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Over the last few months, we’ve shared with you the potential issues within the U.S. banking system. Or rather, that things may be getting worse instead of better.

Banks are currently grappling with:

• Surging credit card delinquencies: About 8.9% of credit card balances transitioned into delinquency¹ over the last year.
  
• Rising missed auto payments: Roughly 8% of auto loan balances transitioned into delinquency over the past year.
  
• Mounting commercial real estate loan losses: Some data² shows a 10% to 20% default rate on commercial real estate loans, translating to $80 billion to $160 billion in bank losses.

Adding to these problems, bank lending growth has slowed dramatically over the last 16 months. Commercial bank loans and leases (L&Ls) – the two main ways banks lend – have plunged from 12% in December 2022 to just 2.3% as of last week.

• Banks need to lend to make money, right? So, this isn’t great as higher interest rates bite both lenders and borrowers.

You may be thinking, “O.K. things appear shaky, and I’m a tad worried. But what now?”

Well, what if I told you the latest FDIC commentary showed further evidence of banking issues?

And more importantly, it seems like no one in the mainstream is talking about it.

Yet, we will. So let’s take a closer look.

$517 Billion in Unrealized Losses Plague The US Banking System, FDIC Reports 63 "Problem Banks" on Brink of Insolvency

The FDIC recently published its Quarterly Banking Profile³ for Q1-2024 which revealed that the US banking system faced $517 billion in unrealized losses in the first quarter of 2024, marking the ninth consecutive quarter of high losses.

• Unrealized losses happen when an asset's value drops but hasn't been sold yet. So that means that if banks were forced to sell their assets in Q1, they would have eaten half a trillion in losses (imagine looking at a brokerage and seeing XYZ stock down, you technically wouldn’t suffer that loss unless you sold it).

The surge in unrealized losses, driven by increased mortgage rates impacting residential mortgage-backed securities, underscores the ongoing challenges faced by the industry.

Furthermore, the FDIC identified 63 lenders as being on the brink of insolvency - a significant increase from 52 in the previous quarter.

These banks are labeled as "problem banks" by the FDIC due to financial, operational, or managerial weaknesses, or a combination of all three.

• Keep in mind the FDIC keeps this list confidential as naming individual banks on the list would likely spark anxiety and create panic - inciting the very thing the FDIC is trying to prevent. 

Now, it’s important to note that these “problem banks” represent just 1.4% of the total number of US banks, which the FDIC labels as within normal ranges.

But what worries me is the rate of change (the percentage increase) of problem banks – rising 17.5% quarter over quarter.

Worse though is that the total assets held by these problem banks increased $15.8 billion to $82.1 billion. And so did uninsured deposits (money that surpasses the $250,000 FDIC limit and is considered "hot money" for how fast it comes and goes).

Now, it wasn’t all iffy news. . .

For instance, bank net income rebounded to $64.2 billion, a 79.5% increase from the prior quarter (mainly due to lower FDIC special assessment expenses and fewer goodwill write-downs).

But, despite this, the industry's net interest margin declined by 10 basis points (0.10%) to 3.17% - now below the pre-pandemic average of 3.25%, due to increased funding costs and declining loan yields.

• This is an issue since banks “borrow short” to “lend long” and net the difference, thus higher funding costs and lower lending rates squeeze their profits (more on this below).

The FDIC parts ways with some dour comments, noting that although the banking industry continues to show resilience, the ongoing economic uncertainty, geopolitical issues, declining profit margins, and deteriorating loan portfolios - such as credit card and commercial real estate loans souring – all pose “significant downside risks” to the banking industry.

• To highlight this, the credit card net charge-off rate (the percentage representing the amount of debt that a company believes it will never collect) was 4.70 percent in the first quarter, 122 basis points (1.22%) higher than its pre-pandemic average and the highest rate since third quarter 2011.  

That’s the keyword from the FDIC here: significant.

So, how are banks at risk here?

Let’s look at it.

The Two Types of Banking Crises: Liquidity vs. Solvency

There are essentially two ways for a bank to fail:

First: a solvency crisis – This occurs when a bank's assets fall and non-performing loans rise, wiping out the bank's capital (equity).

Bank capital mainly comes from shareholder equity (owners), provisions, and retained profits from loans, and it is listed as a liability on the bank's books.

Most banks in the U.S. as of Q2-2023 hold around 8-15% capital-to-asset ratios⁴ as a buffer against potential losses.

However, this also implies that a mere 8-15% fall in realized asset values or an equivalent rise in debt defaults could wipe out bank capital, thus making them bust.

This is what happened in 2008 when mortgage loans and various debt defaults rose, pushing banks into insolvency.

In short, a solvency crisis occurs when customers (borrowers) can't repay their loans and the bank is left holding the bag.

Second: a liquidity crisis – This occurs when a bank lacks sufficient assets to meet its liabilities (i.e. if it can meet sudden withdrawals of deposits).

This situation is often referred to as the 'asset-liability maturity mismatch'.

See, banks typically lend long-term into illiquid assets (like 30-year mortgages) while holding short-term liabilities (such as customer deposits). This means it’s far easier for customers to yank their money out than for banks to sell off the assets (the loan) in order to raise the cash.

So, if widespread confidence in banks declines and customers withdraw deposits, this mismatch becomes problematic because the bank must quickly sell assets to meet liability outflows. And if banks are rushed, those assets may be sold at steep discounts (below their book values), leading to a 'fire sale'.

This is essentially what happened in 2023 with Silicon Valley Bank (SVB) in March 2023.

SVB's asset prices were down, and they couldn’t meet the sudden outflow of deposits. For instance, SVB tried to sell $21 billion in high-quality mortgage-backed and Treasury assets but had to offload them at a roughly 10% discount⁵, amplifying the lack of confidence in their loan books as news broke they suffered a chunky loss.

• This is why the Federal Reserve opened the discount window and emergency lending programs for other banks soon after, allowing them to sell assets to the Fed at full prices because banks were all sitting on massive unrealized losses.

Thus, a liquidity crisis is determined by whether a bank has sufficient liquid assets to meet its liabilities.

Both solvency and liquidity crises seem to be building in the banking system.

Loan losses are rising as credit cards, auto loans, and commercial real estate loans continue to suffer delinquencies and defaults.

Meanwhile, banks are dealing with over $500 billion in unrealized losses, posing a significant risk if depositors start withdrawing money.

This is what I’d call, “stuck between a rock and a hard spot.”

So don’t be surprised if we see more banking issues in the coming months. . .

Wrapping It Up

Banking is a huge part of the economic system. In fact, it may be the most important aspect.

Yet, many modern economists and central bankers overlook the crucial role of the financial and banking system in the broader economy, viewing them as mere intermediaries with a neutral impact.

However, this perspective is misguided (almost absurd).

Classical economists like Irving Fisher, John Maynard Keynes, F.A. Hayek, and Hyman Minsky all highlighted that the financial system significantly affects macroeconomic stability, creating feedback loops that lead to booms when credit expands and busts when credit contracts.

• According to the International Monetary Fund (IMF)⁶, “. . . the nature of banking had by the 1960s, been largely forgotten. In fact, around that time banks began to completely disappear from most macroeconomic models of how the economy works.­”

This implies that most of these economic models driving the economy and markets don’t even factor in banks.

But make no mistake: like the genius economists of old, I believe banks play a vital role as they distribute and allocate credit within the economy, influencing asset prices, economic growth, and markets.

As banks contend with substantial unrealized losses, anemic loan growth, and rising delinquencies (as the FDIC noted), systemic volatility may further increase, amplifying the current economic fragility.

And while many forget — or choose to ignore — the words of the classics regarding banking, we won’t.

Just some food for thought.

Sources:

1. The Dunham Deep Dive: Three Interesting Things I'm Looking At | Dunham
   
   
2. The Commercial Real Estate Crunch: Are Small Banks Sitting on a Ticking Time Bomb? | Dunham
   
   
3. FDIC Quarterly Banking Profile First Quarter 2024 | FDIC
   
   
4. S. Bank Capital Levels: Aligning With or Exceeding Midpoint Estimates of Optimal - Bank Policy Institute (bpi.com)
   
   
5. Seized assets from Silicon Valley Bank and Signature Bank are fetching 85 to 90 cents on the dollar - MarketWatch
   
   
6. The Truth about Banks – Finance & Development, March 2016 (imf.org)

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Information contained in the materials included is believed to be from reliable sources, but no representations or guarantees are made as to the accuracy or completeness of information. This document is provided for information purposes only and should not be considered as investment advice.

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