Why US banks have gone bust – and why I’m shorting them

“How did you go bankrupt?” Bill asked. “Two ways,” Mike said. “Gradually, then suddenly.” Ernest Hemmingway ‘The Sun Also Rises’ (1926)

It seems incredible to think that just over a year ago interest rates were still close to zero, where they had been lowered in response to the Covid crisis.

Now, just 13 months later, after 10 rate hikes in the US, the key Fed Funds rate – which is also the key rate for global financial liquidity – has risen to 5.25 percent.

Similarly, the Bank of England has now raised interest rates 11 times to 4.25 percent.

This represents the fastest rate of monetary tightening in more than half a century, and if we consider the starting point of near zero, then the 20-fold increase from 0.25 percent in the US (42-fold in the UK from 0. 1 percent) is probably historically unprecedented.

Given this sharp increase in the cost of money, it is remarkable that we are not yet witnessing an economic recession or even a significant deterioration in the credit cycle.

But recently four major banks have failed: first the US duo of Silicon Valley, Signature and Credit Suisse in Europe, and most recently First Republic in America.

These institutions suffered a collective loss of confidence, not only from their investors, but especially from their depositors, who transferred their assets elsewhere. These banks depended on it to finance loans and other investments.

Unable to liquidate their assets fast enough to meet customer withdrawals, the banks ran out of money and were suddenly declared bankrupt.

The extraordinary economic stimulus from Covid – at a time when spending was constrained by lockdowns – sparked an explosion of savings that would eventually drown some banks in their own liquidity.

US bank deposits increased by another $4.4 trillion (+37 percent) in just two years, while at the same time demand for US bank loans increased by a paltry $390 billion (+3 percent).

These deposits, which cost nothing at the time but had to be invested somewhere, ended up in “safe assets” such as government bonds and mortgage-backed securities.

Ironically, this was also encouraged by financial regulators, who during the last war focused solely on credit risk and ignored the potential for value losses from higher interest rates on bond portfolios.

Fall and rise: how the Fed Funds rate and base rate have changed since 2020

Barry Norris

Barry Norris, manager of the VT Argonaut Absolute Return Fund

Barry Norris is the fund manager of the VT Argonaut Absolute Return Fund, a long/short equity fund that aims to provide uncorrelated double-digit annual returns.

The fund, which benefited from short positions in Silicon Valley Bank, Signature Bank and Credit Suisse in March, still has selective short positions in US regional banks.

At the end of March, the VT Absolute Return Fund had returned 18.4 percent over three years, 39.7 percent over five years, 115 percent over 10 years and 176 percent since launch.

When interest rates started to rise, US banks had fixed low returns on their investments, which would result in accounting losses, but had not held on to the low cost of deposit financing, as savers would now demand higher rates on their savings if the official central bank rate rose.

When Silicon Valley Bank announced its theoretical losses on its bond portfolio should it ever have to liquidate its holdings, its depositors panicked and withdrew their funding, meaning the bonds sold off in a sell-off, realizing losses where shareholders had no appetite. continue financing.

A few days later, Signature Bank – which had similar funding issues but reportedly had other issues related to cryptocurrency money laundering – was also forced to close by US regulators.

Following Walter Bagehot’s nineteenth-century dictum that in a financial crisis, central banks should borrow freely, as a lender of last resort, against good collateral and at a penalty interest, the Federal Reserve has now allowed banks to pledging assets at their purchase price – rather than market price – in exchange for cash, meaning few banks would now have to go out of business just because of a lack of liquidity.

However, since the cost of this money is the central bank’s base rate, which is significantly higher than the interest charged to savers on their deposits, this source of funding is gradually becoming ruinously expensive for banks.

US banks currently pay an average interest rate of just over 1 percent on their deposits compared to an average return of 4 percent on their assets, generating an average spread of 3 percent.

Increasingly, individual savers and companies are switching their deposits to ‘safer’ banks or to money market funds that can pay a return close to the official interest rate of 5.25 percent.

Since it is unlikely that banks can pass on higher interest costs to their borrowers without causing defaults, or invest in assets with higher yields without more default risk, banks’ profitability will now decline as the spread between bank assets and liabilities will narrow. squeezed.

Failed: A chart showing the history of failed US banks over time

Banks that continue to lose deposits will now try to increase their liquidity, making less credit available to the real economy.

This credit crunch will lead their clients to focus on their own cash flow, which will limit economic activity and depress asset prices, meaning it will be more difficult to liquidate assets without incurring losses.

It is likely that this new credit crunch will accelerate the process of disinflation that began in the summer of 2022, but a significant crisis will likely be needed to bring inflation, which is more stubborn than expected, back below levels of 2 percent that warrant monetary easing.

Many will inevitably compare this banking panic to the financial crisis of 2008, but all the more similar to the “savings and loan crisis” of the 1980s, in which more than 1,400 U.S. banks failed, with the common cause being long-term mortgage financing. with a lower interest rate and a fixed interest rate with higher costs short term deposits.

Paying more to their depositors than their mortgages, these thrift banks gradually went bankrupt due to chronically poor profitability, which their shareholders could not endure indefinitely and were ultimately unwilling to fund.

As they continue to raise interest rates, central bankers have also made it clear through their actions and rhetoric that any turn in monetary policy – cutting interest rates instead of raising them – will put pressure on US banks’ borrowing costs would ease – will only occur after a crisis and not before.

Therefore, the US banking system seems to be stuck between a rock, with rising deposit costs eroding net interest margins, and a hard spot, with economic crisis leading to high credit losses. Neither is attractive from an investment perspective.