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Over the last few weeks, I have written to you about my belief that banks were more fragile than the media expected.

Now, after the resurgence in banking issues courtesy of New York Community Bancorp (NYSE: NYCB) shares plunging¹ over 60% year-to-date (you could read my detailed piece on this here if you missed it), it appears things are in fact on shakier ground.

• Important to note it was down roughly 75% yesterday before it was thrown a lifeline² by raising $1 billion from new investors (including former U.S. Treasury Secretary Steven Mnuchin). But with NYCB deposits down 7% over the past month as many yank their funds out, this could be simply throwing good money after bad. Time will tell.

It appears the big problem plaguing banks is anemic commercial real estate loans (I’ve also written in-depth on all the reasons for this before – you can read it here).

And for good reason.

In short, many banks – specifically smaller and medium-sized banks – are sitting on enormous commercial real estate loan losses. Especially for office buildings.

For instance, Jerome Powell – Chairman of the Federal Reserve – said³ during his testimony to Congress on Wednesday regarding commercial real estate loans that:

“There will be losses by some banks,” Powell said, adding that medium and smaller-sized banks, rather than large lenders, have the higher concentrations. These firms and banks need to have enough capital, enough liquidity and a plan to take the losses that are probably going to take place.

He also mentioned that he believes it’s a “manageable” situation.

Now, just to be clear, Powell is a very smart man (far smarter than me).

But I can’t help scratching my head at his comments.

For starters, can we believe what he says at face value? What I mean is that even if things looked awful, he couldn’t actually say that publicly.

Why?

Because markets would panic, and it could very much cause the problem they’re trying to avoid. Hence why the authorities most often downplay any trouble in order to keep up confidence.

• Imagine if the Fed Chairman said something like, “Oh yes banks are toast,” and watch how fast money flies out of banks as depositors panic – causing a meltdown in the banking system. . .

Secondly, many factors indicate that banks will likely see further stress as liquidity dries up. 

So, here are three big things I’m looking at.

1. The Fed’s Emergency Lending Program Is Ending In A Few Days

To give you some context, after Silicon Valley Bank sparked a wave of banking failures last spring (March 2023) – the Fed created an emergency lending facility called the ‘Bank Term Funding Program’ (aka BTFP).

Essentially, the BTFP offered one-year loans to eligible banks facing liquidity issues to try and prevent further bank failures like those of New York Signature Bank and Silicon Valley Bank. It does this by providing additional funding at a fixed rate and without additional fees, as long as the banks offer acceptable collateral.

Simply put, it’s a fancy way of saying it allowed banks to sell their high-quality securities (such as U.S. government bonds) to the Fed for full price. And in one year, the banks will buy it back from the Fed.

Why would they have done this? Well, banks were sitting on huge unrealized losses on their loan books thanks to the Fed’s interest rate hikes – some roughly $700 billion⁴ as of Q3-2023.

Remember, when the Fed raises interest rates, bond prices decline.

Thus, after Silicon Valley Bank fell, if other banks had to raise capital to meet depositors yanking out cash, they would’ve been forced to sell these assets on the market at much lower prices.

So, the Fed decided, “Hey, just sell it to us. We will buy them at full price. And in one year, once things calm down, you buy it back.”

Keep in mind banks loved this.

To put this into perspective, as of the end of February 2024, banks have borrowed roughly $165 billion from the BTFP.

But it’s important to note two things here:

1. BTFP are only one-year loans. Meaning banks will eventually have to use cash to buy the bonds back - thus pulling liquidity out of the system.
   
2. The Fed announced in January 2024 that they were effectively ending⁵ new BTFP loans on March 11, 2024 – only days away from now.

So, banks not only have to pay back the $165 billion in the coming months, but now they can’t even depend on borrowing from it any longer.

• Imagine if a teenager was using their mom’s credit card for emergencies, only to find out they can no longer use it, and have to pay it all back. This would likely take some adjusting.

This backstop helped banks tremendously after Silicon Valley Bank fell, and I am skeptical of how they will do now as commercial real estate loan losses begin compounding while mom’s credit card is gone. . .

2. Overnight Reverse Repo Continues Bleeding Out As Excess Cash Drains From The System

Now, I wrote an in-depth piece on this complicated reverse repo market two weeks ago and why it matters (read here if you dare).

But long story short, the overnight reverse repo market is a last resort place for banks and institutions to park excess money.

• Think of it this way, when usage of the overnight reverse repo is rising, it indicates a lot of excess money in the banking system. And when it’s falling, it’s the opposite.

Well, since writing about this two weeks ago – the overnight reverse repo has declined another $100 billion – now sitting at just $456 billion and down over 80% since May 2023.

The decline implies banks don’t have much excess cash anymore.

And in a time with loan losses and refinancing needs increasing (specifically for corporations), this could be an issue as there’s literally less money sloshing around.

3. The Fed Continues Sucking Money Out Of The Economy

The elephant in the room is the Fed’s continued balance sheet roll-off through their Quantitative Tightening (QT) program.

In non-economic jargon, QT simply means that the Fed is sucking money out of the economy as it reduces its balance sheet.

• Keep in mind this is the opposite of what the Fed does through Quantitative Easing (QE) – the fancy way of saying expanding the money supply to try and stimulate growth, prices, and confidence.

The easiest way to think of this dynamic is when the Fed expands its balance sheet (through QE) – it’s pumping credit into the system by buying assets from banks (aka it pays the banks in cash, and takes their bond, which means banks have more money to lend). And when it’s reducing its balance sheet (through QT), it’s pulling that credit out (selling the bonds back to banks, which means banks have less money now, Or the Fed simply lets the bond mature and not roll it over).

The issue of the Fed pumping credit into the system began after 2008 to try and prop up banks and asset prices. But it went parabolic during the COVID-pandemic.

In fact, in the last 15-odd years, the Fed’s expanded its balance sheet by roughly $8 trillion – with more than half of it since 2020.

But since the Fed began tightening in 2022, it sucked out roughly $1.4 trillion – from peak levels of around $9 trillion in April 2022 to currently $7.56 trillion (a 16% decline).

And to highlight how the Fed’s QT program causes tightening – according to the Council of Foreign Relations⁶ - the equivalent tightening effect of QT could push the Fed’s policy rate to a peak between 6.0% and 6.2%. This is significantly higher than the current rate of 5.375% (based on projected future policy rates). And the market is grossly underestimating this added tightening.

• Basically, the QT is equivalent to the Fed hiking roughly one full percentage point more.

Lovely, right?

I believe this will likely put further stress on banks.

Wrapping It Up: The Fed's Stuck Between A Rock And Hard Place

So, let’s summarize –

• The Fed’s ending the BTFP on March 11^th, which means no new lending will be made to banks. And banks will begin having to repay the $165 billion over the coming months.
  
• The overnight reverse repo market – where banks park excess cash – is bleeding out fast. And at this pace, will likely be empty by summer.
  
• The Fed continues to shrink its balance sheet at roughly $95 billion per month, which pulls money out of the banking system.

All this together indicates that liquidity is drying up in the banking system. And it’s happening at a pretty bad time.

Banks will have fewer funds to pull from to refinance loans, extend credit, or handle meaningful write-offs.

Now as bank loan losses build as expected – mostly from commercial real estate – then these banks essentially must deal with both souring loans and less liquidity.

Making matters worse, if bank issues persist or compound, the Fed will likely be forced to step back in to inject liquidity into the system (reverse its tightening).

And this could spark inflation back up at a time when they can’t get it yet under 2%. . .

What a fix, right?

Well, as always, this is just some food for thought many in the mainstream disregard.

Take care.

Sources:

1. https://www.wsj.com/livecoverage/stock-market-today-dow-jones-03-07-2024/card/nycb-stock-rises-after-bank-cuts-dividend-11ZFl7CBECGiXr8azrKJ?mod=lctimeline_finance
2. https://www.10news.com/mnuchin-s-firm-leads-1b-lifeline-to-help-new-york-community-bank
3. https://www.barrons.com/livecoverage/fed-powell-congress-testimony-speech-today/card/commercial-real-estate-challenges-are-a-manageable-problem-powell-says-f4awoB6xScrnPmrwy3kF
4. https://www.reuters.com/breakingviews/banks-hidden-losses-are-surprise-survivor-2023-2023-12-13/
5. https://www.reuters.com/markets/us/fed-allow-emergency-bank-lending-program-expire-march-11-2024-01-25/
6. https://www.cfr.org/blog/fed-policy-tighter-it-looks-and-set-tighten-further

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