Feature Stories | Mar 23 2023
Investors have voted with their feet, but how bad is the US banking crisis and how may this affect Australia?
-The S&L crisis all over again (?)
-Discrepancy in accounting
By Greg Peel
"You're thinking of this place all wrong, as if I had the money back in a safe. The money's not here. Your money's in Joe's house, right next to yours. And in the Kennedy house, and Mrs. Macklin's house, and a hundred others,"
-George Bailey (Jimmy Stewart) in It’s a Wonderful Life, 1947.
Savings Versus Loans
In 1973, then US president Richard Nixon, in order to recover the cost of the Vietnam War, decoupled the US dollar from the gold standard that had been in force since the end of the Second World War. The result was, aided by an Arab oil shock, US inflation jumped from 4.7% in 1973 to 12.3% by the end of 1974.
The Fed hiked its funds rate in response, to 16% in March 1975, but this only made the resultant 1973-75 recession worse, so it cut again in April, all the way to 5.25%. It was Fed chair Paul Volker who finally ended the vicious cycle in 1979 by deciding inflation simply had to be tamed, recession or not.
US inflation reached a peak in 1980 of 14.6%. In January 1980 the Fed funds rate was 14%. By December 1980 it had been hiked to its historical peak, being 19-20%. It worked. A recession ensued, allowing the Fed to reduce its funds rate very gradually to more manageable levels by the 1990s.
Any of this sound familiar?
The US Savings & Loan industry grew out of the Great Depression, to take deposits and lend on mortgages at a smaller, regional level than the big banks, and to not offer other services provided by the big banks (such as cheque accounts). In Australia we called them “building societies”.
Prior to 1980, S&Ls had issued long-term loans at fixed interest rates that were lower than the new interest rate at which they could borrow. When interest rates at which they could borrow increased, the S&Ls could not attract adequate capital from deposits and savings accounts of members.
Attempts to attract more deposits by offering higher interest rates led to liabilities that could not be covered by the lower interest rates at which they had loaned money. The end result was that about one third of S&Ls became insolvent.
Between 1986 and 1995 around a third of US S&Ls – around 1000 out of around 3000 – failed. Ultimately, taxpayers were called upon to provide a bailout.
S&Ls do still exist in the US, but these days are better known simply as “savings banks”. In between these and the big money-centre banks such as a JPMorgan Chase or Bank of America sit the commercial regional banks. Regional banks typically provide the same services as a big national bank, but within a specific region, and are much smaller.
The government-owned Federal Deposit Insurance Corporation insures deposits up to the value of US$250,000 in over 4,800 US banks.
Silicon Valley Bank, based in San Francisco, focused heavily on US technology start-ups. During covid, SVB saw a surge in deposits as tech companies profited from providing entertainment and delivery services to people confined to their homes. Those deposits were invested in longer term US bonds.
When the covid boom eased for SVB’s depositors, they started to withdraw, leading the bank to sell its bonds to cover the withdrawals. The problem was the Fed had hiked its funds rate from a covid-emergency 0-0.25% up to March 2022 to 4.50-4.75% in March 2023. A rise in bond yield implies a fall in bond price, hence SVB had to sell its bonds at a loss.
The bank then announced a planned capital raising. The effect was the opposite – a run on the bank as depositors quickly withdrew their funds. Two days later, the FDIC shut the bank’s doors.
Fearing similar problems across the US banking sector, depositors into other regional banks also began withdrawing and the share prices of those banks plummeted. To head off a meltdown, the FDIC, Fed and US Treasury agreed together to insure all regional bank deposits. Not a handout, but a backstop, providing depositors with no reason to panic.
It did not help that shortly after SVB went under, Credit Suisse revealed discrepancies in its accounting for the 2021-22 financial years. The timing was very unfortunate. While unrelated to the US regional bank issue, Credit Suisse’s revelations only fuelled fears of a global financial crisis, similar to one we saw not so long ago.
In the wake of SVB, another San Francisco-based bank, First Republic, was the next to see its share price plummet, assuming guilt by association. Eleven of the largest US banks subsequently stepped in to deposit a collective US$30bn to head off a panic. The share price continued to fall until this week when US Treasury Secretary Janet Yellen assured the SVB backstop could be applied to any regional bank.
But this is not the GFC all over again. Before 2007 the major US banks, and particularly investment banks, were undercapitalised and way over-leveraged. And particularly over-leveraged to smoke & mirrors type assets such as Collateralised Debt Obligations (CDOs) which suddenly one day had no value.
To head off disaster in that instance, the Fed encouraged the biggest banks to “buy out” the smaller, for as good as nothing, leading to acquisitions such as Merrill Lynch by Bank of America and Bear Stearns by JPMorgan.
Lehman Bros was one bridge too far – the resultant financial collapse forcing a massive taxpayer-funded bailout.
Plus a near-zero Fed funds rate and quantitative easing for years to come.
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