The Federal Reserve has entered a new cycle with a vengeance. After last week’s decision to cut a giant 50 basis points, rivers of ink have been spilled over what the road map now looks like. The need to anticipate a weakening labor market, to strengthen the nation’s economy, and other such factors have been Dante’s stars, but there is one problem that remains hidden and requires an aggressive Fed: the nation’s banking system is facing a historical stress situation because of the high price of silver.
American banks of all sizes have it under the carpet a veritable mountain of losses due to rates, a real sword of Damocles that ensures that the fuse of the crisis can be lit at any time. These are latent losses, that is, declines in the value of assets that, not having yet been sold, are not reflected as such, but are recorded by the Federal Deposit Insurance Corporation (FDIC).
According to the institution’s latest quarterly tally, the U.S. banking system’s latent losses They amount to nearly 512 billion dollars. Although this is slightly less than the 516 billion of the previous quarter and much less than the maximums of 2022, with around 690 billion, the reality is that these are quite historic levels. To understand the magnitude, this represents seven times the figures observed during the financial crisis of 2008.
Most of these losses come from the bond market, and more specifically, from U.S. bonds. U.S. entities have been using deposit money on their balance sheets in recent years. Ten-year U.S. debt securities have seen their prices collapse as the central bank has raised interest rates. Specifically, It reached 5% profitability (which is inversely proportional to the price) at the end of 2023 and, although it is now at 3.79%, the reality is that it is very far from its levels of the last decade, which despite it was difficult to exceed 3% and was previously between 1.5% and 2.5%.
These unrealized losses on bonds were the disaster of Silicon Valley Bank, First Republic and Signature Bank. The three banks were involved in a huge banking crisis that caused great turbulence, because the fall of the bonds opened up huge losses that was supposed to face a situation of limited liquidity. This caused panic, creating a chain of deposit withdrawals that spread, generating a real vicious circle that claimed the existence of the three entities. Only the Fed, with the largest injection of liquidity in history ($ 165 billion), was able to end this crisis, ensuring that there would be no more bankruptcies.
The Fed itself explained in a report last August that Silicon Valley Bank used its large influx of deposits during the pandemic to invest heavily in long-term bonds when interest rates were low.” When the Federal Reserve tightened monetary policy to combat inflation after the pandemic, “SVB was left with insufficient capital to absorb the huge losses in its securities portfolio.” In short, “When depositors realized that their uninsured deposits could suffer losses if the bank failed, they withdrew funds in droves.”
The Fed’s rate cuts seem to be the central axis of this problem. As Pimco explains, “bond prices have an inverse relationship with interest rates.” The reason is that “if prevailing interest rates increaseOlder bonds lose value because their coupons are now lower than those of newer bonds offered on the market. ” This happens in the opposite direction if the central bank reduces the “price of money”. Therefore, the downward trend is totally essential, so that its assets can revalue with a rise in prices.
And it’s not just the rate cuts, but, hand in hand with them, the Fed has undertaken a gradual sale alongside a good part of its balance (mainly bonds), filling the market with supply and affecting prices. So, although Powell said at the last meeting that “it will continue like this for some time”, it is expected that in addition to a more “accommodative” policy, the pace of sales will slow.
A bank exposed
Since the Silicon Valley banking crisis, authorities have been imposing new liquidity requirements for ensure they always have capital so you will never have to face unrealized losses due to cash flow problems. However, after months and months of debate within the Fed, on this same September 10, it concluded its new capital requirements, much more lax than initially thought. Concretely, an increase of 9% will be required instead of the 19% announced in the initial proposal. However, doubts are growing that new problems of risk assessment, given the current levels of losses, could generate new crises.
The historical figures that continue to accumulate continue to put pressure on the entities. And this does not only affect the stability of small companies: the large ones, even if they have the muscles to endure, have a big hole because of this problem. The paradigmatic example is that of Bank of America, the second lender in the entire country, which holds 20% of the total, that is to say more than 110.8 billion in unrealized losses in their assets. In fact, from Florida Atlantic University, they explain that the decline in these losses in the last quarter is almost entirely due to the fact that “some large banks sold securities and took significant losses.” This happened at many of them, with Bank of America taking $8.29 billion and Wells Fargo and US Bancorp taking $8 billion and $1.81 million respectively.
Although, without a doubt, the danger lies in small banks. Despite the new rules, the reality is that it is difficult to support such levels. Something that has made the threat remain in the air and, therefore, the FDIC reflects that the number of banks considered “problematic”, increased to 66, or 1.5% of the total. These banks are those which have latent losses greater than 50% of their share capital.
The Office Threat
In any case, this is not just a problem with bonds, but also with many commercial real estate loans, many of which are on the verge of default. This is particularly serious because, as the largest banks resolve their most problematic office loans, the little ones haven’t done it yetto avoid bigger problems on their balance sheets. That’s why, according to the FDIC, 70% of all outstanding commercial real estate debt is held by small banks.
Many of these banks were lending to companies to invest in commercial real estate. The problem is that the value of office space has fallen dramatically as the sector has collapsed. There are several reasons for this, including rising interest rates, but also the rise of remote working and an oversupply in the market. Loans to this sector amount to $2.7 trillion and, according to MSCI, $38 billion in the United States is at risk of default.
The crisis will ‘in crescensus’ and, according to Moody’s, it expects the office vacancy rate to increase from 19.8% currently to 24% in 2026. In the event of a default, these assets, even if they fell into the hands of the banks, would result in huge losses that are not foreseeable. possible at the moment are present because, according to the latest data from JP Morgan, Prices have fallen by an average of 12% from 2022.
“These unacknowledged losses significantly increase the likelihood that the federal government will have to intervene.”
That’s why U.S. banks need a rate cut to help them on both fronts. From Florida Atlantic University, they explain that “the risk of high interest rates represents a real threat to the financial health of banks“and that is why both the decline and the decline in yields on ten-year bonds are good news.
However, Rebel Cole, a finance professor at the institution, argues that “banks are not yet safe” because “the yield on 10-year Treasury bonds has been extremely volatile over the past two years as inflation has risen. “Banks are also affected by their exposure to uninsured deposits, so the combination of unrealized losses and exposure to uninsured deposits can be particularly pernicious.”
Paul H Kupiec, a researcher at the American Business Institute, points out that this is the “single greatest systemic risk” that currently exists in the United States. “These unrecognized losses significantly increase the It is likely that the federal government will have to intervene and provide general deposit insurance guarantees to stop systemic banking crises if depositors lose confidence in the safety and soundness of the banking system.” For the expert, “the banking system is far from being well capitalized if the capacity to absorb capital losses is calculated using the realistic market value of bank assets rather than their stated book value.”
For its part, the Office of the Comptroller of the Currency (OCC) explained in its semi-annual report on the risk outlook that the risk exists and that the American banking sector faces a complicated path.Credit risk increases, “Office and multifamily loans, particularly those with interest-only terms that will be refinanced within the next three years, pose additional risk. “Persistent inflation and high rates (despite declines) can increase financial stress.”
