While Yellen Assures, Banks Run

RSSOpinion / 2023-03-16 22:511


Speaking to the Senate Finance Committee on Mar. 16, 2023, the Treasury Secretary defended the Biden administration and Federal Reserve's response to the collapse of two U.S. banks. Images: Shutterstock/Bloomberg News Composite: Mark Kelly

Janet Yellen offered more assurances Thursday that U.S. banks are safe and sound—and we doubt even the Treasury Secretary believes it. Certainly no one else does. The biggest American banks had to commit $30 billion on Thursday to rescue First Republic Bank—15 years to the day since Bear Stearns's collapse. Happy anniversary!

The San Francisco-based bank's shares have lost 70% since last Wednesday, and its credit rating has been downgraded to junk. First Republic investors and depositors haven't been soothed by the Federal Deposit Insurance Corp.'s guarantee of uninsured deposits at Silicon Valley ( SVB ) and Signature banks, or the Federal Reserve's new emergency lending facility.

More troubling, a $70 billion liquidity lifeline offered by J.P. Morgan and others over the weekend appears to have been insufficient. If First Republic's problems go deeper than liquidity, the risks in the U.S. banking system may be bigger than regulators recognized and could grow if the economy slows.

First Republic caters to the affluent in California's Bay Area, Los Angeles, Boston and New York. About two-thirds of its deposits are uninsured and thus susceptible to a run if customers lose confidence. Wealthy customers were pulling deposits even before SVB failed.

The SVB blowup accelerated the flight, and the Fed's emergency lending facility was intended to help banks ride out a run. At the same time the FDIC guarantee of uninsured SVB and Signature deposits under its "systemic risk exception" was supposed to prevent contagion by creating an implicit backstop at other banks. Fed data show banks borrowed $164.8 billion from two Fed backstop facilities in the most recent week, but the panic is still on.

One reason is that only 15% of First Republic's $212.6 billion in assets are investment securities, mostly made up of municipal bonds. By contrast, most of SVB's assets consisted of U.S. government or mortgage-backed securities, which bear a duration risk if interest rates rise, but can also easily be liquidated in a crunch.

Muni bonds have the advantage of being tax-exempt and bear a low-risk weighting for the purposes of calculating capital to meet regulatory standards. Regulators also deem muni bonds "high-quality liquid assets"—except they're really not. Most muni bonds are held by households and mutual funds and are thinly traded on the secondary market.

Muni bonds have a similar duration risk to other long-dated government securities but can't be rapidly sold to redeem deposits. The Fed's emergency lending facility also doesn't accept most muni bonds as collateral, and First Republic holds few securities that it can borrow against at the central bank's new super-duper discount window.

Most of the bank's assets consist of commercial and residential real-estate loans. "Our loan portfolio is concentrated in single family residential mortgage loans, including non-conforming, adjustable-rate, initial interest-only period and jumbo mortgages," its investor report warns, adding these may be vulnerable to defaults as interest rates rise. Uh-oh.

Defaults on commercial real-estate loans have been increasing, especially in First Republic's chief lending markets. Housing prices have crashed in California's Bay Area to near pre-pandemic levels, and tech layoffs raise another credit risk. The risk of loan losses could explain the government's rush to shore up First Republic with a capital infusion.

Like SVB, First Republic benefited from the Federal Reserve's zero-interest rates and quantitative easing, which caused deposits from its wealthy customers to soar. It used these deposits to fund loans that appeared safe at the time but now look much less so. Markets today are enforcing more discipline.

This is another illustration of how the Dodd-Frank regulatory apparatus has failed. Democrats blame the 2018 bipartisan banking reform, which freed regional banks from many burdensome regulations applied to the big banks. But First Republic's Tier 1 leverage ratio is greater than that of most big banks, though it still may not be enough to absorb losses.

The underlying problem is that the Fed's modern monetary experiment and Dodd-Frank regulation distorted bank balance sheets. Vulnerabilities are emerging as the Fed corrects its inflationary mistakes. The more the Biden Administration insists the economy and banking system are A-ok when they're manifestly not, the more markets get nervous.

To adapt Taylor Swift, banks might be okay, but they're not fine at all.

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