Our Financial System Is Starting to Melt Down
Insuring All Deposits Is the Only Answer. But Even That May Not Work.
A week ago, Friday, when Silicon Valley Bank failed, I wrote, Why SVB’s Failure Is Really Scary, pointing out its potential for igniting a massive, global bank run. Two days later, after Signature Bank failed and First Republic started failing, I wrote, Is Our Financial System Starting to Melt Down? Two days after that, I posted a podcast with the same title. It featured Jonathan Treussard, a brilliant former student and financial consultant with years of Wall Street experience, and PBSNewsHour’s outstanding economics correspondent, my friend and co-author, Paul Solman.
Jonathan shared my concern. Paul was more upbeat. We’ve spent every day since observing and txting. Jonathan and I, like the dismal scientists we are, have gone from scared to slightly terrified. Paul is older (a couple years older than me) and has remained calm. Today he asked me, “How disappointed are you going to be if the banking system doesn’t collapse?”
Truth is I’ll be tremendously relieved. But a week after SVB failed, things are heading in the direction I feared. Republic Bank is now in its death throes. This is after our eleven largest banks rode to the rescue and injected $30 billion in deposits. The market’s reaction was
OMG, This bank is history!
One day later, First Republic’s stock tanked — by a third! — and Moody’s rated First Republics’ credits, which include its remaining deposits, as junk!
As of December, First Republic (FR) was roughly as large as SVB. It too had been the proud recipient of billions in large, i.e., uninsured deposits. It too figured those depositors were loyal clients, impressed by its 38 years of banking experience — clients who would never run. It too had invested in “safe” long-term assets, ignoring the obvious interest-rate risk. It too was dead wrong.
The eleven big (money center) banks, led by the world’s largest bank, JP Morgan, surely had their arms broken by the Treasury and Fed before agreeing to “save” FR. But even broken arms couldn’t get the rescue team to buy FR’s stock, which is what FR needed. Instead, it bought (made) deposits, which struck me and surely others as passing strange. This is like racing to a conflagration with a massive fire truck, but leaving behind the hoses. Here’s my guess at the team’s txt messaging.
Let’s be careful that we don’t throw away $30 billion in ten seconds. Let’s deposit the money in FR, not buy FR’s stock. The Feds might insure all FR’s deposits as it did with SVB and Signature. If not and FR fails, at least our deposits will be repaid with a haircut. But if we buy FR’s stock, we’ll lose all $30 billion the instant FR is closed by the FDIC, which will remain highly likely regardless of what we do. What about lending FR on a long-term, rather than immediate term (demand deposit) basis that lets us demand our money back instantly? Again, too risky. We’d miss out on the Feds potential insurance of all of FR’s deposits and, after FR fails, as it likely will, end up with bubkis on the dollar.
Depositing money in FR didn’t improve FR’s balance sheet. Its only purpose was to reassure uninsured depositors that their deposits were safe and not to run. But the purchase of deposits from FR, not stock, was properly read as an act of distrust in FR. No surprise then that it made matters far worse.
As I write, FR’s funeral is surely being arranged. It will likely come in the form of a shotgun wedding like that arranged by the Fed between JP Morgan and Bear Stearns in 2008. JPM bought Bear for $2 per share (subsequently adjusted to $10), but only after the Fed agreed to purchase Bear’s worst subprime mortgage securities. (The collection of liar loans, no doc loans, and NINJA loans was called The Maiden Lane Fund. Maiden Lane is, btw, at the rear end of the NY Federal Reserve. This was an inside joke acknowledging that the fund was full of excrement.) The price JPM paid for Bear was, I understand, less than the value of Bear’s NY City headquarters building. In short, the Fed bribed JPM to acquire Bear for free.
But back to the present. Across the pond, Credit Swiss — Switzerland’s 156 year-old and second largest bank, with clients in 50 countries, is also in extremis. It’s surely no coincidence that this is happening in the aftermath of the runs on SVB, Signature, First Republic, and other banks with a high share of uninsured deposits. Credit Swiss is a very large, global bank. At year’s end it had $569 billion in deposits. That’s over 70 percent of Switzerland’s GDP. No small-country government can credibly insure the deposits of a global bank. Doing so could bankrupt the county primarily to the benefit of foreign depositors. It can, however, try to help by other means.
Last week, Credit Swiss received a $56 billion loan from the Swiss Central Bank. This was supposed to persuade remaining movie patrons, smelling smoke in the dark theater and seeing others rushing for the door, to stay calm, sit still, and enjoy the show. It did the opposite, prompting this reaction.
OMG, if Credit Swiss needs this massive infusion, it’s in worse shape than I thought. I’m out of here.
Like the “rescue” of FR, Credit Swiss’ “rescue” was a kiss of death. More depositors took flight and the bank’s stock sank even lower. A share of Credit Swiss is now down 75 percent compared to a year ago. Rumors have it that UBS, Switzerland’s largest bank, will purchase/digest Credit Swiss in the next few days.
If this week’s de-facto failures of First Republic and Credit Swiss marked the beginning of the end of this latest credit crisis or even the end of the beginning it would be one thing. But they likely represent the beginning of the beginning.
There are some $8 trillion in U.S. uninsured deposits. This is 80 percent of the $10 trillion in insured deposits. The uninsured deposit can be moved and are being moved, with a few key strokes, from risky U.S. banks to safe U.S. mutual funds holding short-term Treasuries. The same is happening or will likely happen in every advanced country.
Nor are the U.S. money center banks, including JP Morgan, safe. Quite the opposite. These banks have a disproportionately high share of uninsured deposits, many held by foreigners. Uninsured deposits represent 96 percent, 91 percent, 83 percent, and 77 percent, respectively, of total deposits of BNY Mellon, our nation’s oldest bank, Northern Trust, Citigroup, and State Street, respectively. This is far higher than First Republic’s 68 percent share. True, these banks are less exposed to the interest rate risk that hit SVB, Signature, and First Republic. But two thirds of Citigroup’s assets are long-term Treasuries, mortgages, and other assets valued at hold-to-maturity, i.e., not marked to market.
As I’ve previously reported, there are north of $600 billion in unreported (marked to par/book/hold-to-maturity rather than market) losses in the U.S. commercial banking system. Most of these losses are on the underlying real as opposed to fake books of the money center banks. Here’s a real shocker. If one looks at the real books of all 4,236 FDIC-insured commercial banks, i.e., if one marks their balance sheets to market, over half are insolvent! This is the finding of a just released study by four finance profs at USC, Northwestern, Columbia, and Stanford.
What can be done? Well, here’s what’s not being done. The feds (the Treasury, the Federal Reserve, and the FDIC) aren’t fully insuring uninsured deposits. Instead, Treasury Secretary Yellen made clear in this week’s Congressional testimony that the feds would decide which uninsured depositors in which banks they would, under dire circumstances, protect depending on the bank’s systemic risk.
A bank only gets that (SVB’s) treatment if a majority of the FDIC board, a supermajority of the Fed board, and I in consultation with the president, determine that the failure to protect uninsured depositors would create systemic risk and significant economic and financial consequences.
These words surely struck fear in the hearts of uninsured depositors in every small bank in the country. Expect most if not all to move their money to mutuals or the large money center banks in the coming days. This will produce more headlines of deposit withdrawals, Fed discount-window lending (It’s way up already.), and bank failures. This will, in turn, lead uninsured depositors of large banks to question whether their bank is systemically risky enough to merit SVB treatment. All this will happen under the watchful eyes of uninsured depositors in banks all across the planet.
Should the Feds immediately commit to insuring uninsured demand deposits as they did on a temporary basis in the Great Recession?
My answer is yes. But there is massive risk in doing so. As indicated, uninsured deposits total roughly $8 trillion out of the roughly $18 trillion total. That’s one third of a year’s GDP. Suppose the uninsured depositors say to themselves,
You know, my investments are risky enough, my job’s risky enough, Social Security benefits and future taxes are risky enough, my company’s sales are risky enough. Why do I need to have to stay awake at night worrying that the “safe” money in my checking account will go poof? I don’t owe my bank anything. My brother doesn’t own it, my sister doesn’t work there, I know none of its staff, it has who knows how many uninsured depositors who may be heading out the door. Why do I need this tsouris (Yiddish for grief.)? I’m out of here.
If this becomes the collective calculus of uninsured depositors, we’ll have a massive run requiring the FDIC to come up with, yikes, $8 trillion. But the FDIC doesn’t have $8 trillion in reserve. It has $128 billion. Hence, the Fed would need to print $8 trillion. Well, that’s an exaggeration. The banks do have assets, which the FDIC would seize. But their market value in the ensuing fire sale is surely far below the current level. In any case, just the presumption of hyperinflation would turn money into a hot potato. But faster money is equivalent to more money. Hence, hyperinflation can arise largely endogenously. With prices soaring, uninsured depositors would run for their money — to buy furniture at Ikea or acquire anything else tangible. This includes a garage full of toilet paper. Unlike stiff dollar bills, toilet paper can be used as toilet paper. The uninsured depositors would also reason that printing $18 trillion — three quarters of a year’s GDP — isn’t as likely as what happens in Argentina in these cases, namely the government freezes bank accounts. In this case, you receive your money in drips and drabs, well after prices have shot through the roof.
In short, Secretary Yellen and Jerome Powell, are in a terribly difficult position. Unless Paul is right, and he may well be, that things will calm down, insuring all deposits is the only potential national financial sedative. But if depositors still head to mutual funds? Yikes.
In closing, let me point out the big picture. It’s finally dawning on most everyone that leveraged banking is unsafe at any speed. What we need is a new financial system where financial intermediaries are limited to intermediating — not gambling with other people’s money, as President Roosevelt put it. This requires forcing all financial corporations to operate as 100 percent equity-financed mutual funds. I.e., it requires Limited Purpose Banking, which I proposed in my 2010 book, Jimmy Stewart Is Dead and discuss in On the Economic Consequences of the Vickers Commission. What we’re seeing with the flight of uninsured deposits from leveraged, indeed highly leveraged banks to Treasury-bills and other equity-financed mutual funds is the financial system’s endogenous transition to Limited Purpose Banking.
There is a good chance the FDIC will insure all deposits and things will settle down. This is more likely than a complete meltdown. Stay diversified, including real estate and gold. best, Larry
Dear Professor Kotlikoff: Private debt funds have provisions that permit the manager to "gate" withdrawals if investors seek to withdraw funds in excess of readily available cash. Would it be too far fetched for the Fed to impose gates on withdrawals from regulated banks? One could imagine that depositors who could demonstrate an ordinary business purpose would be permitted to withdraw as usual and that provisions would be available to allow extraordinary withdrawals with justification while others would have to wait until cash becomes available.