It has been a tumultuous several weeks in the world of finance. Just when “soft landing” (i.e., the notion that Fed rate hikes would tame inflation without causing a nasty recession) was the meme, a string of banks went belly-up. We summarized the history and status of this dismal parade of corpses a week ago.
On Friday, Germany’s Deutsche Bank (DB) was added to the list of endangered financial species. Its share price plunged as the cost of insuring its credit swaps soared, a sign of lack of confidence in DB among other financial parties. As best I can discern, however, DB is a relatively poorly-managed bank, but not one teetering on insolvency like Credit Suisse or the smaller American banks that have collapsed.
Silicon Valley Bank Getting Sold Off, Finally
On this side of the pond, the big news is that Silicon Valley Bank (SVB), whose spectacular implosion was really what brought “crisis” to banking, will be taken over by another regional bank, First Citizens Bank of North Carolina. The first attempt to auction off SVB was a fizzle, so the feds tried again. They really, really wanted to get this kind of full takeover deal done (rather than breaking up SVB and selling off bits piecemeal), so First Citizens was able to drive a juicy bargain. First Citizens was a fairly modest-sized bank, about half the size of SVB at the end of last year. First Citizens will get SVB assets of $110 billion, deposits of $56 billion and loans of $72 billion, and will start operating the SVB branch offices again. They will pay only $55 billion for the nominal $72 billion in loans that SVB had made, a 29% mark-down. The cost to the FDIC for this deal is about $20 billion. (I don’t know how First Citizens is paying for this acquisition). First Citizens stock skyrocketed on this news, so the market sees this as a sweet deal for First Citizens.
Going forward, the FIDC has pledged to share any losses (or gains) on those loans in the future, which offers further protection to First Citizens. FDIC gets shares of First Citizens valued up to $500 million. First Citizens decided not to take an additional $90 billion in securities that the FDIC will now have to sell on its own. These are likely the long-term bonds which sunk SVB when their value cratered with rising interest rates this past year. I’m not sure how much further losses the FDIC will bear on these bonds.
Anyway, so far, so good, kind of; it is sobering to note that this $20 billion cost to the FDIC just chewed up 1/6 of its total $128 billion kitty for backstopping all qualifying deposits at all banks in America. So we can’t readily afford too many more meltdowns of this magnitude.
Bank Deposits Continue to Flee, But Slower
A worrisome trend in the past month or so has been for depositors to pull their funds from bank checking/savings accounts, and stash their money instead in higher yielding money market funds or CDs or Treasury bills. Banks have borrowed records amounts from the Fed in recent weeks, in order to have lots of cash on hand if they have to pay off departing clients. And within the banking system, about half a trillion dollars has been moved from smaller regional banks to large banks.
I can’t find the reference now, but in the past two days I read an article stating that rate of deposit withdrawals is slowing down, and will likely not of itself destabilize the system. I’m going with that narrative, for now.
An indirect fallout from all this bank turmoil is the reduced inclination of banks to extend loans to businesses. This will make for a slowdown in economic activity, which should cool off inflation – -which is exactly what Jay Powell was hoping would be the outcome of the Fed rate hikes.
So much has been happening in the banking world it is a little hard to keep track of it. See recent articles here by fellow bloggers Mike Makowsky, Jeremy Horpedahl, and Joy Buchanan. Here is a quick guide to all the drama.
Credit Suisse Takeover by UBS
Perhaps the biggest, newest news is a shotgun wedding between the two biggest Swiss banks announced over the weekend. Credit Suisse is a huge, globally significant bank that has suffered from just awful management over the last decade. Its missteps are a tale in itself. Its collapse would be an enormous hit to the Swiss financial mystique, and would tend to destabilize the larger western financial system. So the Swiss government strong-armed a takeover of Credit Suisse by the other Swiss bank behemoth, UBS, in an all-stock transaction. The government is providing some funding, and some guarantees against losses and liability. An unusual aspect of this deal is that Credit Suisse shareholders will get some value for their stock, but a whole class of Credit Suisse bonds Is being written down to zero. Usually bond holders have strong priority over stockholders, so this may make it more difficult for banks to sell unsecured bonds hereafter.
Silicon Valley Bank Collapse: Depositors Protected
The Silicon Valley Bank (SVB) collapse is old news by now. The mismanagement there is another cautionary tale: despite having a flighty tech/venture capital deposit base, management greedily reached for an extra 0.5% or so yield by putting assets into longer-term bonds that were vulnerable to a rise in interest rates instead of into stable short-term securities.
A key step back from the brink here was the feds coming to the rescue of depositors, brushing aside the existing $250,000 limit on FDIC guarantees. That was an important step, otherwise large depositors would stampede out of all the regional banks and take their funds to the few large banks that are in the too-big-to-fail category. It is true that this new level of guarantee encourages more moral hazard, since depositors can now be more careless, but the alternative to guaranteeing these deposits (i.e. the collapse of regional banks) was just too awful. Bank shareholders and most bondholders were wiped out. Presumably that will send a message to the investing community of the importance of risk management at banks.
The actual disposition of the business parts of SVB are still being worked out. The feds originally tapped the big, well capitalized banks to see if one of them would take over SVB as a going concern. That would have been a nice, clean, thorough resolution. But the big banks all declined. I suspect the actual responses in private were unprintable. Here’s why: in the 2008 banking crisis, the Obama-Biden administration went to the big banks and encouraged them to take over failing institutions like Countrywide Mortgage, who among other things had made arguably predatory loans to subprime borrowers who had poor prospects to keep up with the mortgage payments. The Obama administration’s Department of Justice promptly turned around and very aggressively prosecuted these big banks for the sins of the prior institutions. J. P. Morgan ended up paying something like 13 billion and Bank of America paid 17 billion. So when today’s Biden administration reached out to these big banks this month to see about taking over SVB, they got no takers.
Now the assets of SVB (renamed Silicon Valley Bridge Bank) are getting auctioned off, perhaps piecemeal, but how exactly that happens does not seem so critical.
Signature Bank: Shut Down, But Sold Off Intact
Crypto-friendly Signature Bank was shuttered by New York State officials on Sunday, March 12, making this the third largest (SVB was the second largest) bank failure in U.S. history. Forbes gives the whole story. At the end of last year, Signature had over $110 billion in assets and $88 billion in deposits. Spooked by Signature’s similarities to failed banks SVB and Silvergate, customers rushed to withdraw deposits, which the bank could not honor without selling securities at huge losses. As with SVB, the feds had the FDIC insure all deposits of all sizes at Signature.
Unlike SVB, Signature has received a bid for the whole business, from New York Community Bancorp’s subsidiary Flagstar Bank. Flagstar will take over most deposits and loans and other assets, and operate Signature Bank’s 40 branches.
First Republic: Teetering on The Brink, Propped Up by Banking Consortium
First Republic is in a somewhat different class than these other troubled institutions. Its overall practices seem reasonable, in terms of equity and assets. However, it caters to a wealthy clientele in the Bay Area, with a lot of accounts over the $250,000 threshold. In the absence of a rapid and decisive move by Congress to extend FDIC protection to all deposits at all banks, somehow (I haven’t tracked what started the stampede) depositors got to withdrawing huge amounts (like $70 billion) last week. This was a classic “run on the bank.” That would stress any bank, despite decent risk management. Once confidence is lost, it’s game over, since there are always alternative places to park one’s money. Ratings agencies downgraded First Republic to junk status, and the stock has cratered.
It is in the interest of the broader banking industry to forestall yet another collapse. If folks start to generally mistrust banks and withdraw deposits en masse, our whole financial system will be in deep trouble. In the case of First Republic, the private sector is trying to prop up it up, without a government takeover. So far this has mainly taken the form of depositing some $30 billion into First Republic, as deposits (not loans or equity), by a consortium of eleven large U.S. banks led by J. P. Morgan. This is was a quick and fairly unheroic intervention, since in the event of liquidation, depositors (including this consortium) have the highest claim on assets. This intervention will probably prove insufficient. Two potential outcomes would be a big issuance of stock to raise capital (which would dilute existing shareholders), or some large bank buying First Republic. The stock rose today on reports that Morgan’s Jamie Dimon was talking with other big banks about taking an equity stake in First Republic, possibly by converting some of the $30 billion deposit into equity.
Old News: Silvergate Bank Liquidation
Overshadowed by recent, bigger collapses, the orderly shutdown of the crypto-focused Silvergate Bank is old news. It was two weeks ago (March 8) that Silvergate announced it would shut down and self-liquidate. The meltdown of the crypto financing world led to excessive loss of deposits at Silvergate. Unlike SVB and Signature, it held a lot of its assets in more liquid, short-term securities, so its losses have not been as devastating – – all depositors will be made whole, though shareholders are toast (stock is down from $150 a year ago to $1.68 at Monday’s close).
Warren Buffett To the Rescue?
Banks generally operate on the model of borrow short/lend long: they “borrow” from depositors and buy longer-term securities. Normally, short-term rates are lower than long-term rates, so banks can pay out much lower interest on their deposits than they receive on their bond/loan investments. With the Fed’s rapid increases in short-term rates this past year, however, the rate curve is heavily inverted, which is disastrous for borrow short/lend long. Fortunately for banks, many depositors are too lazy to do what I have done, which is to move most of my immediate-need money out of bank accounts (paying maybe 1%) and into T-bills and money market funds paying 4-5%.
All this churn goes to highlight an inherent fragility of banks: there is typically a maturity mismatch between a bank’s deposits/liabilities (which are short-term and can be withdrawn at any time) and its assets (longer-term bonds it purchases, and loans that it makes which can be difficult to quickly liquidate). Runs on banks, where if you were late to panic you lost all your deposited money, used to be a real feature of life, as dramatized in classic films Mary Poppins and It’s a Wonderful Life. Eliminating this danger was a key reason for setting up the Federal Reserve system, and in general that has worked pretty well in the past hundred years. Banks in general (see chart above) are now carrying enormous amounts of unrealized losses on their portfolios of bonds and mortgage-backed securities (MBS) due to the increase in market rates. In addition to the existing “discount window” at which banks can borrow, the Fed has set up a new lending facility to help tide banks over if they (as in the case of SVB and Signature) get stressed by having to sell marked-down securities to cover withdrawal of deposits. Also, new measures reminiscent of 2008 were announced to extend dollar liquidity to central banks of other nations.
But when Gotham really has a problem, the Commissioner calls in the Caped Crusader. Warren Buffett has been in touch with administration officials about the banking situation. We wrote two weeks ago about Warren Buffett’s gigantic cash hoard from the float of his Berkshire Hathaway insurance businesses which allows him to quickly make deals that most other institutions cannot. Buffett rode to the rescue of large banks like Bank of America and Goldman Sachs in the 2008-2009 financial crisis. A lot of corporate jets have been noted flying into Omaha from airports near the headquarters of various regional banks. Buffett’s typical playbook in these cases is to have the troubled institution issue a special class of high yielding (with today’s regional banks, think: 9%) preferred stock that he buys, perhaps with privileges to convert into the common stock. That stock would count as much needed equity in the banks’ books.
An unwillingness to guarantee all the deposits would satisfy the desire to penalize businesses and banks for their mistakes, limit moral hazard, and limit the fiscal liabilities of the public sector. Those are common goals in these debates. Nonetheless unintended secondary consequences kick in, and the final results of that policy may not be as intended.
Once depositors are allowed to take losses, both individuals and institutions will adjust their deposit behavior, and they probably would do so relatively quickly. Smaller banks would receive many fewer deposits, and the giant “too big to fail” banks, such as JP Morgan, would receive many more deposits. Many people know that if depositors at an institution such as JP Morgan were allowed to take losses above 250k, the economy would come crashing down. The federal government would in some manner intervene – whether we like it or not – and depositors at the biggest banks would be protected.
In essence, we would end up centralizing much of our American and foreign capital in our “too big to fail” banks. That would make them all the more too big to fail. It also might boost financial sector concentration in undesirable ways.
To see the perversity of the actual result, we started off wanting to punish banks and depositors for their mistakes. We end up in a world where it is much harder to punish banks and depositors for their mistakes.
The problem is, what happens if PNC fails? PNC is the sixth largest bank in the country with over $500 billion in assets. That makes it dramatically smaller than the Big Four banks that are informally labeled “too big to fail” and formally classified as Global Systemically Important Banks (GSIBs).
Tyler wants to see more banks, and not just “Too big to fail” banks. In as many industries as possible, we prefer less concentration. More competition tends to be good for customers and leads to more innovation. Tyler is more comfortable in the messiness that midsize banks cause, or at least he presents that as a necessary evil.
Matt is arguing against more banks, because Silicon Valley Bank wasn’t pre-designated as too big to fail, and yet we are in crisis mode now.
Matt might say that I’m mischaracterizing his argument. Specifically, Matt said that tiny banks are fine because they are small enough for a private company to buy in times to distress. Matt does not explicitly call for fewer banks. However, I think the demise of the mid-size bank would almost certainly result in fewer banks total.
To give a full picture of the arguments being made this week, here’s someone arguing against bailing out SVB.