Lots of Blame to Go Around for Banking Turmoil

Bryan Perry

A former Wall Street financial advisor with three decades' experience, Bryan Perry focuses his efforts on high-yield income investing and quick-hitting options plays.

Yields on Treasuries have nosedived in a full-scale rebuke of Fed Chair Jerome Powell claiming that rate cuts in 2023 were not a consideration. The quarter-point hike, the ninth in a string of increases, was hardly a cherry on the sundae. Bond traders see it as the straw that could potentially break the economic camel’s back.

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Thankfully, long-duration bond yields have come down to just under 1.0% since the first week of March, thereby pushing bond prices higher. But yields would have to fall much further to right the wrongs of poor risk management at so many banks that invested way too much money in the long end of the curve when rates were at historic lows.

A new report by researchers at New York University on March 13 found that Silicon Valley Bank isn’t the only bank with the unrealized losses on the balance sheet issue that triggered the run on the banks. Apparently, U.S. banks had unrealized losses of $1.7 trillion at the end of 2022. The losses were nearly equal to the banks’ total equity of $2.1 trillion, professors Philip Schnabel, Alexi Savov and the University of Pennsylvania’s Itamar Drechsler explained.

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Additionally, of the $17 trillion in total U.S. bank deposits, nearly $7 trillion are currently not insured by the FDIC, according to that paper. It’s this most recent revelation that has the market in flux. Unrealized losses aren’t reflected on banks’ balance sheets, due to an accounting practice where assets are held on banks’ books at the value at which they are bought, instead of their current market value.

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Back in 2015, the Financial Standards Accounting Board (FASB) determined, in the interest of reducing costly disclosures related to value of core assets and deposits, to invoke an accounting standard that limited its requirement for mark-to-market (MTM) accounting. “The final standard, ‘classification and measurement,’ became effective in 2018 and does not require MTM for loans or debt securities. It does, however, require all equity investments to be treated as trading securities, with changes in fair value recorded through earnings — an important concern for banks that hold significant levels of equity securities.” Click here for the full report.

It seems almost impossible that the scenario of owning a disproportionate amount of low-yield, long-duration Treasuries and agency debt couldn’t spark a run on deposits if future rates on short-term Treasuries rose. Logic would have it that during the most recent stress test, this inherent risk of money leaving the bank’s low savings and money market rates for the higher-yielding, short-term Treasury market that is correlated to Fed rate hikes, would have been identified as a potential tinder box. Instead, what unfolded at Silicon Valley Bank was like yelling “fire!” in a theatre.

According to a recent article in Fortune, “When it comes to the fall of Silicon Valley Bank last week, the bank’s models to predict risk and performance are said to have been flawed. The Federal Reserve, the primary federal supervisor of Silicon Valley Bank, issued a warning to the bank over its risk-management systems back in 2019, the Wall Street Journal reported.”

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There were red flags, yet, Silicon Valley Bank’s collapse wasn’t prevented. A new report by Fortune’s Shawn Tully provides some insight into the situation: “The Fed’s ‘stress tests’ were supposed to save banks from the exact crisis now engulfing markets. Here’s how they were so spectacularly wrong.” In 2018, a bill was passed that raised the threshold from $50 billion in assets to $250 billion in assets for when companies qualify as a “systemically important financial institution.”

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“The $250-billion-and-up banks are still stress-checked annually, and the central bank put the $100-250 billion group on a bi-annual cycle, where they’re measured only in the even years,” Tully writes. “A rule called Standardized Liquidity Ratio gets waived for the mid-sized banks, meaning they can hold less liquid capital than for the top tier lenders.” And, “Silicon Valley Bank didn’t fulfill $100 billion mark in average assets until the end of 2021, and therefore wasn’t included in the 2022 test, nor had it ever endured a Fed exam.”

True to form, the Fed not only missed the degree to which inflation was not transitory, its stress models totally missed the potential damage that would be inflicted on banks’ balance sheets due to a big rise in rates as the economy gained strength, along with the outlook for increased inflation. Incredible as it might seem, according to Tully’s research, the Fed’s most stressful scenarios had the CPI running at sub-2% all the way out to 2025.

The Federal Reserve employs just over 400 economists with PHDs, who apparently represent an exceptionally diverse range of interests and specific areas of expertise. Maybe plugging in some banking executives might make for a better mix. Fed Head Jerome Powell is not an economist.

Powell is a politician who made a lot of money at the Carlyle Group. He has an undergraduate degree in politics and went to law school. I guess the optics of pausing to see the implications of eight rate hikes might have on the economy and a severely flawed stress testing system were not in Powell’s or the Fed’s best interests.

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What is widely apparent is that the market is suffering the pain of poor oversight and management of monetary policy by the Fed, the FASB and Treasury Secretary Janet Yellen for her bungling the deposit insurance dialogue. The Fed and the Treasury would be much better served with seasoned bankers with real-world business experience — such as Bank of America’s CEO Brian Moynihan. Powell can’t be fired, and it is already past time to discard the optics of replacing Yellen when she is slow walking the crisis.

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But it is up to the White House to make the change, and Joe Biden is siding with Yellen for political reasons. Maybe another domino (First Republic) falling might force his handlers to help him change his thinking. Opening day for the 2023 baseball season is this week, and by all means the Treasury already needs a relief pitcher to get in the game the way it should be played. Just one man’s opinion.

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