It is remarkable to see the Fed determined to keep driving banks and investors into the ditch in the name of combatting an inflation it can’t fix. Since when do banks get in trouble from losses on Treasuries?
The typical pattern is the central bank raises rates late in an economic cycle, and “late in cycle” generally includes overly permissive lending. The economy weakens and loans (and bonds) start going bad. Some banks are heavily exposed to weak credits, and they start to have trouble with funding, via deposit flight and/or trouble rolling short-term funding. If enough banks start looking sick, lenders and counterparties start pulling back on a broad basis, afraid they don’t know enough about who might keel over next to take any risks. That leads to a widespread inability to obtain funding, even by institutions that are pretty sound. Enter central banks opening up special facilities….and not making much in the way of demands, even after the immediate crisis has passed. 1
Instead, we have interest rate losses produced directly by the Fed pushing though interest rate increases fast and hard. One economist colleague deems the panic, and the Fed’s refusal to back off much, as ridiculous.
Mind you, that is not to say that financiers would escape a day of reckoning after such a long period of super easy money. In his latest post at Naked Capitalism, derivatives expert Satyajit Das set forth a very long list of potential flash points for a banking industry conflagration. But that should have been obvious to the Fed and other central banks, particularly after the 2014 taper tantrum. Financial regulators should have pressed hard for more capital if a mere market hissy fit really did scare Bernanke so much that he relented. But the authorities had vested a lot of personal and institutional credibility in the notion that the weak post crisis reforms were sufficient. How could they go back then and admit, “Oopsie, we dropped rates too low, so we need all of you to strengthen your balance sheets so we can unwind that.” Backing out of this mess as carefully as possible would have been the wisest option, but this bunch is not big on wisdom or caution.
We are now in an intermediate phase where the financial system could pull out of its wobbles and have a period of comparatively calm sailing, or the crisis could get worse. While I try to avoid forecasting (the old saying goes, “If you must predict, predict often”), the fact that the first article at the Wall Street Journal about the bank panic is way below the fold says nerves are less frayed. Similarly, at the Financial Times, neither of the two lead stories are about the bank tsuris and there is only one related story, and then not about wheels falling off (L&G chief says UK levelling up ‘failing’ and bank turmoil will not help).
Bloomberg does give the banking mess lead placement, but the headlines signal things being handled, even if supposedly innocent bystanders like the IPO market got whacked:
Even though the media is signaling that the financial markets are on their way out of the acute phase of the panic, I would not bet that banking problems are over.
First and foremost, the Fed is making the worst possible decisions as far at the health of the financial system is concerned. It is engaging in a disastrous course of greatly increasing support for banks, without even suggesting they be subject to more constraints. This is a license for even more profligate behavior and bigger eventual losses. And at the same time, the Fed is stressing the financial system severely by not relenting on or even suspending its rate increases.
So as the central bank’s bad medicine pushes the economy into recession, on top of interest rate losses, we’ll see rising credit losses.
Second, the Eurobanks, particularly Deutsche Bank and the Italian banking system, are both in a weakened state and it won’t take much to put them in a crisis. Despite cheery talk at Bloomberg that unlike Credit Suisse, Deutsche has not been suffering sustained deposit withdrawals, and only has small problems right now (The Differences Between Deutsche Bank and Credit Suisse), Deutsche has long been very undercapitalized and had been on the banking watch list for so long that investors view it with skepticism.
Both Deutsche and the Italian banks are also exposed to the underlying weakness of their economies, namely, being the two countries most dependent on cheap Russian gas. While Europe escaped a severe energy crisis last winter, it was due to mild weather, government subsidies of energy consumption, and conservation. The latter included suspension of production and shuttering of some energy-intensive factories in Germany. This de-industrialization is set to weaken Germany’s economy permanently, and also generate loan downgrades and losses at companies that have cut capacity. Recession conditions will hit profits at companies not otherwise much exposed to higher energy prices.
Oh, and European leaders have been quietly saying that energy subsidies next winter will either be reduced or revoked. Even if Europe is able to offset most of its lost Russian gas with LNG, the cost will be much higher.
Third, Deutsche is believed to have meaningful exposure to US commercial real estae, which is already looking green around the gills. Office occupancy rates in major urban centers are well down from their pre-Covid peaks. Many tenants are cutting back on their square footage when their current leases come up for renewal. Similarly, warehouse expansion has gone into reverse. Starting a year ago, Amazon has been cancelling and delaying warehouses as port of a major cost-cutting effort.
While US commercial real estate market is not as big as residential market, remember it was only the subprime loans that went into meltdown. During the foreclosure crisis, losses on “prime” mortgages, though well above Fannie and Freddie loss reserves, were vastly lower in percentage terms. I have yet to see size estimates of the commercial real estate lending sectors that are at risk to compare them to subprime loans. And even if the problematic commercial real estate areas are indeed not too large compared to subprime, remember that if a too big to fail institution is heavily exposed, it could still kick off a crisis.
Finally, while it actually is possible to make an informed guess of the health of small and mid-sized banks, it’s close to impossible to be sure of what is going on at the TBTF players, both due to their very large trading books and their greater business complexity. The effective opacity means panic readily spreads in the absence of solid information.
This section from a 2010 Steve Waldman post is a perennial:
Bank capital cannot be measured. Think about that until you really get it. “Large complex financial institutions” report leverage ratios and “tier one” capital and all kinds of aromatic stuff. But those numbers are meaningless. For any large complex financial institution levered at the House-proposed limit of 15×, a reasonable confidence interval surrounding its estimate of bank capital would be greater than 100% of the reported value. In English, we cannot distinguish “well capitalized” from insolvent banks, even in good times, and regardless of their formal statements.
Lehman is a case-in-point. On September 10, 2008, Lehman reported 11% “tier one” capital and very conservative “net leverage“. On September 25 15, 2008, Lehman declared bankruptcy. Despite reported shareholder’s equity of $28.4B just prior to the bankruptcy, the net worth of the holding company in liquidation is estimated to be anywhere from negative $20B to $130B, implying a swing in value of between $50B and $160B. That is shocking. For an industrial firm, one expects liquidation value to be much less than “going concern” value, because fixed capital intended for a particular production process cannot easily be repurposed and has to be taken apart and sold for scrap. But the assets of a financial holding company are business units and financial positions, which can be sold if they are have value. Yes, liquidation hits intangible “franchise” value and reputation, but those assets are mostly excluded from bank balance sheets, and they are certainly excluded from “tier one” capital calculations. The orderly liquidation of a well-capitalized financial holding company ought to yield something close to tangible net worth, which for Lehman would have been about $24B.
So Lehman misreported its net worth, right? Not according to the law. From the Valukas Report, Section III.A.2: Valuation — Executive Summary:
The Examiner did not find sufficient evidence to support a colorable claim for breach of fiduciary duty in connection with any of Lehman’s valuations. In particular, in the third quarter of 2008 there is evidence that certain executives felt pressure to not take all of the write‐downs on real estate positions that they determined were appropriate; there is some evidence that the pressure actually resulted in unreasonable marks. But, as the evidence is in conflict, the Examiner determines that there is insufficient evidence to support a colorable claim that Lehman’s senior management imposed arbitrary limits on write‐downs of real estate positions during that quarter.
In other words, the definitive legal account of the Lehman bankruptcy has concluded that while executives may have shaded things a bit, from the perspective of what is actionable within the law, Lehman’s valuations were legally indistinguishable from accurate. Yet, the estimate of net worth computed from these valuations turned out to be off by 200% or more.
Advocates of the devil and Dick Fuld will demur here. Yes, Lehman’s “event of default” meant many derivatives contracts were terminated prematurely and collateral on those contracts was extracted from the firm. But closing a marked-to-market derivatives position does not affect a firm’s net worth, only its exposure. There may be short-term changes in reportable net worth as derivatives accounted as hedges and not marked-to-market are closed, but if the positions were in fact hedges, unreported gains on other not-marked-to-market assets should eventually offset those charges. Again, the long term change in firm net worth should be zero. There are transaction costs associated with managing a liquidation, but those would be minimal relative to the scale of these losses. Markets did very poorly after Lehman’s bankruptcy, but contrary to popular belief, Lehman was never forced into “fire sales” of its assets. It was and remains in orderly liquidation. Last July, more than 9 months after the bank fell, Lehman’s liquidator reported that only a “fraction” of the firm’s assets had been sold and the process would last at least two years. Perhaps the pessimistic estimates of Lehman’s value were made during last year’s nadir in asset prices, and Lehman’s claimed net worth looks more reasonable now that many assets have recovered. But if Lehman’s assets were so profoundly affected by last Spring’s turmoil that an accurate September capitalization of $28B shifted into the red by tens of billions of dollars, how is it plausible that Lehman’s competitors took much more modest hits during that period? Unless the sensitivity of Lehman’s assets to last year’s markets was much, much higher than all of its peers, Lehman’s assets were misvalued before the asset price collapse, or its competitors assets were misvalued during the collapse.
We get lost in details and petty arguments. The bottom line is simple. The capital positions reported by “large complex financial institutions” are so difficult to compute that the confidence interval surrounding those estimates is greater than 100% even for a bank “conservatively” levered at 11× tier one capital.
Errors in reported capital are almost guaranteed to be overstatements. Complex, highly leveraged financial firms are different from other kinds of firm in that optimistically shading asset values enhances long-term firm value. Yes, managers of all sorts of firms manage earnings and valuations to flatter themselves and maximize performance-based compensation. And short-term shareholders of any firm enjoy optimistic misstatements coincident with their planned sales. But long-term shareholders of nonfinancial firms prefer conservative accounts, because in the event of a liquidity crunch, firms must rely upon external funders who will independently examine the books. The cost to shareholders of failing to raise liquidity when bills come due is very high. There is, in the lingo, an “asymmetric loss function”. Long-term shareholders are better off with accounts that understate strength, because conservative accounting reduces the likelihood that shareholder wealth will be expropriated by usurious liquidity providers or a bankruptcy, and conservative accounts do not impair the real earnings stream that will be generated by nonfinancial operations….
So, for large complex financials, capital cannot be measured precisely enough to distinguish conservatively solvent from insolvent banks, and capital positions are always optimistically padded.
So it isn’t crazy for investors and counterparties to run away when banks start looking unhealthy. Sadly, their confidence game depends evermore on state support.
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1 Some readers may argue that the S&L crisis was an interest rate crisis, not a credit crisis. It is true that in the first wave, in the later 1970s, S&Ls, caught between their long-dated mortgage books and the end of regulated deposits, were hit by escalating losses during the inflationary 1970s. But instead of shuttering sick institutions, regulators engaged in an early version of extend and pretend. As a very good write-up at Federal Reserve History put it:
S&Ls primarily made long-term fixed-rate mortgages. When interest rates rose, these mortgages lost a considerable amount of value, which essentially wiped out the S&L industry’s net worth. Policymakers responded by passing the Depository Institutions Deregulation and Monetary Control Act of 1980. But federal regulators lacked sufficient resources to deal with losses that S&Ls were suffering. So instead they took steps to deregulate the industry in the hope that it could grow out of its problems. The industry’s problems, though, grew even more severe….
As a result of these regulatory and legislative changes, the S&L industry experienced rapid growth. From 1982 to 1985, thrift industry assets grew 56 percent, more than twice the 24 percent rate observed at banks. This growth was fueled by an influx of deposits as zombie thrifts began paying higher and higher rates to attract funds. These zombies were engaging in a “go for broke” strategy of investing in riskier and riskier projects, hoping they would pay off in higher returns. If these returns didn’t materialize, then it was taxpayers who would ultimately foot the bill, since the zombies were already insolvent and the FSLIC’s resources were insufficient to cover losses.
For more detail, see Bill Black’s The Best Way to Rob a Bank Is to Own One.
