‘Most U.S. banks are technically near insolvency, and hundreds are already fully insolvent,’ Roubini says
In January 2022, when yields on U.S. 10-year Treasury bonds TMUBMUSD10Y, 3.518% were still roughly 1% and those on German Bunds were -0.5%, I warned that inflation would be bad for both stocks and bonds.
Higher inflation would lead to higher bond yields, which in turn would hurt stocks as the discount factor for dividends rose. But, at the same time, higher yields on “safe” bonds would imply a fall in their price, too, owing to the inverse relationship between yields and bond prices.
This basic principle — known as “duration risk” — seems to have been lost on many bankers, fixed-income investors, and bank regulators. As rising inflation in 2022 led to higher bond yields, 10-year Treasurys lost more value (-20%) than the S&P 500 SPX, +1.44% (-15%), and anyone with long-duration fixed-income assets denominated in U.S. dollars DX00, -0.10% or euros USDEUR, -0.24% was left holding the bag.
The consequences for these investors have been severe. By the end of 2022, U.S. banks’ unrealized losses on securities had reached $620 billion, about 28% of their total capital ($2.2 trillion).
Making matters worse, higher interest rates have reduced the market value of banks’ other assets as well. If you make a 10-year bank loan when long-term interest rates are 1%, and those rates then rise to 3.5%, the true value of that loan (what someone else in the market would pay you for it) will fall. Accounting for this implies that U.S. banks’ unrealized losses actually amount to $1.75 trillion, or 80% of their capital.
The “unrealized” nature of these losses is merely an artifact of the current regulatory regime, which allows banks to value securities and loans at their face value rather than at their true market value.
In fact, judging by the quality of their capital, most U.S. banks are technically near insolvency, and hundreds are already fully insolvent.
To be sure, rising inflation reduces the true value of banks’ liabilities (deposits) by increasing their “deposit franchise,” an asset that is not on their balance sheet. Since banks still pay near 0% on most of their deposits, even though overnight rates have risen to 4% or more, this asset’s value rises when interest rates are higher. Indeed, some estimates suggest that rising interest rates have increased U.S. banks’ total deposit-franchise value by about $1.75 trillion.
If depositors flee, the deposit franchise evaporates, and the unrealized losses on securities become realized. Bankruptcy then becomes unavoidable.
But this asset exists only if deposits remain with banks as rates rise, and we now know from Silicon Valley Bank and the experience of other U.S. regional banks that such stickiness is far from assured. If depositors flee, the deposit franchise evaporates, and the unrealized losses on securities become realized as banks sell them to meet withdrawal demands. Bankruptcy then becomes unavoidable.
Moreover, the “deposit-franchise” argument assumes that most depositors are dumb and will keep their money in accounts bearing near 0% interest when they could be earning 4% or more in totally safe money-market funds that invest in short-term Treasurys. But, again, we now know that depositors are not so complacent. The current, apparently persistent flight of uninsured — and even insured — deposits is probably being driven as much by depositors’ pursuit of higher returns as by their concerns about the safety of their deposits.
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About the Author: Patriotman
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