDIC), pulled their money when they heard the bank had a $1.5 billion hole in its balance sheet from selling $2 billion of fixed income Treasury securities to Goldman Sachs at a loss, to raise money against the falling value of its loan book.

First Republic Bank also failed in March when depositors pulled their funds, leaving the bank’s assets woefully “underfunded” and pushing the bank far below reserve requirement levels.

All of a sudden everyone became aware of what depositor flight could do to a bank’s solvency and the March banking panic became headline news, as it should have.

Fortunately, the crisis was stemmed when the Feds said they’d backstop uninsured depositors and that the three banks that failed, SVB, First Republic, and Signature Bank, were “idiosyncratic” and not representative of how the rest of the banks in the system were doing.

As calm prevailed, investors, analysts and regulators looked to banks’ second quarter earnings reports to see how they were really doing, especially whether or not they were still losing deposits, which would mean the crisis was still brewing.

The banks, it turns out, had net deposit inflows in Q2, and everyone exhaled in relief.

Don’t buy it.

The only reason banks had net deposit inflows is because they’ve been paying for them in the brokered deposit market.

And as I said above, brokered deposits are problematic for a number of reasons.

For the banks that need to replace lost deposits, brokered deposits are expensive. Not only do the banks have to offer competitive yields with the likes of money market funds now offering sweet returns, they have to compete with each other, with hundreds of other banks offering competitive rate CDs in the brokered deposit universe.

Brokered deposits aren’t “sticky,” they’re considered to be “hot money.” Sticky deposits are deposits that aren’t running out the door any time soon. Hot money refers to deposits, mostly the kind that are shopped in the brokered deposit market, which will get pulled as soon as the term or maturity on the brokered CD is up, which can be a matter of months or a year, maybe longer than a year, but not often. Hot money, especially in a competitive market, is always looking for the next best yielding CD when theirs matures, and that yield may not be at the bank they’re currently parked at.

Besides costing banks a lot, requiring them to lend out at a spread higher than what they’re paying in short-term interest, which is another huge problem if they make loans with maturities longer than the duration of the limited term CDs they’re using to fund loans, those hot money deposits can up and leave.

Starting to get it? Brokered deposits are at best a slippery slope for banks that rely on them.

At worst, if enough banks have to pay up for deposits, make loans against them that then fall in value if rates go higher, or the economy falls into recession and defaults start picking up, or they simply have to “realize” losses on assets they’re sitting on, for any reason, like SVB did, the whole banking system will be shaken.

And, yes, that’s going to happen, because of the bad and underwater loans banks have, because of the underwater securities on their books, because rates will remain elevated for longer, because we will likely fall into a recession, because the banks are in bad shape already, and because they’re masking their condition by paying up for deposits.

Moody’s said as much in a separate note explaining the downgrades and warning, “Rising funding costs and declining income metrics will erode profitability, the first buffer against losses. Asset risk is rising, in particular for small and midsize banks with large CRE exposures.”

You’ve been warned, by Moody’s and by me.

Keep watching the SPDR S&P Regional Banking ETF (KRE). Me and my subscribers are, and we’re trading it, along with a bunch of the banks that are headed down. Buy yourself some put option spreads on KRE and follow me to find out which banks are headed lower and how to play them for some quick and thick profits.