Is there a financial crisis bubbling under the surface?

When the Federal Reserve started raising rates, it precipitated a financial crisis. The central bank managed to paper over the problem with a bailout program, but the crisis continues to bubble and percolate under the surface.

According to the latest data from the FDIC, the U.S. banking system is sitting on $517 billion in unrealized losses due to deteriorating bond portfolios.

Unrealized losses triggered the collapse of Silicon Valley Bank, Signature Bank, and First Republic Bank in 2023.

According to the FDIC, unrealized losses on available-for-sale and held-to-maturity securities increased by $39 billion in the first quarter. That’s an 8.1 percent increase.

It was the ninth straight quarter of “unusually high” unrealized losses corresponding with Fed monetary tightening that started in 2022.

Unrealized losses amount to 9.4 percent of the $5.47 trillion in securities held by commercial banks. 

The unrealized loss problem

As interest rates rise, the price of Treasury bonds and mortgage-backed securities fall. The decline in these asset prices has put a dent in bank balance sheets.

WolfStreet offered a good explanation of how banks got into this situation...

“During the pandemic money-printing era, banks, flush with cash from depositors, loaded up on securities to put this cash to work, and they loaded up primarily on longer-term securities because they still had a yield visibly above zero, unlike short-term Treasury bills which were yielding zero or close to zero and sometimes below zero at the time. During that time, banks’ securities holdings soared by $2.5 trillion, or by 57 percent, to $6.2 trillion at the peak in Q1 2022.”

In other words, the Federal Reserve incentivized the bond-buying spree.

With the Fed keeping interest rates artificially low for more than a decade in the wake of the 2008 financial crisis and slamming rates to zero again during the pandemic, most people began to assume that the era of easy money would never end.

But what the Fed giveth, the Fed taketh away.

The easy money had to end when price inflation reared its ugly head thanks to the stimulus mania during the pandemic, and the Fed could no longer plausibly claim it was “transitory.”

WolfStreet called this “a colossal misjudgment of future interest rates.”

Do unrealized bank losses even matter?

The conventional wisdom is that unrealized losses aren’t a big deal. They only become losses if banks try to sell the bonds. If they hold the bonds to maturity, they won’t lose a dime.

But there is no guarantee that things will play out that way, as we saw with Silicon Valley Bank and others in March 2023.

As WolfStreet put it, “Unrealized losses don’t matter until they suddenly do.”

“In reality, they [unrealized losses] matter a lot as we saw with the above four banks after depositors figured out what’s on their balance sheets and yanked their money out, which forced the banks to try to sell those securities, which would have forced them to take those losses, at which point there wasn’t enough capital to absorb the losses, and the banks collapsed.”

This is exactly what happened to Silicon Valley Bank. The bank needed cash and 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 with a $1.8 billion loss driving worried depositors to pull funds out of the bank.

The Fed papered over the problem with a bank bailout program (the Bank Term Funding Program or BTFP) that allowed troubled banks to borrow money against their devalued bonds at face value. It allowed banks to quickly raise capital against their bond portfolios without realizing big losses in an outright sale. It gave banks a way out, or at least the opportunity to kick the can down the road for a year.

The BTFP shut down in March, but banks haven’t paid back much of the money they borrowed. As of April 30, the BTFP still had an outstanding balance of just under $148 billion.

The high level of unrealized losses still sloshing around in the banking system means a lot of banks are in the same precarious position as SVB was last year.

According to the FDIC, the number of “problem banks” increased from 52 to 63 in the first quarter. That’s not an alarmingly high number, but it would only take a small blip in the economy to push a lot of other banks over the edge.

We’ve already had one bank failure this year.

State regulators in Pennsylvania shuttered Republic First Bank on April 26 and the FDIC took control of the bank. The bank with $6 billion in assets and about $4 million in deposits had branches in Pennsylvania, New Jersey, and New York.

According to American Banker, Republic First’s underwater bond troubles “mirrored those at First Republic Bank and Silicon Valley Bank” before they went under.

Klaros Group partner Brian Graham told American Banker this scenario is playing out in a whole bunch of other bank balance sheets, even as we speak.

“This disconnect between the economic reality of how much capital a bank really has and the stated regulatory capital level … is troubling."

The commercial real estate problem

Banks are also under pressure due to the rapidly deteriorating commercial real estate market (CRE).

According to the FDIC, the delinquency rate for non-owner-occupied CRE loans is now at its highest level since the fourth quarter of 2013.

“The increase in noncurrent loan balances continued among non-owner occupied CRE loans, driven by office loans at the largest banks, those with assets greater than $250 billion. The next tier of banks, those with total assets between $10 billion and $250 billion in assets, is also showing some stress in non-owner occupied CRE loans. Weak demand for office space is softening property values, and higher interest rates are affecting the credit quality and refinancing ability of office and other types of CRE loans.”

The CRE sector faces the triple whammy of falling prices, falling demand, and rising interest rates. The post-pandemic rise of telecommuting and work-at-home programs crushed demand for office space. Vacancy rates in commercial buildings have soared.

This has put significant stress on commercial real estate companies. The biggest bankruptcy in 2023 was the failure of the Pennsylvania Real Estate Investment Trust. The company had loaded up with more than $1 billion in liabilities.

The collapse of the commercial real estate market could easily spill over into the financial sector. That’s because a lot of loans are coming due.

According to the Mortgage Bankers Association, around $1.2 trillion of commercial real estate debt in the United States will mature over the next two years.

Small and midsized regional banks hold a significant share of commercial real estate debt. They carry more than 4.4 times the exposure to CRE loans than major “too big to fail” banks.

According to an analysis by Citigroup, regional and local banks hold 70 percent of all commercial real estate loans.

And, according to a report by a Goldman Sachs economist, banks with less than $250 billion in assets hold more than 80 percent of commercial real estate loans.

Officials continue to insist that the banking system is “sound” and “resilient.” But it’s clear there is trouble bubbling under the surface. It’s like the Jenga tower – it only takes removing one block to send the whole tower tumbling.