The Breakdown - Is the Banking Crisis Really Over?

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Starting point is 00:00:49 It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is produced and distributed by CoinDesk. What's going on, guys? It is Wednesday, April 5th, and today we are asking whether this banking crisis is really over. A quick note before we dive in, there are two ways. to listen to The Breakdown. You can hear us on the Coin Desk Podcast Network feed, which comes out every afternoon and features other great CoinDesk shows, or you can listen on the breakdown-only feed, which comes out a few hours later in the evening. Wherever you're listening, if you're enjoying the show, I would so appreciate it if you would take the time to leave a five-star rating

Starting point is 00:01:24 or review. It makes a big difference, and I really appreciate it. All right, guys, so over the weekend, I noticed a tweet from prominent political writer Matthew Iglesias. This tweet broke my brain, and so I thought to myself, well, let's do a show about it. Matthew writes, really simply, so all that bank stuff people were worried about seems to have turned out fine, shrug emoji. Now, it didn't break my brain because Matthew's wrong that banking contagion seems to be for the time contained,

Starting point is 00:01:51 or that it appears that the Fed's facilities are working, or really anything substantive of what might underlie the tweet. It broke my brain because the thing is such a monument to trying to write off trying to understand complexity, as well as a glib dismissal of people who had concerns about the wider problem. all that bank stuff, as if there wasn't something specific to try to actually understand. Now, at the risk of acting like a college student reading too much into a single line of text, I think that this was pretty clearly a jab at the Bology type set,

Starting point is 00:02:21 who were arguing that there was a much bigger problem than just Silicon Valley Bank. Now, I don't care at all if people don't like Bologi's million dollar Bitcoin bet, or don't buy into someone like Arthur Hayes' argument that the bank term funding program is going to almost assuredly see mission creep. And honestly, I don't even really mean to call out Iglesias here as every day there are a million tweets from a variety of commentators that are equally glib and dismissive for the sake of Twitter engagement. I just happen to think that being glib about the most important issues we're dealing with

Starting point is 00:02:50 is a huge part of the problem with current public discourse. And in this case, I think the underlying contention that the bank stuff people were worried about seems to have turned out fine is worthy of some serious consideration and dissection. So today, let's explore exactly that, whether the bank stuff people were worried about seems to have turned out fine, is worthy of some serious consideration and dissection. So today, let's explore exactly that. the bank stuff people were worried about turned out fine. And let's look at some of the numbers to start. By way of recapping, let's set a framework for what we're actually talking about here specifically when we talk about the bank stuff that people were worried about. In short,

Starting point is 00:03:17 people have been worried that numerous banks would see people withdrawing assets in an extra normal way. Due to some combination of, one, being able to get better yield elsewhere, including buying treasuries directly, and two, concern about the viability of especially smaller banks whose asset side of the balance sheet is underwater due to the rapid increase in interest rates. Looking at the big stories, the Silver Gates and Silicon Valley banks, there was an attempt to write them off as just the concentration risk of having a specific industry as a lead depositor. And certainly that was a part of the issue. Silvergate was, of course, extraordinarily concentrated in crypto, and Silicon Valley Bank

Starting point is 00:03:53 had a big portion of its deposits from the tech sector. This mattered because both of those beleaguered industries experienced circumstances that required depositors to request to withdraw their funds, for reasons having nothing to do with concern over the viability of the banks. E.G. startups burn cash to live and had less venture capital coming in to replace it, ergo net outflows for SVB. Now, the issue, of course, is that banks don't just keep their depositors cash in a vault. They put it into other things, such as loans or mortgage-backed securities. Over the zero interest rate period, and especially during the COVID years, in many cases these institutions put those deposits in much longer dated securities in order to increase their

Starting point is 00:04:34 yield. When interest rates rose, the value of those assets decreased comparatively. If you can get 4% plus on a risk-free rate somewhere else, why are you going to keep your money in a 0% yielding bank account? When interest rates rose, the value of those assets decreased comparatively. This led to the phenomenon of American banks having more than $600 billion of unrealized losses on their books. An unrealized loss, of course, means that there is a security on the bank's books that would be worth less than when they bought it if it were forced to be sold on the open market. Now, this doesn't matter if banks are able to hold those assets to maturity. But that brings us back to depositors.

Starting point is 00:05:14 Depositors come in, need their money back, and that means banks have to sell those securities. as was the case for SVB, that selling means that unrealized losses become realized. Realized losses, meanwhile, when reported, can catalyze insecurity around the bank itself and cause other nervous depositors to want to pull their money as well, which of course exacerbates the problem and creates a positive feedback loop where more realized losses, lead to more withdrawals, lead to more realized losses, and so on and so forth. So what we really saw with these examples was a slew of different types of risk, concentration risk of depositor bases, duration risk of the assets banks buy and invest in,

Starting point is 00:05:51 and interest rate risk of, for example, the Fed hiking faster than it had in 40 years. Not to mention, for good measure, new types of risks banks are just really wrapping their heads around, including social media risk. So when we talk about the quote-unquote bank stuff people were worried about, it was really about all of that together, with the specific concern that people were worried about other people withdrawing their money from banks en masse. So have we seen any of that? Bloomberg last week writes,

Starting point is 00:06:16 U.S. bank deposits in lending both dropped amid turmoil. The story is that deposits declined by the largest amount in two years, with commercial bank deposits dropping by about $126 billion. But while that's a big, scary seeming number, it's worth asking how much of that is due to fear of bank solvency versus just yield hunting. On that front, it certainly appears that a lot of these deposits are going right into higher yielding money market funds.

Starting point is 00:06:39 Since the end of 2022, there have been a little under $400 billion in cumulative bank deposit declines, and a very similar cumulative amount of increase in money market fund assets. A lot of folks are discussing this exact dynamic. Lisa Abramowitz from Bloomberg writes, Money Market Funds globally saw inflows of more than $60 billion in the week ending March 29th, while $5.2 billion flowed out of global equities. The volume of U.S. money market funds has surged by $305 billion since the start of March.

Starting point is 00:07:06 Basim Lahood responded to that, saying spot on, except banks started paying 4%. Got an email from J.P. Morgan, not starved for deposits, last week. balances over 100K equal API 4%. Apollo Macro responded, I got the same. Small banks lose deposits to big banks, but big banks lose to money market funds. The flows to MMFs have been relentless. And if you think government paper has started to crowd out private sector paper, just wait until

Starting point is 00:07:30 they raise the debt ceiling and Yellen makes it rain. Indeed, banks being out-competed with has been a really huge topic on FinTwit. QE Infinity tweets, Fed announces deposits at domestic banks drop by $97 billion for the week of 322. Here's the interesting part. 96 billion left the large banks, only 1 billion left the regionals. My guess is that people are leaving banks for higher rates and treasuries and money market funds. Pretty interesting to see the money flying out of the big banks. That's what happens when you offer 0.1% rates on your CDs.

Starting point is 00:07:59 Money will flow elsewhere. It blows my mind that they could be this stupid. Or maybe they just aren't well capitalized. Something stinks. Now, outside of these money market flows, a lot of the debate, frankly, is what's the real story here? Are these deposits, in other words, cause for concern, and some think they are? The Kobayisi letter writes, In March, U.S. banks lost around 390 billion in deposits the biggest monthly decline in history.

Starting point is 00:08:23 By comparison, not a single monthly decline in 2008 exceeded $100 billion. Since the recent high, total deposits in the U.S. are now down a record $1 trillion. Where did all this money go? Most of this money went into money market funds and treasury bonds. Meanwhile, gold is set to break 2000 while Bitcoin gained 45% in March. inflation and instability have people questioning the system. This is the product of quote-unquote free money and zero percent interest rates. Noriel Rubini, Dr. Doom himself, says depositors realizing that they can earn 4% on safe short-term T-bills while they get close to 0% on bank deposits.

Starting point is 00:08:56 This is a key source of continued bank runs. The free lunch that banks used to get on free deposits is ending. Interest sensitivity of deposits is sharply rising. Now, this is far from the only perspective. A completely different interpretation says the thing that so many were worried about. Deposits fleeing small and regional banks simply hasn't happened. Robin Brooks, the chief economist at the Institute of International Finance Rights, there is no deposit flight out of U.S. banks. Small banks saw inflows of $6 billion in the weekend in March 22nd after outflows of $196 billion in the weekending March 15th. Big banks are seeing outflows, but those predate SVB and are small versus the stock of deposits. Joseph Wong said depositors care much more about

Starting point is 00:09:35 safety than rates. We had big outflow into MMFs as bigger accounts became more risk-averse, and but looks like that is over. There is no big outflow of deposits due to rates. Great majority of depositors are not rate sensitive. Bob Elliott, the CIO of Unlimited Funds, says much the same. Weekly bank data, he writes, indicates small bank run paused post March 15th. Deposits flat through March 22nd, small decline in borrowings was paid for by small reduction in cash assets. Otherwise, everything's stable. The banking crisis has moderated substantially, and in particular the pressure on small banks stopped following the aggressive Fed and Treasury actions. With the acute matter resolved, now the focuses on how much credit extension falls, which will take a while to know. Now, one really interesting

Starting point is 00:10:15 take came from Austin Campbell, who was on the show just a few weeks ago. On April 1st, he tweeted, the actual biggest story of the week, and we are ignoring it, regional bank prices are stabilizing and recovering even as fundamentals deteriorate, tells me the market is not prepared for the next crisis. Which I think, of course, brings up the question, what might the next crisis be? So let's turn back to that last line of Bob Elliott's thread, with the acute matter resolved, now the focus is on how much credit extension falls. So let's discuss credit risk. From the Federal Reserve website, quote, credit risk arises from the potential that a borrower or counterparty will fail to perform an obligation. For most banks, loans are the largest and most

Starting point is 00:10:53 obvious source of credit risk. So what specific credit risks are people concerned with? I would point you to a tweet I sent on March 23rd. Within the next two weeks I wrote, everyone on bank Twitter and VC Twitter and FinTwit is going to be talking about huge volume of commercial real estate debt that was taken on during ZERP, but is maturing and will need to be refied in a high-rate-a-liquidity environment. Did that come to pass? Well, I'll let you decide. Adam Slater of Oxford Economics says, as quoted by Bloomberg,

Starting point is 00:11:20 bank troubles have been largely a liquidity issue, but there are asset problems too. U.S. banks are sitting on large unrealized losses on securities due to rising rates. They also face losses of 15% or more in areas like commercial real estate. QE Infinity again tweets a fortune article about Morgan Stanley and says, Morgan Stanley is predicting a 40% drop in commercial real estate values from peak to trough as a result of high vacancies and having to roll over debt into higher interest rates. 2.9 trillion in CRA loans must be renegotiated and rolled over in the next 24 months. The piece of that came from was titled Morgan Stanley analysts are forecasting something

Starting point is 00:11:57 quote worse than the great financial crisis for commercial real estate. Boas Weinstein talked about how this is affecting other sectors, saying, A new front in the battle opened up this week, life insurers. The fundamental rationale is commercial real estate and financials exposure, even if they don't have the hold to maturity bond issues of the banks. Basically saying that life insurance companies that have a big part of their portfolio in commercial real estate are also facing problems even if they're not the same problems that we saw from the banks.

Starting point is 00:12:24 X.72 or Ming Zau wrote a little threat about CREs that goes into some more detail. She writes, soon you'll hear a lot more about CRE. Why? Because U.S. banks and private equity firms are headed for real estate doomsday. Four collapses in 11 days, $270 billion in CRA loans due end of year, $3 billion plus defaulted in March 23 alone. What is CRA and why does it matter? Commercial real estate equals property for business. The U.S. CRE industry is a $20.7 trillion market. Core segments include office, industrial, multifamily, retail, hotels, and land.

Starting point is 00:12:56 Investors specialize into three major investment strategies, core, value add, opportunistic. The ways to invest in CRA include directly buying property and managing or outsourcing to a management I.e. a CRE equity investor. Or originate or buy CRE loans, a CRE debt investor. Or three, invest in a property reet which does number one or a mortgage reet which does number two. Here's the problem. CRE debt investors today are highly concentrated. Small banks hold 80% of CRE loans worth $2.3 trillion. Once default, start piling in the U.S. banking sector and all its stakeholders will be effed. How we got here. In 2022, U.S. banks went on a frenzied buying spree for CRE. exposure increased 4.8 trillion to 5.3 trillion, 4x the rate of years prior. Why? Back in 21,

Starting point is 00:13:43 rates were 0% and hikes imminent. Many CRE loans promised floating rate returns. Result banks unanimously said buy. This frenzied buying was much worse at small banks than big. Borrowing as a percentage of reserves shot from 25 to 95% year over year, versus the same metric only increased to 35% for big banks. What's ahead? Defaults. Cascading defaults. So far in 2023, In February, Brookfield, the number one largest office owner in L.A. defaulted on $784 million. March, Pacific Investment Management Company defaulted on $1.7 billion of mortgage notes on seven assets. Also, March, Blackstone defaulted on $562 million in Nordic CNBS. This is just the tip of the iceberg.

Starting point is 00:14:24 The current value of loans and securities held by banks is $2.2 trillion lower than the book value recorded on their balance sheets. So while a single $1.7 billion commercial mortgage default in March 23 may have spooked market, this is a bellwether for many more to come. Investors and policymakers need to understand the contagion risk of the CRA loan crisis and beyond before it's too late. Now, lest you think it's just the Twitterati who are talking about this? Not so.

Starting point is 00:14:51 J.P. Morgan's CEO, Jamie Diamond, has gone on the record with his views on the banking crisis in the bank's annual letter to shareholders released this week. He said that Silicon Valley Bank's problems were encouraged by the state of U.S. regulations and that the issues at the bank went untested by Federal Reserve supervisors, even though they were hiding in plain sight. Diamond warned that, quote, the current crisis is not yet over, and even when it is behind us, there will be repercussions from it for years to come. He cautioned that regulator should resist the temptation to be seen to be doing something by layering on additional rules. We should not aim for a regulatory regime that eliminates all failure, but one that reduces

Starting point is 00:15:25 the chance of failure and the odds of contagion. So friends, when it comes back to that original question, is all that bank stuff people were worried about seeming to have turned out fine? The The answer is, of course, it's complicated. The Fed's bank term funding program has done the job that people wanted. It has shored up confidence in the banking sector. We're not seeing massive flows out of small and regional banks, which is a good thing. We're seeing competitive pressure for money market funds and direct U.S. Treasuries on banks, but that's not necessarily a problem. Competition is part of the system. But there is so much more to what might happen and challenges that the banking sector faces. And those are things that the same people who were worried about all this bank

Starting point is 00:16:05 stuff we're worried about before and continue to be worried about now. This is strange advice in today's times, but I would suggest that we all take the time, not to panic blindly nor to dismiss things, but to understand what challenges we actually face. I appreciate you guys making this show part of your journey to do so. So until tomorrow, be safe and take care of each other. Peace.

The Breakdown - Is the Banking Crisis Really Over?

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