QE & the Yellen Banking Crisis
Updated: Mar 15
Interview on Bloomberg Radio
March 14, 2023 | Several days have gone by since our post on the collapse of Silicon Valley Bank on Friday. On Sunday, we saw Signature Bank of New York also collapse into the arms of the FDIC. If you are a depositor of either of these banks, you likely have little risk. If you have questions, please contact the FDIC.
Big Picture: Is the crisis affecting US banks over? Not by a mile. In fact, to paraphrase our friend Josh Rosner in a client note: “The regulators have not gone far enough to address this crisis. Markets are aware of this and there has not been a full-throated enough or strong enough response from regulators or the Hill.” Ditto
The first thing we want to say to our readers is that both SVB and SBNY failed due to deposit runs, but for different reasons. In each case, idiosyncratic and even unprofessional behavior by management led to a bank failure, but the risks were greatly magnified by rising interest rates and QE. Today, we have several large commercial clients that continue to use both institutions, but only because of the guarantee on uninsured deposits.
When Treasury Secretary Janet Yellen appeared on television Sunday, she had no plan but the former President of the San Francisco Fed had another agenda: protecting her former colleagues who so badly dropped the ball supervising SIVB. Yellen knew that if the bank were allowed to collapse, people would start making the obvious comparisons to the same assets at other larger banks and in the system open market account.
Since the 2008 crisis, the Fed’s Board of Governors in Washington took control of most bank supervision matters, further removing the central bank from the real world of money and markets. When Chair Yellen pushed for the Fed to “go big” with QE, the NY Fed was not even consulted.
Now we have toxic waste killing our banks and inflation that looks to be permanent rather than transitory. By any reasonable standard, Secretary Yellen should have already resigned, but not in the strange world of Washington. It is increasingly clear that Yellen and the other economists that run the FOMC had no idea about the downside risks of pushing interest rates to zero. And Yellen did not ask for input from Congress.
Today the Fed’s Board of Governors remains largely clueless about the damage done by QE to the US financial system, banks and nonbanks alike. And the clock is ticking on a number of smaller community and regional banks. The irony is that QE has now made regional and community banks more risky than nonbank lenders. Consider that.
The Treasury debt and mortgage-backed securities (MBS) created during the 2020-2021 period of “Max QE,” are toxic waste despite the “AAA” rating. The fact of below-market coupons makes these securities unusually volatile and impossible to hedge. Why did the Fed even allow banks to buy these risky securities? Janet Yellen needs to address this issue publicly.
The big question that Steve Liesman, Nick Timaraos, Kate Davidson and our other colleagues that cover the Fed need to ask is this: Why did the Fed create Treasury debt and MBS that cannot be hedged? The hedge cost for a Ginne Mae 2.5% MBS, for example, is 2-3x the coupon. Why would anybody want to own this security (other than a central bank, of course)?
SIVB & Signature Bank
With that background, we come to the disaster at SIVB. Not only did the State of California, the Fed and FDIC drop the ball, but SVB made a number of management mistakes, most notably investing more than a third of the bank’s assets in mortgage-backed securities (MBS) in 2021 and even more in US Treasury debt. When interest rates rose 500bp, no surprise, the bank became insolvent. Just to be clear about the significance of a 5% rise in interest rates, note the corporate ratings breakpoints below from S&P:
Maximum Number of Basis Points
AAA: 1 bp
AA: 4 bp
A: 12 bp
BBB: 50 bp
BB: 300 bp
B: 1,100 bp
CCC: 2,800 bp
Default: 10,000 bp
What is interesting is that SIVB maintained an outsized position in MBS for years, yet neither the State of California nor the Fed nor even the FDIC seem to have noticed. Of note, none of the SIVB Board committees responsible for risk and asset liability management (ALM) were actually financial professionals. The rest of the SIVB Board were either decorative or focused on tech companies.
As we Tweeted to Sara Eisen earlier today, what is the point of new regulation proposed by President Joe Biden if regulators and auditors are too incompetent to read a financial statement? The drumbeat from Washington by Senator Elizabeth Warren (D-MA) for new regulation of smaller banks is part of the problem. We need to regulate the Fed and prevent any future FOMC from doing QE.
Source: Federal Reserve Board
What is fascinating about the chart above is that SIVB added to their MBS exposure as interest rates rose. At the end of 2021, thirty-year mortgage rates were at a bit over 3% and MBS yields were in the 2s. SVB added to the portfolio in the next year as mortgage rates peaked over 7% and MBS followed into the 6s.
“It seems that SVB management anticipated a recession on the heels of last year's tech meltdown,” notes a veteran fund manager and long-time reader of The IRA. “Not only was new biz going into hibernation but the credit quality of the SIVB loan book was going to be in jeopardy as were the potentially juicy returns of their warrant book and other holdco assets.”
He continues: “So, in anticipation of recession and the consequently assumed Fed pivot, they decided to proactively make a very large, long duration Treasury/MBS bet, figuring they'd hit the ball out of the park on that play which would more than offset the ensuing pain in the loan book, warrants, etc.”
At Signature Bank of New York, different errors in judgment by management led to a deposit run on this systemically important institution. In the chart below from the Q4 2022 earnings for SBNY, the flight of deposits at the bank is very clear. Starting first with the volatile crypto deposits and then business deposits, SBNY saw a classic bank run of 20% of total deposits in less than a year. Crypto started the run and then real deposits followed out the door.
The decision to support SIVB and SBNY was essential, yet as Politico reports, the Biden Administration almost balked at providing cover to the failing banks. “President Joe Biden began the weekend highly skeptical of anything that could be labeled a taxpayer-funded bailout, according to four people close to the situation, who were not authorized to speak for attribution,” Politico reports.
“Biden, who as vice president had watched then-President Barack Obama get hammered over his role in bailing out giant banks during the financial crisis, had little desire for a repeat, Politico relates.
And why is SBNY, a bank half the size of SIVB, systemically important? Because SBNY is a major player in both the commercial and residential real estate markets. The $110 billion asset bank, which traced its lineage bank to Edmond Safra and Republic National Bank, focused on serving the Jewish community in New York.
SBNY is the last lender willing to finance rent stabilized multifamily real estate in New York City. Do you think that New York Governor Kathy Hochul understands this? As mortgages mature on these properties, SBNY will not be there to roll the assets.
The Real Deal reports that the bank has already stopped issuing letters of credit to landlords of these properties. "Withdrawing deposits, drawing down loans and replacing letters of credit are among the issues borrowers and depositors are facing after the Federal Deposit Insurance Corporation took the bank into receivership Sunday," TRD reports.
Not only is SBNY the ONLY bank now willing to lend on rent stabilized apartments in New York City, but the prospect of a purchase of the bank means that these assets and the businesses that own them will be basically orphaned. When the New York legislature in Albany crippled the ability of landlords to recover costs on multifamily rentals with the latest rent control law, this entire asset class was impaired. Once SBNY is sold to a larger lender, these assets will be impossible to finance with a bank.
But there is more. Not only is SBNY a major player in multifamily, but it also plays in financing residential real estate and has participated in most of the financings for mortgage servicing rights (MSRs). SBNY will be but the latest lender to exit this market for MSR financing. The bank also manages escrow balances for a number of nonbank lenders, all of whom may now need to find a new bank at a time when many regionals are fighting for their lives.
The Yellen Banking Crisis
When we say that the Yellen Banking Crisis is not over, what exactly to we mean? First, by creating a two-tier approach between large and small banks, Yellen is exacerbating the run by businesses away from regionals to the largest banks. Consider a recent report from our risk manage pal Nom de Plumber, who is currently embedded inside one of the larger TBTF zombie banks.
“In a desperate move to retain business deposits, some regional banks are pressuring corporate clients to make uninsured deposits which sound like repos (repo sweep investments), but which are not truly documented and secured as repo transactions,” he reports. "The clients want to buy Treasury bills, but regional banks are offering high yields to retain the cash."
Essentially the banks take the uninsured deposits, then sweep them into a repurchase transaction overnight. The only problem is that the transaction is not in the name of the client but rather the bank. This is the same scam run by SBF at busted crypto scheme FTX. There is no documentation provided to the client and no lien on the collateral. If the bank fails, the customer will take a total loss because the FDIC receivership will repudiate the transaction in favor of the estate of the dead bank.
Bottom line: The Yellen and then Powell FOMC created the present banking crisis by embedding “AAA” rated toxic waste into the balance sheets of US banks. The steps taken so far are inadequate to address the threat. Since most members of the Biden Administration responsible for financial markets and institutions are incompetent (they’d rather talk about ESG and inclusion), the White House remains in the dark about the true scope of the problem.
Unless Congress acts quickly to extend blanket coverage (and deposit insurance fees) for all deposits, we will see more regional banks fail. Large banks are GSEs. Smaller banks are not, yet, but we suspect that the era of the uninsured deposit is over. FDIC should prepare to insure all deposits of US banks and tax the industry accordingly. The alternative is a debt deflation and return to 1933.
In the next issue of The Institutional Risk Analyst, we'll be reviewing changes to our portfolio and looking at some opportunities in banks and nonbanks.
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