By MICHAEL ROBERTS*
The bold optimism that gained expression in March that a recession will be averted will prove unfounded.
Bank stock prices stabilized earlier this week. And all the top officials at the Federal Reserve, US Treasury and European Central Bank are assuring investors that the crisis is over. Last week, Fed Chairman Jerome Powell said the US banking system was "strong and resilient" and there was no risk of a banking meltdown like in 2008-9.
US Treasury Secretary Janet Yellen, meanwhile, said the US banking sector was "stabilising". She stated that the US banking system was strong. Furthermore, ECB President Christiane Lagarde has repeatedly told investors and analysts that “there was no opposition” between fighting inflation by raising interest rates and preserving financial stability.
So all is well, or at least soon it will be. And this is supposedly due to the massive liquidity support that the Fed and other US government lending agencies are offering. In addition, stronger banks stepped in to buy out failing banks (SVB and Credit Suisse) or invest money in failed banks (First Republic).
So is it all over? Well, nothing's over until it's over! The latest Fed data shows US banks lost $100 billion in deposits in one week. Since the crisis began three weeks ago, while large US banks have added $67 billion to their deposits, small banks have lost $120 billion and foreign banks $45 billion.
To cover these outflows and prepare for further withdrawals, US banks borrowed $475 billion from the Fed. This amount is divided equally between large and small banks, although in relation to their size, it is true that small banks borrowed twice as much as large ones.
The weakest US banks have been losing deposits to the strongest banks for more than two years. However, another $500 billion has been withdrawn since the collapse of the SVB on March 10 and $600 billion since the Fed started raising interest rates. This is a record.
Where are all these deposits going? In the past three weeks, half of that $500 billion has gone to bigger, stronger banks; the other half went into money market funds. What is happening is that depositors (mostly wealthy individuals and small businesses) are panicking that their bank will fail just like the SVB and are therefore switching to 'safer' big banks. In addition, depositors see that, with the increase in interest rates in general, which has been driven by central banks to “fight inflation”, there are better results investing in bonds in money market funds.
What are money market funds? They are not banks, but financial institutions that offer a better rate than banks. How do they do it? Why, they don't offer any banking services. FMMs – as they are called – are just investment vehicles that pay higher fees. They can do this in turn by buying short-term securities, such as Treasuries, which offer only a slightly higher rate of return.
Thus, the MMFs obtain a small interest gain, but as they operate with large amounts, they manage to become viable. More than $286 billion has flooded into money market funds so far in March. The latter was the highest inflow month since the height of the Covid-19 crisis. While not a huge change from the size of the US banking system (it's less than 2% of the $17,5 trillion in bank deposits), the fact shows that nerves remain on edge.
Well, let's remember how this all started. It all started when Silicon Valley Bank (SVB) closed its doors. Then came Signature Bank which specialized in cryptocurrency. Then First Republic had to be bailed out by a coalition of big banks. Then, in Europe, the Credit Suisse bank went bankrupt in less than 48 hours.
The immediate cause of these recent bank failures, as usual, was the loss of liquidity. What is meant by this? SVB, First Republic, and Signature depositors began withdrawing their money at a certain point, and thus these banks no longer had the cash to meet the demands of depositors.
Why does it happen? There are two main reasons. First, much of the money deposited in these banks has been reinvested in assets by the bank boards, which have lost enormously in value over the last year. Second, many of these banks' depositors, particularly small businesses, found that they were no longer making a profit or getting extra funding from investors, but still needed to pay their bills and staff. So they started withdrawing money instead of keeping and accumulating it in the bank.
Why did bank assets lose value? It boils down to rising interest rates across the financial sector, driven by the Federal Reserve's actions to raise its benchmark interest rate sharply and quickly, supposedly to control inflation. How does it work?
Well, to make money, let's say banks offer depositors interest at 2% per annum on their deposits. They must cover this interest by lending at higher rates to customers or by investing depositors' money in other assets that earn higher interest rates. Banks can get that higher rate if they buy financial assets that pay more interest or that they can sell at a profit (but may be riskier), such as corporate bonds, mortgages or stocks.
Banks can buy bonds, which are safer because banks get their money in full at the end of the bond's maturity — say, five years. And each year the bank receives a fixed interest rate higher than the 2% its depositors receive. They get a higher rate because they lend on a long-term basis and therefore cannot get their money back immediately, but must wait even for years according to contracts.
The safest bonds are government bonds because Uncle Sam (probably) won't fail to redeem the bond after five years. So SVB managers thought they were being very prudent in buying government bonds. But here's the problem.
The bank buys – suppose – a government bond for $1.000 that will “mature” in five years (that is, the investor will receive his investment in full after five years), which supposedly pays interest at 4% per year; as he pays his depositors only 2% a year, he is making money. But if the Federal Reserve raises the interest rate by 1%, banks must also raise the rates they pay depositors or else they will lose customers. The bank's profit is reduced. Even worse, the price of your existing £1.000 bond on the secondary bond market (which is like a used car market) drops. Why? Because even though government bonds still pay 4% a year, the differential between bond interest and current interest on cash or other short-term assets has narrowed.
Now, if the bank needs to sell its bond on the secondary market to raise cash, any potential buyer of that “paper” will no longer be willing to pay $1.000 for it; he only wants to give $900. That's because the buyer, paying only $900 and still getting the 4%, can now earn an interest yield of 4/900 or 4,4%, which makes the purchase worthwhile. SVB had a huge amount of bonds that it bought “at par” ($1.000) but which “now” were worth less on the secondary market ($900). Therefore, it had “unrealized losses” on its books.
But why does it matter if you don't need to sell them? The SVB could wait until the bonds mature and then get back all the money invested, plus interest, over five years. But here's the second part of the SVB problem. With the Fed raising interest rates and the economy slowing towards a recession, the technology sector that SVB specializes in began to struggle. As companies in the sector began to lose margin and profit mass, they were forced to “burn” their own liquidity, thus depleting their deposits at SVB.
Well, SVB did not have enough liquid cash to meet withdrawals; instead, it had many investments that had not matured. When this became obvious to depositors, those who were not covered by the state deposit insurance (something above 250 thousand dollars) panicked… they rushed to the bank to withdraw the money deposited there. This became obvious when SVB announced that it would have to sell most of its bonds at a loss to cover withdrawals. The losses appeared to be so great that no one would put new money in the bank, and so SVB soon declared bankruptcy.
Thus, illiquidity turned into insolvency – as it always does. How many small businesses, in times of difficulty, think they could have overcome the lack of liquidity if they had obtained a little more funding from their bank or a potential investor, thus staying in business? Instead of this “dream”, as they received no more help, they had to drop out of the market. This is basically what happened in these banks.
But the current argument is that these cases are isolated and that the monetary authorities acted quickly to stabilize the situation, thus significantly reducing depositors' panic. Two things were done by the government, the Fed and the big banks. First, they offered funds to meet depositors' demand for their money. While in the United States, any cash deposits over $250.000 are not covered by the government, the government has waived this limit and said it will cover all deposits (for these banks only) as an emergency measure.
Second, the Fed created a special lending instrument called Bank Term Funding Program, whereby banks can borrow for one year, using the bonds as collateral “at par”. By doing so, it gets money to meet depositors' withdrawals. Therefore, they don't need to sell their bonds below par as the market is now demanding. These measures are aimed at stopping the panic-driven run on banks.
But here's the problem. Some argue that SVB and the other banks are small and highly specialized. Therefore, they do not reflect any broader systemic issues. But this is very doubtful. First, SVB was not a small bank, even though it specialized in the technology sector – it was the 16th largest among US banks; moreover, its decline was the second largest in US financial history. Furthermore, a recent report by the Federal Deposit Insurance Corporation shows that SVB is not alone in having huge “unrealized losses” on its books. The total for all banks is currently $620 billion, or 2,7% of US GDP. That is the potential impact, either on the banks or on the economy as a whole, if these losses materialize.
In fact, 10% of banks have unrecognized losses greater than those found in SVB. SVB was also not the most poorly capitalized bank, with 10% of banks having lower capitalization than SVB. A recent study found that the market value of banking system assets is $2 trillion less than suggested by the book value of assets (accounting for held-to-maturity loan portfolios). Marked-to-market bank assets fell by an average of 10% across all banks; moreover, the bottom 5th percentile experienced a 20% decline. Even worse, if the Fed continues to raise interest rates, bond prices will fall further, unrealized losses will increase, and more banks will face a liquidity shortage.
Therefore, the current emergency measures may not be enough. The current claim is that the extra liquidity can be financed by bigger and stronger banks; they can take over weaker banks, thus restoring financial stability without hurting workers. This is the market solution where the big vultures cannibalize dead carrion – for example, the UK arm SVB was bought by HSBC for £1. In the case of Credit Suisse, the Swiss authorities forced a takeover by the biggest bank UBS for a price of one-fifth of that bank's current market value.
And that's not the end of the troubles to come. US banks are heavily positioned in commercial real estate assets (CRE), i.e. offices, factories, supermarkets, etc. (See this in the chart below, which presents data for large and small banks). Lending as a share of bank reserves accelerated from 25% per annum to 95% per annum in early 2023 for small banks and 35% for large banks.
But commercial property prices have been falling since the end of the pandemic, with many of them vacant and therefore not receiving rent. And now, with commercial mortgage rates rising due to Fed and ECB hikes, many banks are facing the possibility of further defaults on their loans.
Already in the last two weeks, $3 billion in loans have defaulted due to the collapse of developers. In February, the largest office owner in Los Angeles, Brookfield, defaulted on $784 million; in March, the pacific investment co. defaulted on $1,7 billion in mortgage notes and Blackstone defaulted on $562 million in bonds. And there is an additional $270 billion of these loans (i.e. CRE) maturing in the short term. Furthermore, these loans are highly concentrated. Small banks hold 80% of total CRE-type loans worth US$2,3 trillion (see chart below).
The risk of CRE loans has not yet manifested itself. But it will hit the already reeling regional banks the hardest. It is a vicious spiral. CRE defaults hurt regional banks as lower office occupancy and rising interest rates depress property valuations, creating losses. In turn, regional banks hurt property developers by imposing stricter lending standards after the SVB. This deprives commercial real estate borrowers of affordable credit, reducing their profit margins and increasing bad debt.
In addition, there is yet another risk that has not yet been resolved, namely the international risk. The liquidation of 167-year-old Swiss international bank Credit Suisse and its forcible takeover by rival UBS was only made possible by the $18 billion write-off of all CS secondary bonds held by hedge funds, private investors and others. banks globally.
Canceling bonds (debts) and saving CS shareholders is unprecedented in financial law. This increased the risk of holding these bank bonds, despite ECB assurances that this would not happen in the eurozone. As a result, investors began to worry about other banks. In particular, his eyes are now focused on the difficulties of Germany's largest bank, Deutsche Bank, which after the events of Credit Suisse is no longer "too big to fail".
What this shows is that the assertion repeated by ECB President Christiane Lagarde turns out to be nonsense. Here she states that there is no “opposition” between fighting inflation with interest rate increases and financial stability, even if banks are struggling to keep depositors and avoid defaulting on their loans. In fact, a recent article by leading financial scholars, including the former governor of the Reserve Bank of India, says quite the opposite. It states that “the evidence suggests that the expansion and shrinkage of central bank balance sheets involve opposition between monetary policy and financial stability”.
The rejection of past and future dangers by monetary authorities should come as no surprise to readers of my blog. Orthodox economist Jason Furman has noted that after the 2008-9 global financial crisis, the Fed began issuing regular financial stability reports. But see his comment on the accuracy of these reports: “The Fed completely missed what happened – it didn't show even an ounce of concern. There are two interpretations: the first points to incompetence; the other asserts that these things are difficult, even if they are obvious in hindsight.” For example, the 2022 report “presented a reassuring picture of the financial sector. And he was especially calm about the banks – both in terms of their capital and the possibility of them suffering depositor runs”.
The Fed report never predicted interest rate hikes. And yet, when interest rates started to rise, it should have been clear that banks would take losses relative to the market markup; they were not accounting in their portfolios for these losses that remained as possible until maturity. That risk was ruled out in a footnote because the Fed thought that higher interest rates would mean gains in banks' net interest income. The same story occurred with the Swiss National Bank; he gave a confident assessment of Credit Suisse's future just a few months ago.
As for banking regulation, I have been beating the drum of denial of the “evident”; I have claimed that it is incapable of preventing crises that occur under various circumstances in the capitalist economy. Now, in support of my thesis, here is what a professor and legal expert on banking regulation said: “In the wake of the 2008 crisis, Congress erected a huge legal edifice to govern financial institutions – the Dodd-Frank Act. Why, in the course of a weekend it was seen that it was all an expensive and wasteful construction. What good is having a huge set of regulations… if they are not enforced? Have deposit insurance limits…if they are breached? Dodd-Frank is still on the books, but its prudential provisions are all but dead. Why should anyone follow their regulations now when they will be disregarded as soon as they are inconvenient? And why should the public trust that they are being protected when the rules are not followed? By the way, did anyone look at the SVB resolution plan or was it all a show?”
“I really don't know how I'm going to be able to teach prudential banking regulation after the SVB case. How do you teach students the formal rules – supervision, exposure and concentration limits, immediate corrective action, deposit insurance limits – when you know the rules are not being followed?” “The rules always go out the window in financial crises and then there are a lot of finger wavings and new rules that are followed until the next crisis, when they won't be either.”
Furthermore, the head of the world's main financial regulator, Pablo Hernández de Cos, chairman of the Basel Committee on Banking Supervision, said last week that "the only way to fully prevent a bank run would be to require them to hold all their deposits into liquid assets, but then you wouldn't have any more banks. What he means is that there could be no banks that aim to profit and speculate at every opportunity; but you could still have non-profit banks providing a public service. But, of course, this is not the order of the day.
Now news has emerged that the bankrupt Silicon Valley Bank paid huge bonuses to its senior executives based on the bank's profitability - to achieve this result, the executives invested in riskier long-term assets to increase profitability and thus earn bigger bonuses. And that's not all. Shortly before the bank failed, it made huge loans at favorable rates to top executives, managers and shareholders worth $219 million. Now, nobody can get that by not being an “insider”.
What went wrong in SVB? Fed Chairman Jay Powell put it this way: “At a basic level, the management of Silicon Valley Bank has failed miserably. They made the bank grow very quickly. They exposed the bank to significant liquidity risks, as well as interest rate risks. However, they did not obtain coverage for these risks.” But "we now know that supervisors saw these risks and intervened." Really? If so, they were a little late! “We know that SVB has experienced an unprecedented rapid and massive bank run. This is a very large group of connected depositors, concentrated group of connected depositors in a very, very fast run. Faster than the historical record suggests.” Oh! So this is why the Fed was taken by surprise!
But don't worry, he assured that it won't happen again. “For our part, we are reviewing oversight and regulation. My only interest is in identifying what went wrong here. How this happened is the question. What went wrong? – that is the question. You need to answer it. And we're going to answer it. We will then make an assessment of what are the correct policies to implement so that this does not happen again. Next, we will implement these policies.”
But this is a superficial explanation. There will always be some fault line in banking. As Marx explained, capitalism is a monetary economy in which money is both the beginning and the end of the circular process of accumulation. Production is not intended to meet demand; consumption is only a condition for the true purpose of making profit and more profit as time passes. Production puts commodities up for sale on a market to be exchanged for cash. And money is needed to buy goods. The logic of surplus money dominates in the capitalist system.
Money and commodities are not the same thing, so the circulation of money and commodities is inherently subject to collapse. At any time, cash holders can refrain from buying commodities at current prices and hoard cash instead. So those who sell goods must slash prices or even go bankrupt for lack of buyers. Many things can trigger this collapse in trading money for commodities or trading money in financial assets such as bonds or stocks – fictitious capital, as Marx called it. And it can happen suddenly.
But the main underlying cause is always the overaccumulation of capital in the productive sectors of the economy, or, in other words, the fall in the profitability of investment in commodity production. Technology companies, customers of the SVB, were seeing a drop in profits and, therefore, were suffering a loss of funding from so-called venture capitalists (investors in startups). They then had to spend their cash deposits. This destroyed SVB's liquidity and forced it to announce a liquidation of its bond assets. At the same time, interest rates rose, increasing the cost of borrowing. A 'liquidity' crisis is now brewing in real estate and banks with large bond debts.
Therefore, the banking crisis is not over yet. Indeed, some argue that there may be an ongoing crisis lasting for years – thus echoing what happened during the savings and loan crisis of the 1980s-90s.
What is certain is that credit terms are getting tighter, bank loans will fall and companies in the productive sectors will find it increasingly difficult to raise funds to invest and families to buy expensive items. This will push economies into a recession this year. The bold optimism that gained expression in March that a recession will be avoided will prove to be unfounded. Just last week, the Federal Reserve's own predictions for US economic growth this year have been reduced to just 0,4%, which, if met, would mean at least two quarters of contraction by the middle of this year.
And if the current banking crisis becomes systemic, as it did in 2008, there will have to be a “socialization” of the losses suffered by the banking elite through government bailouts, which will raise public sector debts (already at record levels); everything will be done at the expense of the rest, that is, the vast majority of people and families) through higher taxes and more austerity in welfare-oriented public spending and services.
*Michael Roberts is an economist. Author, among other books, of The Great Recession: A Marxist View.
Translation: Eleutério FS Prado.
Originally published on The next recession blog.
