Banks

My daddy taught me in this country everyone’s the same.
You work hard for your dollar and you never pass the blame,
When it don’t go your way.
Now I see all these big shots whining on the evening news,
About how they’re losing billions and it’s up to me and you,
To come running to the rescue.

Well, pardon me if I don’t shed a tear.
They’re selling make believe and we don’t buy that here.
Because in the real world, they’re shuttin’ Detroit down.
While the boss man takes his bonus pay and jets on out of town.
DC’s bailing out them bankers while the farmers auction ground.
Yeah, while they’re living it up on Wall Street in that New York City town.
Here in the real world, they’re shuttin’ Detroit down.

Shuttin’ Detroit Down  -   John Rich

…..

That country song came out in 2009. Change New York to Silicon Valley and make a few other adjustments, and it would seem relevant again right now. I was in Congress in the middle of the crisis in 2008. I rarely toot my own horn, but I actually do know a lot about this stuff. So, here’s my analysis on where we are, how we got here and what is next. I apologize that it is a bit longer than my usual missives. But, this is important stuff.

Fundamentals of Banks: Any bank will fail with a big enough “run” on that bank. Any bank customer can withdraw their deposits in a day. Even if you have a 1 year CD, you can withdraw the money if you are willing to forego the interest. But the loans that a bank makes with deposit money have terms of 1, 5 or even 30 years. If you remove your deposit, the bank can’t go to someone with 3 years left on a loan and demand that loan be paid off so you can get your deposit out. A “run” is when too many people want their deposits back at once and the bank can’t raise the liquid assets fast enough to pay them. “Runs” on banks have happened throughout history whenever people worry that they may not be able to get their deposits back if they wait.

A second fundamental is that a bank has to balance where its capital comes from (deposits, equity holders, bonds, etc.) with the loans or investments it makes. If you have too much capital from sources like deposits that can demand money back overnight and have too many 30 year loans that don’t turnover, you can have problems. This imbalance is what happened to many Savings and Loans in the 1980s and led to that financial crisis. Well run banks balance this well in addition to having a sufficient spread between what they pay for money and what they lend it out for. Badly run banks do neither.

What Went Wrong: The big problem is not where interest rates are now, but where they were for far too long. The easy, free money of the last number of years encouraged a lot of malinvestment and excessive risk taking all over the economy. Many people carried on as though easy, free money would go on forever, even though it had never been like this in 5000 years of human history. That is probably the biggest single reason that we are where we are today. The problem is not the headache you have in the morning. It is that you drank too much last night.

You don’t hear about it nearly enough, but in my mind, another of the biggest problems is that we have banks that have been designated “Too Big to Fail” (TBTF). This happened in 2008. These huge 6 or 7 institutions are deemed to be so integrated into the economy that they cannot be allowed to fail and the government will rescue them if they do. This gives them a huge market advantage because they have an implicit government guarantee for which they pay nothing. While in Congress, I proposed that they either have such a huge capital requirement that they literally could not fail, or that they pay a massive insurance premium for their implicit guarantee. Either of these solutions would have made them largely not profitable. To solve that problem, I suggested they could break themselves up so they weren’t TBTF and avoid this. Needless to say, they did not like my suggestions and my legislation went nowhere. TBTF banks make the whole system unstable and uncompetitive as I will explain more below.

And finally, despite what some in the leftist media are saying, smaller banks were not deregulated in the bipartisan 2018 legislation. They are still heavily regulated. But those regulators did not see anything wrong with any of the 3 banks (Silvergate, Silicon Valley Bank (SVB) and Signature) that have failed in the last month. They missed it. That’s a problem. All 3 of these failed banks made a big deal about their commitment to the leftist cultural gods of DEI and ESG. I have no direct evidence of this, but could the regulators and the companies have been more focused on these cultural idols than the safety and security of their institutions?

The Solution: The government (The Fed, FDIC, Treasury and the White House) needed to take some action here. Without any action, the runs on banks last Monday would have been massive. Hundreds if not thousands of banks would have failed and the money would have gone to enrich the TBTF banks that are already too advantaged. I would have preferred that they had limited the FDIC guarantee expansion to $5 million or something rather than making it unlimited. Under that scenario, deposits over $5 million would likely have lost 10-20% which is reasonable since much of that money was chasing unrealistic yields at these 3 failed banks. But they had to do something to stop runs on the whole system. That said, it is important to note that most of SVBs customers are Democrats and major donors to Newsom and Biden. Do you think the rescue of depositors would have been as great had the failure been of a bank in Midland, Texas with largely oil and gas customers? I think not.

I am pleased that the government decided to let the stockholders and bondholders of these 3 banks get wiped out. Moral hazard is a giant risk in all of this. If taking huge risk for huge gain has no consequences of failure, we should all do it.

SVB had affiliates in Canada and the UK. In those countries, the fallout has been contained because other banks took over the local SVB and, although shareholders and bondholders still lost, it was a much more orderly process. However, for some nonsensical reason, the Biden administration has adopted the view that no US bank can buy or take over any other US bank. So, this option was off the table. This is apparently an Elizabeth Warren type of view. It is stupid.

Lastly as far as the solution is concerned, President Biden said it is not a bailout and taxpayers will not lose any money. That is a lie. The Treasury is exchanging real dollars for the stated book value of the “assets” of the failed banks. Those “assets” almost certainly will be worth less than book as loans default and others lose value. The taxpayer will bear that loss and it will be in the billions for sure. They did not ‘bailout” the bank’s owners, but they did “bailout” the bank’s customers.

What Happens Next?: Some more banks will fail in the coming weeks and months. (As I send this to press, Credit Suisse appears to be on the ropes along with 5 or 6 midsized US banks) Maybe just a few. Maybe dozens. Depositors will not lose any money because of the new unlimited federal guarantee. But how long will the unlimited guarantee last? Back in 2008, it was increased to $1M for a while then reduced to $250K, which is what we had until today. The banks pay for this insurance, but currently at the $250K level. Increasing it to unlimited will require a massive increase in bank premiums. The good news from that would be that small banks and the TBTF banks would finally be on the same footing. But, no risk of loss always encourages bad and fraudulent behavior, which would almost certainly increase. And banks would have to recover those extra premiums somewhere, presumably in account fees. Also, small banks would be paying to insure $10M deposits when they are actually not allowed to have that high a percentage of big deposits from a single customer. So, their deposits are required to be small. But because of the unlimited guarantee for now, there shouldn’t be major runs on well-run banks.

But there are other problems to which this will lead. Banks are going to be understandably more careful with loan credit, terms and duration both to avoid going broke and to prepare for increased scrutiny by regulators. There may be some “non-banks” that step in the void here, but regardless, obtaining credit is likely to be more difficult and more expensive. That will slow down a lot of economic activity. The area most at risk of this is commercial real estate. These assets are being squeezed from both ends. Values are declining at the same time that interest rates are increasing. If your loan on a building matures, you have less value upon which to borrow and must pay a higher rate of interest to boot. That may not work financially in which case there will be some defaults. That is already happening with large office properties in big blue cities.

There are other second and third tier effects of all this because the financial sector is the blood upon which the rest of the economy runs. Offsetting this, however, is the fact that there is still a lot of money sloshing around leftover from the easy money times. That money is evaporating. But there was so much of it that it probably lasts for another year or so which will keep many companies afloat for a while longer.

Finally, of course, what will the Fed do? As of the date of this writing, I have no idea. They are trapped because of keeping rates so low and money so abundant for so long. If they keep raising rates, the financial fallout will deepen. If they don’t, inflation will persist at 6% or higher and wild risk taking will be back in vogue. They will try to thread the needle. That will be tough. Either way, the headache from the previous night’s bender is just beginning. We don’t know how bad it will get or how long it will last.

I remain respectfully,
Congressman John Campbell
Drive Fast and Live Free