Past and Present U.S. Bank Failures: A Review of the Causes
When Silicon Valley Bank’s (SVB) problems first came to light, it looked like a “classic” bank run as depositors scrambled to get their money out of the bank. The run at SVB was on, but it wasn’t a classic run in the sense of how long it took to unfold. This run occurred at light speed as nervous depositors got on their smartphones and transferred money out of the bank to other institutions.
Bank runs aren’t anything new. When the Federal Reserve starts to raise interest rates, which of course it has been doing over the last year, it seems to do so until something breaks. What normally creates bank runs is a spark provided by the Fed that morphs into a lack of trust or faith in the bank in question—or perhaps the entire financial system. This happened en masse during the Great Depression. The Fed doesn’t intend to start bank runs, but let’s face it: Many (some would say most) government actions have unintended consequences. The SVB problem is just one such unintended consequence of the Fed’s tightening activity.
I’m not going to go into the mechanics of what happened at SVB. Many commentators have already done so. Will other banks succumb to the same pressures that infected SVB? I don’t know, but I think if the SVB “disease” proves to not be idiosyncratic to SVB, then the new victims of the Fed’s tightening policies will probably be other smaller banking players. The nation’s largest banks have been deemed “too big to fail” and are essentially fully backed by the Fed. The Fed is the “lender of last resort” and, as such, a big bank failure, which could bring down the entire financial system, is highly unlikely to happen.
Bank Regulations and Bonds
Part of the problem at SVB revolved around the regulation that allows banks to hold a significant portion of their bond portfolio in a classification of “hold to maturity.” Under this classification, the bank isn’t required to “mark” those assets to market value. If the bonds are sold at a loss, which is what happened at SVB, then the bank’s balance sheet may be thrown into jeopardy. Prior to the 2008-2009 recession, federal regulation required banks to “mark to market” their entire bond portfolio quarterly. The hold to maturity regulation, which allows banks to not market significant portions of their bond portfolios to current market value, wasn’t in place until the 2008-2009 financial meltdown. The new regulation was part of the Dodd-Frank legislation passed by Congress in the wake of the 2008-2009 downturn. Another example of unintended consequences of government regulations.
Now, the FDIC reports that banks have $620 billion in unrealized losses on their balance sheets due to rising interest rates. Again, much of this loss hasn’t been reported by the banks due to the new financial regulations.
I don’t know what portion of the average bank’s bond portfolio is intended to be held to maturity and not marked to market, but a rough approximation may be above 50%. The Bloomberg Barclays Aggregate Bond Index lost about 14.9% of its principal in 2022.1 Applying that very rough principal markdown to the average bank’s held to maturity portfolio shows us that the average bank’s bond portfolio suffered large unrealized losses last year. That said, the same bond index was up about 2.7% in principal value during the first quarter of this year.2 But the unrealized losses in many banks’ bond portfolios are still present.
Banking Business: It’s About Risk Taking and Trust
But bond portfolio problems are not normally the issue that drives a bank to insolvency and bankruptcy. Normally, the risks taken in the lending arena drive insolvency. Business lending is a risky business, not just due to the fact that the bank is counting on the business to repay the loan (with interest), but also because of a lack of liquidity. If the loan to the local business goes bad, the bank may not be able to sell the loan and offload the risk to someone else. The bank either has to foreclose on the loan by taking collateral from the business or has to simply write off the loan from its books, depleting its own capital base.
If the collateral backing the bad loan is a liquid asset of some kind (receivables or inventory), then the write-down process may not turn into a long-term problem. On the other hand, if the collateral is illiquid in nature, the process to write down tends to be a real capital burn problem the bank has to face. What illiquid assets back bank commercial loans? Commercial real estate. Therein lies the illiquidity risk.
The Commercial Real Estate Market Is Troubled
The commercial real estate market has of course struggled since the COVID-related recession. The Vanguard REIT ETF (VNQ) has generated an annualized return of -25% since the end of 2021 , underperforming most asset classes as well as the S&P 500’s annual return of -12% over the same period.3
Along with rising interest rates, I suggest the performance of the VNQ has been negatively affected by the problems associated with business/societal changes that the pandemic brought forward. Namely, the increase of work-at-home and mail order retail shopping trends, both of which negatively impacted the need for retail and office space, resulting in increased vacancy rates in these important segments of the commercial real estate market.
Perhaps problems in the commercial real estate market have yet to be fully felt. Default rates on commercial real estate loans made by banks remain very low. Less than 1% of outstanding commercial real estate loans made by banks are currently in default. Since 1990, the average default rate of commercial real estate loans has been 3.3%.4
Commercial real estate loan default rates accelerate during recessions. Over the last three “real” recessions (1990, 2001, 2008-2009), the default rate on commercial real estate loans averaged 7.5%.5 These are the kind of numbers that normally cause banks to have problems during downturns. Banks haven’t suffered specifically due to their bond portfolios. Problems normally occur due to defaults/write-downs in their lending portfolios. While I am not looking for a deep recession to unfold over the next year, I am suggesting that the probability of an upcoming recession is real.
The Banking Industry – The Biggest Seem Safe
Of course, not all banks are the same. As noted above, many banks don’t get heavily involved in commercial real estate lending, while others may. The bank’s decision to do so lies heavily on the bank’s culture and its view of risk taking.
Can we make a broad-brush statement regarding what kind of banks tend to have higher exposure to commercial real estate lending? Yes, but again, these are broad-brush generalities, which don’t apply to all banks.
I recently ran data on a group of 20 banks with which I am familiar, ranging in size from the majors to some small “regional” banks. Assets in these banks ranged from a high of $2.5 trillion to a low of $7 billion. The average commercial real estate portfolio was as high as $144 billion to a low of $2 billion.
I broke my work into three groups, arranged by bank size (total bank assets). I then calculated commercial real estate loans outstanding as compared to total bank assets. The results of this work are below.
Given the data above, if the U.S. economy were to fall into a recession over the next 12 months, and assuming the recession has a similar average duration/intensity of the last three recessions, then investors may start to assume we will see banks face write-downs of around 1% of their assets (7.5% default rate on 13.4% of their assets).
But the story becomes much more intense, as the smaller banks have tended to have much higher levels of commercial real estate lending exposure compared to the major money center banks.
Compared to the economic “soft landing” or “no landing” crowds, I have been standing firmly in the “soft recession” outlook camp for quite some time. Remember, according to the Conference Board (the people who call recessions), the U.S. economy has historically been in recession 12% of the time over the last number of decades. I have written that I believe the probability of an upcoming recession (over the next 12 months) is 50%. After the SVB meltdown, many have been raising their probabilities of such an outcome.
Historically, the Fed has raised rates and tightened monetary conditions prior to the start of historical recessions and does so until something in the financial system “breaks.” Financial crisis events have historically occurred prior to the start of most recessions; for example, before the 1970 Penn Central bankruptcy, the 1974 Franklin National Bank failure, the 1982 Mexico banking crisis, the nationwide 1990 S&L crisis and the 2008 subprime mortgage meltdown, which led to the Bear Stearns and Lehman Brothers bankruptcies. Now, we have SVB. We have seen this movie before.
Ned Davis Research reports that 44% of banks are now tightening lending standards compared to very few at the beginning of the year. In another measure, bank equity compared to assets now stands at 9.3%, down from a high of 11.7% a couple of years ago. And this is before the bond valuation adjustments noted earlier and the serious potential commercial real estate loan write-downs. Again, we have seen this movie before.
Irrespective of a bank’s exposure to commercial real estate or an overstated value of bonds on the balance sheet, banks don’t go out of business unless there is a liquidity event that leads to insolvency. If depositors’ faith in the bank is shaken, people today don’t “run” to the bank to withdraw their deposits; rather, they do so on their cell phone or computer. The run on a bank can occur literally in the blink of an eye. In the classic movie “It’s a Wonderful Life,” Jimmy Stewart plays George Bailey, a savings and loan proprietor during the Great Depression. A depositor “run” on his institution— Bailey Building and Loan—occurred. He survived the run due to people having trust in his capabilities.
Such homespun knowledge of our local bankers doesn’t seem to exist any longer, at least in most cases. This is where trust comes into play. Trust in the financial system and trust in your personal financial counselor. Trust, particularly during times of economic stress, is dear.
It is probably time to err on the side of caution or, as my colleague Jeff Krumpelman has been saying, a time to stand your ground. With the events in the banking world that have occurred over the last few weeks, bankers are husbanding capital more dearly than has been the case for some time. It is time to “hold your ground.” Keep your head down, but keep looking for opportunities. They will occur.
4,5St. Louis Federal Reserve
The S&P 500 Index is a market-value weighted index provided by Standard & Poor’s and is comprised of 500 companies chosen for market size and industry group representation.
The Bloomberg Barclays Aggregate Bond Index provides a measure of the performance of the U.S. dollar denominated investment grade bond market, which includes investment grade government bonds, investment grade corporate bonds, mortgage pass through securities, commercial mortgage-backed securities and asset backed securities that are publicly for sale in the United States.
Indexes are unmanaged and cannot be directly invested into. Investing involves risk and the potential to lose principal. Past performance does not guarantee future results.
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