Treasury Secretary Janet Yellen keeps insisting that the banking system is “sound.” Is it though? Because it doesn’t look particularly sound.

In fact, we just witnessed the second-largest US bank failure ever.

Government regulators seized control of First Republic Bank over the weekend and sold the majority of the bank’s operations to JP Morgan Chase. It was the third major bank failure this year and the biggest bank to collapse since the 2008 financial crisis. It was the second-largest bank by assets to fail in US history.

First Republic went under after it revealed $100 billion in deposit losses in the first quarter.

The beleaguered bank has been struggling for a while. It was initially bailed out back in March with $30 billion in deposits from several large banks, including JP Morgan and Wells Fargo. The bank also borrowed heavily from the Federal Reserve’s bank bailout program. First Republic shares tumbled 75% last week before the FDIC stepped in.

While JP Morgan is taking over First Republic’s business, the FDIC will provide “shared-loss agreements.” As the FDIC website explains it, “the FDIC absorbs a portion of the loss on a specified pool of assets sold through the resolution of a failing bank – in effect sharing the loss with the purchaser of the failing bank.”

If we are to believe the mainstream narrative, the failures of Silicon Valley Bank, Signature Bank and First Republic Bank were isolated events and do not reflect a broader problem in the banking system. But as we have reported, these bank failures are just the tip of the iceberg. A report by the Wall Street Journal cites a study from Stanford and Columbia Universities that found 186 US banks are in distress.

And as Manuel Garcia Gojon pointed out in an article published by the Mises Wire, it’s not just the small and medium-sized banks. Charles Schwab and other big banks may also be insolvent.

One of the biggest problems facing banks is the rapid devaluation of their bond portfolios.

Banks were incentivized to load up on high-priced, low-yield bonds thinking that the Fed would keep interest rates low forever. As the Fed jacked up interest rates to fight price inflation, it decimated the bond market. (Bond prices and interest rates are inversely correlated. As interest rates rise, bond prices fall.) With interest rates rising so quickly, banks have not been able to adjust their bond holdings. As a result, many banks have become undercapitalized on paper as the value of the bond portfolios shrinks. The banking sector was buried under some $620 billion in unrealized losses on securities at the end of last year, according to the Federal Deposit Insurance Corp.

As the Washington Post reported, this means banks would face unprecedented losses if they were forced to liquidate their bond portfolios. In fact, that is exactly what doomed Silicon Valley Bank. The plan was to sell the longer-term, lower-interest-rate bonds and reinvest the money into shorter-duration bonds with a higher yield. Instead, the sale dented the bank’s balance sheet and caused worried depositors to pull funds out of the bank.

According to the Post, the total capital buffer in the US banking system totals $2.2 trillion. Meanwhile, total unrealized losses in the system based on a pair of academic papers is between $1.7 and $2 trillion.

Gojon explains how the big banks have dealt with this problem

Many big banks in the United States have substantially increased their use of an accounting technique that allows them to avoid marking certain assets at their current market value, instead using the face value in their balance sheet calculations. This accounting technique consists of announcing that they intend to hold such assets to maturity.”

In other words, this accounting trick makes the bank look far more solvent than it actually is.

At the end of 2022, Charles Schwab had the largest amount of assets marked as “held to maturity” relative to capital. According to data cited by Gojon, Schwab had over $173 billion in assets marked as “held to maturity,” while its capital (assets minus liabilities) stood at under $37 billion. At that time, the difference between the market value and face value of assets held to maturity was over $14 billion.

If the accounting technique had not been used the capital would have stood at around $23 billion. This amount is under half the $56 billion Charles Schwab had in capital at the end of 2021. This is also under 15 percent of the amount of assets held to maturity, under 10 percent of securities, and under 5 percent of total assets. An asset ten years from maturity is reduced in present value by 15 percent with a 3 percent increase in the interest rate. An asset twenty years from maturity is reduced in present value by 15 percent with a 1.5 percent increase in the interest rate.”

Other banks that may be close to effective insolvency include the Bank of Hawaii and the Banco Popular de Puerto Rico (BPPR). According to Gojon, the Bank of Hawaii, BPPR, and Charles Schwab have lost between one-third and one-half of their market capitalization over the last month.

Gojon concedes that it’s hard to know how this will play out, but he said there is clearly a large amount of risk in the banking system.

It is difficult to say with certainty whether they are indeed secretly close to insolvency as they may have some form of insurance that could absorb some of the impact from a loss of value in their assets, but if this were the case it is not clear why they would need to employ this questionable accounting technique so heavily. The risk of insolvency is currently the highest it’s been in over a decade.”

Gojon said the Fed can solve liquidity problems even as it continues to raise interest rates to fight inflation. That’s the whole point of the bank bailout program. But he said the Fed can’t fix solvency problems without pivoting to loser monetary policy or through more blatant bank bailouts. Those scenarios would both raise inflation expectations.

The bottom line is that despite Janet Yellen’s constant assurances, the banking system is not sound. It is a house of cards that could fall down at any time.

Photo by Can Pac Swire via Flickr

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The US Banking System Is Sound?

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