Cheap deposits have become a painful pandemic hangover for US banks

The bankruptcy of Silicon Valley Bank and the subsequent US bank sell-off have highlighted the lingering dangers of a strategy many lenders used to boost profits when interest rates were low.

Over the past three years, banks have become accustomed to investing customer deposits in fixed-income securities when they cannot lend them profitably. SVB, which was taken over by US regulators on Friday, was a particularly heavy user of the strategy: more than half of its assets were invested in securities.

But as interest rates have risen over the past year, the bonds that banks bought with their abundance of cheap deposits have sunk in value, creating a whopping $600 billion in paper losses. This gives investors a better understanding of the risks some banks have taken with their excess deposits.

In extreme cases, such as with the SVB, those paper losses can lead to a death spiral in which fearful savers force banks to liquidate their portfolios, turning those paper losses into real losses that may be too great for some small or even medium-sized banks to bear. to process . That seems to scare investors in bank stocks in recent days.

“I quote my high school economics teacher who said there is no such thing as a free lunch,” said Greg Hertrich, head of U.S. Depositary Strategies at Nomura. “I think there was more of a tendency to think about the additional income that can be made by having longer-maturity assets compared to this new pool of peak deposits.”

From April 2020 and a peak two years later, nearly $4.2 trillion in deposits flowed into U.S. banks, according to data from the FDIC. But only 10 percent of that was ultimately used to fund new loans. Some banks simply held those new deposits in cash. But a large chunk of the money, about $2 trillion, was funneled into securities, mostly bonds. Prior to the pandemic, banks had just over $4 trillion in securities investments. Two years later, those portfolios were up 50 percent.

What may have made low-yield bonds more attractive than new loans, at least low-yield government bonds or government-guaranteed bonds, was the perception of low credit risk. And for a while, those new bonds ultimately drove bank profits. But in retrospect it now appears that the banks may have bought at the top end of the market. And that’s what’s causing the problem. Last year, lenders’ bond portfolios plummeted, generating some $600 billion in losses, but since banks don’t sell their bonds regularly, many of those losses have yet to be realized.

“The banks fell asleep. No one expected this continued inflation,” said Christopher Whalen, a longtime banking analyst who heads Whalen Global Advisors. “The banks with big treasury books have the most problems.”

Among the big banks, JPMorgan was more cautious than others. While interest rates were low, CEO Jamie Dimon told investors it was “difficult to justify the price of US debt” and that he “wouldn’t [Treasuries] with a 10-foot pole.” While JPMorgan brought in just over $700 billion in new deposits after the pandemic, its securities holdings only increased by $200 billion during that period.

But as Bank of America’s deposits soared by $500 billion after the pandemic began, its bond holdings skyrocketed almost as quickly, reaching nearly $480 billion. As a result, BofA’s losses in the past year on its securities portfolio have climbed to just over $110 billion, or more than double the roughly $50 billion in losses recorded at Wells Fargo and JPMorgan.

However, analysts point out that most banks can avoid losses by holding the securities to maturity. This is especially true for the country’s largest banks, which can rely on wholesale funding to cover deposit outflows, and where losses on securities remain small relative to their overall size. But at a time when banks must offer higher interest rates to depositors, having to hold low-yield bonds to avoid those losses is likely to weigh on profits.

“We think the big banks are doing just fine this year,” said Gerard Cassidy, banking analyst at RBC Securities. “It’s definitely a headwind.”

But what is merely a headwind for the country’s largest banks could be a tornado for some smaller lenders betting heavily on their bond portfolios. That’s largely what happened with Silicon Valley Bank, which took $15 billion in losses on its bond portfolio, only slightly less than the bank’s total value.

PacWest, based in Beverly Hills, California, for example, has incurred $1 billion in losses in its bond portfolio, enough to wipe out more than a quarter of its $4 billion in equity. Shares of PacWest are down 50 percent in the past week.

“Most banks are not insolvent,” Whalen said. “But every bank has losses.”






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