Fundamentally, the financial system has become bogged down in the quagmire of rising interest rates, and it is unclear how it will get out. The root cause — a selloff in longer-dated government bonds and affiliated debt and the ensuing mark-to-market collapse in the assets of vulnerable US lenders — has only worsened.
According to an influential paper by academics from Stanford and other US universities, “The US banking system’s market value of assets is $2tn lower than suggested by their book value of assets accounting for loan portfolios held to maturity. Marked-to-market bank assets have declined by an average of 10% across all the banks, with the bottom fifth percentile experiencing a decline of 20%.”
If this sounds concerning, more so are the implications. The US banking sector is, like all banking systems, extremely highly geared. A system running on an average of only 10% equity means that a 10% drop in asset values makes the entire system (on a mark-to-market basis) insolvent.
Bank treasurers will doubtless argue that this is no immediate cause for concern. Banks, self-evidently, do not operate on a mark-to-market basis. Given their (supposedly) sticky depositor base they should be fully capable of holding assets to maturity — in that case, who cares what the market might be valuing them at? Furthermore, outside of whoever was running the balance sheet of the doomed Silicon Valley Bank, any treasurer appreciates the importance of hedging interest rate risks.
However, this (hopefully) momentary insolvency of the US banking sector has some very real consequences. First, deposit holders are not stupid. Two weeks ago we reported that there was a worrying trend of clients withdrawing their deposits from regional US banks and transferring them to money market funds and “systemically important” majors such as JPMorgan Chase and Goldman Sachs. This has only accelerated.
More than $286-billion has flooded into money market funds so far in March from mid and small-tier US regional lenders, making it the biggest month of inflows since the depths of the Covid-19 crisis, according to the data provider EPFR. While not exactly a rush for the exits, it does resemble that awkward time in the evening when slipping away from the party without an overly elaborate farewell starts to seem like a sensible idea.
Second, bank runs are not the only threat to financial institutions. Profitability matters. Dwindling deposits mean that banks will have to start paying higher deposit rates to try to retain them. Calls for liquidity will require forced selling in their distressed asset books. This toxic combination will decimate banking profitability, especially among the most vulnerable institutions, making it not only impossible to retain equity from earnings, but increasingly difficult to raise any equity if they need to shore up their creaking balance sheets.
As Rob Armstrong writes in the Financial Times, “The heart attack phase of the banking crisis may be over, as the threat of runs subsides in the face of official support for banks. Now, however, we have to see if any banks are going to die slowly, killed by the cancer of declining profit.”
But perhaps the most concerning effects of the increasingly sclerotic US banking system will be in specific areas of the economy which are most exposed. Among others, these strains are starting to show in the arteries of the $5.6-trillion market for commercial property loans.
For commercial real estate in the US, it seems like a perfect confluence of toxic circumstances. Already battling lower post-pandemic occupancy, higher interest rates have led to ever-lower valuations, creating losses for the regional banks which do most of the lending in this market.
Then, the recent crunch in the financial sector is limiting lenders’ ability to extend additional credit to struggling commercial borrowers, as banks try to offload assets. This puts further pressure on valuations, as embattled developers are forced to sell into a market already experiencing a glut of empty office space.
Thousands of small and medium-sized banks account for about 70% of so-called commercial real estate loans, according to JPMorgan Chase analysts. The risk of a vicious death spiral in this sector, triggered by rising interest rates, falling property valuations and collapsing banks, is not inevitable. However, it is hard to imagine how it could be averted.
This is but one potential next act in the saga playing out across global financial markets. Central bankers demonstrated last week they are not done hiking rates. Good luck to them in their battle against inflation. Good luck to everyone else in surviving the fallout. DM/BM