“Every Bank is Deeply Underwater.”

Economist Says All Banks Fundamentally Unsound

Bullion.Directory precious metals analysis 12 April, 2024
By Isaac Nuriani
CEO at Augusta Precious Metals

Last March, Silicon Valley Bank, Signature Bank and First Republic Bank fell like dominoes as fast-rising interest rates significantly decreased the value of their substantial bond portfolios. 

Such losses remain unrealized (“paper” losses) as long as the affected institutions don’t have to liquidate their assets. Unfortunately, Silicon Valley, Signature and First Republic each faced depositor bank runs and had no choice but to start selling their underwater holdings to make good on the withdrawal requests.[1] 

In what seemed like no time, the bottom had fallen out of each institution and their doors were shuttered. And while the banks were regional and not globally systemic – i.e., “too big to fail” – their sudden closures were by no means insignificant; the three banks had more total assets under management – $532 billion – than did the 25 banks that failed in 2008 ($526 billion).[2] 

Since that wave of closures through the first several months of 2023, it appears as though conditions largely have settled. But as it turns out, the actual risk to banks has not. 

Some analysts say the source of the current threat is distress in commercial real estate. But upon closer inspection, much of that threat is rooted in the same interest rate risk that played such a big part in toppling Silicon Valley Bank et al. in 2023. 

An overview: The advent of the internet and other technology advancements over the last couple of decades have made office space and other commercial space obsolete. Obsolescence translates to emptiness. And empty space on which no rent revenue is generated makes it difficult for property owners to make good on their loan obligations to the banks. 

Admittedly, none of that has to do with interest rates. But here’s the part of the problem that does: Landlords who are managing to hang on despite the drop in revenue can do so in no small way because the loans on which they’ve been paying were taken out years ago, when interest rates were a lot lower. As these loans come due – $2.2 trillion over the next three years, according to one estimate – they will be refinanced at prevailing, higher rates.[3]  

It’s expected that will be more than many already-distressed landlords can bear. And as those landlords default, banks – particularly smaller, regional banks – will be left holding the bag. For banks with less than $10 billion in assets, nearly 40% of their loan portfolios are made up of commercial real estate.[4] 

So, even with respect to the threat to banks posed by commercial real estate, much of that threat actually is rooted in the same higher interest rates that have so badly wounded the value of banks’ bond portfolios. 

According to economist Lynette Zang, then, the primary threat to the banking system is the risk posed by higher interest rates to an industry that is built primarily on debt. And in her view, the scope of the problem is so vast that it means every single U.S. bank is insolvent right now. 

Sound outrageous? 

We’re going to take a careful look at what she said and break down what she means. And regardless of whether one emerges from our examination in lockstep agreement with how she feels about universal bank insolvency, it may well be the conclusion of many investors that the banking system is, at least, vulnerable to one degree or another. 

Finance Professor: “Very High Leverage” Is Banking System’s “Fundamental Problem”

“Banking is all about leverage,” Stefan Ingves, former governor of Sweden’s central bank, said some years ago. “Put simply, banks are highly leveraged institutions that are in the business of facilitating leverage for others.”

In other words, debt is the lifeblood of banks. Which means it also sits at the foundation of their biggest potential problem. 

“What is the fundamental problem in the US banking system? Ultimately, it’s very high leverage,” Tomasz Piskorski, a finance professor at Columbia Business School, said recently. “A typical bank in the US – and there’s actually not much variation, whether it’s big, whether it’s small – is about 90% debt-funded.”[6] 

The average size of a regional U.S. bank is somewhere in the realm of $50 billion.[7] Using Prof. Piskorski’s assessment, consumers and investors can assume such a bank is made up of $5 billion in equity – and $45 billion in debt. 

It also means banks can be a lot closer to “unrealized insolvency” than many people likely imagine. That’s because with all that debt, it doesn’t take much of a decline in the value of a bank’s portfolio to put the institution underwater. 

Even the worst implications of that problem may not come to pass for a bank unless depositors want their money out right away. But if a wave of depositors suddenly shows up on the bank’s doorstep to withdraw their money at the same time asset values are down – as we saw last spring – then unrealized insolvency can quickly turn into very real insolvency. 

As a matter of fact, in the opinion of one economist, the true condition of banks – all banks – is much more concerning than most people likely imagine. 

“Every bank – including every central bank – is deeply underwater,” Lynette Zang said recently.[8] 

Come again? 

“They are all insolvent…every single one.”[9] 

“What have the central banks been doing? They’ve been buying up all of this government debt with interest rates at zero, or even at negative rates,” Zang explains. “Now that the interest rates are pushed up to fight inflation, all of the valuation of all of that debt is way underwater.”[10] 

Zang makes clear her view that this is not just about commercial real estate debt…but all debt. 

“If the valuations of all of the banks – including the central banks – are based on debt…which they are, because the entire system is based on debt…those interest rates have pushed down the valuations of all that debt,” Zang says. “Not just bonds; not just mortgages; it’s also auto loans, student loans, credit cards…and then all of the trillions of derivative bets against that debt…so, yes, every single central bank, every single commercial bank…all of that debt is underwater.”[11] 

Zang also emphasizes that the worrisome conditions she says exists are not a function of just U.S. monetary policy, but the manner in which monetary policy around the world has been applied since the financial crisis. 

“Every central bank has been supporting their governments’ spending by buying the debt,” Zang says.[12] 

Zang’s suggestion that even central banks have been harmed significantly by their own rate policies of the past two years is not a matter of speculation. 

In fact, many developed central banks are awash in operating losses right now. Higher interest rates are forcing them to pay more in interest to commercial banks than they can actually afford. 

The Bundesbank – Germany’s central bank – suffered $23.3 billion in operating losses last year.[13] The Dutch central bank lost $3.8 billion.[14] 

Morgan Stanley estimates the Eurosystem – which refers to the European Central Bank and associated national banks, like the Bundesbank – will see nearly $70 billion in operating losses, collectively, in 2024.[15] 

Research: If Federal Reserve Was a Private-Sector Bank, It Would Be Facing Liquidation  

Things aren’t any better at our own Federal Reserve, which is paddling around in the same interest rate boat as other central banks. The Fed suffered its highest operating loss in history last year: $114.3 billion. And through September 2023, the unrealized losses on the Fed’s asset portfolio amounted to $1.3 trillion.[16]  

As it happens, central banks don’t run the risk of literal insolvency as commercial banks do for reasons few would consider surprising. One reason is they can issue more currency, if necessary, while another is that they’re backstopped indirectly by the nation’s taxing authority.[17] 

To Lynette Zang’s point, however, those exceptions don’t change the fact that central banks can be fundamentally insolvent, as she contends they – and all other banks – are. 

To her point, a paper published in February by the Hoover Institution maintains that if the Federal Reserve was a private-sector bank, it would be facing takeover, bankruptcy or liquidation.[18] 

I didn’t mean to go quite so far down the central bank rabbit hole, but doing so may help to underscore at least the spirit of what economist Lynette Zang is suggesting. For a host of reasons, all banks the world over – including central banks – may not be literally insolvent at present. But it’s not unreasonable to consider that a large number could be less than completely sound to varying degrees, particularly in the current interest rate climate that has done so much damage to the value of their bond portfolios.  

“But wait,” some might say. “Isn’t the current rate climate about to improve?” 

There has been a significant uptick in chatter over the recent months that the Fed is coming close to pivoting back to a posture of accommodative monetary policy wherein it will begin slashing interest rates. 

Lower rates wouldn’t change the degree to which the entire banking system is leveraged. But they would help ratchet down the acute pressure on financial institutions by serving to reinflate the value of their bond portfolios. 

Except there’s a problem: Recent economic data – data to which the Federal Reserve refers in considering whether to lower interest rates – has been coming in uncomfortably hot. Which raises the possibility that rate cuts, along with the hoped-for improvement in banks’ portfolio values, could remain elusive. 

Hot Economic Data Could Put a Hold on Rate Cuts, Keeping Pressure on Bank Assets

For many months now, it appeared that inflation was making a slow – but relatively certain – voyage back to earth from the long, strange trip it began taking in April 2021, when the annual consumer price index (CPI) meaningfully surged above the Federal Reserve’s 2% target.

After ascending to a high of 9.1% in June 2022, CPI has made a fairly steady retreat back toward 2%. By June 2023, CPI had fallen to 3%, suggesting that America’s long, national inflation nightmare…at least for this cycle…was nearing an end, and a return to interest rate cuts was close at hand.[19] 

But that’s where things started to get sticky – quite literally. Since falling to 3% last June, CPI hasn’t been able to drop any lower. In fact, it hasn’t even been that low again any month since. 

A textbook example of inflation stickiness had set in, where the lower it goes, the more stubborn it becomes. And, more recently, inflation’s been getting worse, accelerating the last two straight months; after coming in at 3.1% in January, annual CPI increased to 3.2% in February and 3.5% in March.[20]  

As for core CPI, which excludes more volatile food and energy prices in an effort to present a “cleaner” look at monetary inflation, that landed at 3.8% last month – still nearly twice the Fed’s target rate.[21] 

And so, with inflation still running hot and unemployment remaining below 4% for 26 straight months – the longest such stretch since the late 1960s – the prospect of imminent rate cuts that would help relieve the pressure on banks’ government bond portfolios, commercial real estate debt and other obligations…is suddenly in doubt.[22] 

In fact, just a month ago, traders pegged the chances of a rate cut in June at 70%. Since then, those chances have fallen to 23%.[23] 

At their policy meeting in March, Fed policymakers’ reiterated their expectations of making three 25-basis-point rate cuts before the end of the year.[24] 

Now, last month seems so far away.   

And that means the current risks to the banking system, which have been intensified by rate pressures, could persist. 

Unrealized Bond Portfolio Losses Have Wiped Out 70% of Banking System’s Capacity to Absorb Losses  

According to Paul Kupiec, an economist at the public policy think tank American Enterprise Institute, higher interest rates are responsible for the banking system accumulating more than $1.5 trillion in unrealized rate-related losses on its fixed-rate securities and loan investments as of September 2023.[25]  

According to Kupiec colleague Desmond Lachman, those unrealized losses rooted in higher rates have wiped out “more than 70% of the total loss-absorbing capacity of the banking system’s reported Tier 1 regulatory capital,” which is a bank’s primary funding source and the core measure of its financial strength.[26]   

It’s unclear, of course, to what extent the risks that Lynette Zang, Tomasz Piskorski, Desmond Lachman and others say are posed by the banking system right now may translate into real trouble for the broader economy, as well as for the investors who are directly exposed to its gyrations. 

But it seems reasonable to at least acknowledge those risks are real, to one extent or another. And if one accepts that, then he or she might additionally accept that it could be prudent to take steps designed to mitigate the fallout should those risks become reality. 

As for how to mitigate that fallout, some investors could choose to acquire assets with a reputation as stores of value, such as physical gold and silver…perhaps even opting to purchase their metals through a gold IRA. Other investors may seek to lower their risk exposure another way. Still others may elect to do nothing and assume – or hope – that risks never become reality. 

But aside from whatever one decides to do or not do as far as managing the current circumstances of the banking system, it seems clear those circumstances are as profound as they are real.

And as long as that’s the case, all concerned would do well to keep a close eye on how conditions evolve from here. 

[1] Courtney Carlsen, Yahoo Finance, “The FDIC Assessed $16 Billion to Banks For Last Year’s Banking Failures: Here’s How Much the Big Banks Are Paying” (January 22, 2024, accessed 4/11/24).
[2] Thomas Barrabi, New York Post, “This year’s 3 bank failures held $532B in assets — more than all lenders that collapsed in 2008 crisis” (May 1, 2023, accessed 4/11/24).
[3] Elisabeth Buchwald, CNN Business, “Here’s why regional banks have so much commercial real estate exposure” (February 29, 2024, accessed 4/11/24).
[4] Ibid.
[5] Stefan Ingves, Bank of International Settlements, “Banking on leverage” (February 26, 2014, accessed 4/11/24).
[6] Allison Morrow, CNN Business, “Banks are still fighting safeguards even as risks pile up” (March 12, 2024, accessed 4/11/24).
[7] Erin Gobler, Investopedia, “What Is a Regional Bank? How It Differs from a National Bank” (April 26, 2023, accessed 4/11/24).
[8] Michelle Makori and Anna Golubova, Kitco.com, “No bank is safe, implosion coming: ‘Every single bank is insolvent’ — Lynette Zang” (April 8, 2024, accessed 4/11/24).
[9] Ibid.
[10] Ibid.
[11] Ibid.
[12] Ibid.
[13] Balazs Koranyi and Bart H. Meijer, Reuters.com, “German, Dutch central banks post big losses, warn of more” (February 23, 2024, accessed 4/11/24).
[14] Ibid.
[15] Ibid.
[16] Bob Fernandez, Wall Street Journal, “Pro Take: Fed Operating Losses Are Piling Up Amid Higher Interest Rates” (December 7, 2023, accessed 4/11/24).
[17] BIS.org, “Why are central banks reporting losses? Does it matter?” (February 7, 2023, accessed 4/11/24).
[18] Andrew T. Levin and Christina Parajon Skinner, Hoover Institution, “Central Bank Undersight: Assessing the Fed’s Accountability to Congress” (February 8, 2024, accessed 4/11/24).
[19] U.S. Inflation Calculator, “Historical Inflation Rates: 1914-2024” (accessed 4/11/24).
[20] Ibid.
[21] U.S. Inflation Calculator, “United States Core Inflation Rates (1957-2024)” (accessed 4/11/24).
[22] Bureau of Labor Statistics, “Labor Force Statistics from the Current Population Survey” (accessed 4/11/24).
[23] CME Group, “FedWatch Tool,” (accessed 4/11/24).
[24] FederalReserve.gov, “Summary of Economic Projections” (March 20, 2024, accessed 4/11/24).
[25] Desmond Lachman, AEI.org, “Jerome Powell Is Inviting a Banking Crisis” (February 27, 2024, accessed 4/11/24).
[26] Ibid.

This article was originally published here

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