We distributed this yesterday to News Items subscribers. Today, we’re distributing it to those of you who are Political Items subscribers. Because: why not?
It’s a smart summary of where we are at this stage of the “banking crisis.” The banking crisis will have political “ripple effects.”
What follows are excerpts from “Daily Observations.” which are research reports and briefings on financial matters from Bridgewater Associates. Bridgewater’s research “product” is consistently smart, data-based and well-written. Monday’s and Tuesday’s editions — ‘What We’ve Learned So Far from the Bank Run” — were and are no exception.
So, let’s get to it.
While there is still much for us to learn, the diagnosis of the problem in the US banking system has come into clearer focus for us, and through digging deep into all the numbers we can map out the likely ripple effects. In terms of the diagnosis, it is clear now that all the post-2008 restructuring of the US credit system significantly lowered the amount of credit risk that was held in levered vehicles, but those same moves pushed many banks to take on more duration exposure. This shift was gradually building and then accelerated parabolically during the pandemic. In 2020 and 2021, the combination of QE and fiscal spending mechanically led to a surge in bank deposits at the same time as Treasury- and government-guaranteed mortgage issuance ballooned. Many banks used the surge in deposits to buy duration (particularly mortgages, whose duration increases as rates rise, which worsens the problem).
These policies and the slow reaction to the initial uptick in inflation by the Fed led to significant inflation and eventually a fast tightening. Now many banks have assets with yields well below market funding rates, and their solvency depends on retaining a very cheap deposit base. The events of the last two weeks will make that much more difficult to manage. The Fed has done an admirable job of providing liquidity to stop the deposit run, but that funding—and any private sector funding that banks attract as they wean off the Fed—comes at market rates that are hundreds of basis points above the 1.3% average cost of funds banks enjoyed just a few months ago. As this happens, banks whose deposits reprice quickly will be in a zombie-like state. They won’t fail quickly, but they will bleed for years unless the Fed cuts rates. For the Fed, cutting rates fixes the bank problem but makes the inflation problem worse; hiking rates fixes the inflation problem but just worsens the issue for the banks.
The problem facing the US banking system is not a bank run, which policy makers came out quickly to address with emergency liquidity and expanded FDIC guarantees. The problem is that many banks have a big duration bet that would be underwater if marked (which it isn’t) and are only profitable if they are able to retain the extremely cheap deposits they got during the pandemic. Funding costs started rising late last year due to pressure from much higher-yielding alternatives like T-bills and money funds. The past two weeks were an acceleration as uninsured depositors got a wake-up call that will likely drive many to reconsider their cash management strategy and force banks to replace the funding at closer to market rates. We think this crisis will reshape the US banking system and credit pipes:
If the current trajectory doesn’t change, a tail of the banking system will turn into zombie companies. By this we mean that they will be losing money and steadily burning through their capital as they are stuck with long-duration, low-yielding assets that don’t make sense in a higher-rate environment. Even though they aren’t forced to mark these assets to market by accounting rules, they are still stuck with them and will face weak profitability and the need for more capital for a long time. A slowdown in the economy and a pickup in credit losses would be an even bigger drag on top of that.
The credit markets will need to find a new buyer of duration now that the banks (and the Fed) are out. We see large continued long-duration bond issuance from the government, the GSEs, and other borrowers going forward. In recent years, the banks were a key piece alongside the Fed in taking down almost all the duration that was being issued. After this month’s banking crisis, it seems likely that banks will not be eager to buy many bonds (and will probably over time let the ones they hold mature), either on their own initiative or due to regulatory changes. This means the bond market will need to find a new buyer.
We expect consolidation and retrenchment in the banking system. The largest banks have been more tightly regulated and were the destination for many of the funds leaving regional banks. For banks whose business models become unviable, a sale to a larger entity may be the only available choice. These dynamics will impair the banks’ ability to provide credit to the real economy and tighten credit standards, especially to niche sectors that were very dependent on relationships with smaller banks.
These excerpts from “Daily Observations” were re-published with the permission of Bridgewater Associates. “Daily Observations” is paywalled by the firm and unavailable on the web.