Source: St. Louis Fed, Economic Research Division
The next calamity to have long-reaching consequences was the Covid-19 pandemic. Faced with a global economic shut-down, authorities responded with a firehose of monetary and fiscal stimulus.
Again, the intention of the efforts was noble- to keep citizens from falling into destitution. But the consequence of trillions of dollars pumped into the economy was the highest inflation in 40 years. A more sober-minded analyst would have predicted such an outcome, but amid a crisis such cautionary voices were drowned out.
Source: Zephyr StyleADVISOR
Once inflation became too big to ignore the Federal Reserve Bank belatedly started draining liquidity from the system. The Fed rapidly raised interest rates and started whittling down their vast balance sheet. After all, price stability is one of the official objectives of the Federal Reserve; supporting the stock market is not.
Once again, the intent was good, but the consequences were dire. Inflation needed to be brought down as it damages broad swaths of the economy and the citizenry. However, the consequence of the rate hikes was to drive down the value of many financial assets. In a world where inflation was approaching 10% and yields were back above 5%, one of the most susceptible assets to rising interest rates is long-term, low-yielding bonds.
Throughout 2022 investors saw the impact of rising rates on both their equity and bond holdings. The S&P 500 index returned -18.1% and the Bloomberg U.S. Aggregate Bond index had its worst year in history with a -13.0% return.
Hidden from view was the impact of these rate rises on the bond and loan holdings of banks. Investors in fixed income bond funds would see their holdings marked-to-market on a daily basis; the pain was immediate and visible. However, depending on the size of the bank and how the bonds were classified, regional banks were able to defer the problem and weren’t forced to immediately recognize the problem. But that doesn’t mean the problem wasn’t there.
Once again, we turn to intentions and consequences. In 2018 the regulations were relaxed for smaller banks. Previously every bank with assets greater than $50 billion was required to undergo Federal Reserve stress tests to gauge the impact of adverse scenarios, as well as meet stricter capital requirements. By changing the requirements from $50bn to $250bn the intent was to relieve some of the regulatory burden and costs from regional lenders- certainly a reasonable goal. However, by reducing the oversight in banks in the mid-size range, these festering problems were overlooked for most of 2022.
The above graph illustrates the unrealized bond losses on bank portfolios. If the bonds are classified as being “held to maturity”, the losses needn’t be recognized. However, if circumstances dictate that these bonds are sold the price will be whatever the market deems fair, and these losses could be realized.
In early March Silicon Valley Bank and Signature Bank experienced a 21st-century bank run, where skittish depositors started moving uninsured deposits out of these troubled banks. Unable to raise capital or stem the outflow of deposits, these banks collapsed and the Federal Reserve stepped in and took over their operations. A month later, First Republic was forced into the arms of JP Morgan Chase. These three failures are the second-, third-, and fourth-largest bank failures in U.S. history.
Source: The Washington Post, “Three of the Four Largest-Ever Bank Failures Have Happened Since March”, May 1, 2023