After writing a series of relatively weedy legal and regulatory Musings in 2023, I promised myself that my next Musing would be something that is accessible to everyone (sort of like Pickleball). Fate intervened and the “S bank”[1]failures happened (Silicon Valley Bank (SVB), Signature Bank and Silvergate Bank). So now I have to accessibly discuss topics like bank runs, interest rate risk, liquidity, bailouts, moral hazard, and deposit insurance and how it impacts the mortgage industry.
Don’t feel sorry for me. I volunteered for this job. I’ll figure out how to keep this accessible, and if I fail, you can always ask for your subscription fees back.
We all crave a narrative
My readers (and everyone else) are accustomed to me talking about narrative in the context of regulatory compliance (especially RESPA). But narrative plays a much bigger role in how we think and interact with society generally. Creating and offering my own narrative about the different issues I observe is the raison d’etre of this blog.
A narrative is what allows us to put complex and diffuse experiences and information into something we can rationally understand. That is, we can’t just have random chaos all around us. Instead, there needs to be an explanation involving actors who intend certain outcomes or who make mistakes and learn lessons for the future. There are often villains, heroes and innocent bystanders in the narrative. We crave the narrative to make sense of world and create that narrative based on our perspectives[2].
From a recent article in the Atlantic,
Maybe the most interesting thing about all of this is what it suggests about the human proclivity for narrative. When we shift our memories from one perspective to another, we are, often without even realizing it, shaping and reshaping our experience into a story, rendering chaos into coherence. The narrative impulse, it seems, runs even deeper than we generally acknowledge. It is not merely a quirk of culture or a chance outgrowth of modern life. It’s a fact of psychology, hardwired into the human mind.
So, now my job is to put these S bank failures in some kind of narrative perspective about what happened, so we can make sense of it all. Wish me luck.
The S bank failure narratives
Truth be told, I’ve spent the better part of this past week shaping and reshaping this Musing seeking to distill a coherent narrative. It’s still early in the information gathering cycle and it can be hard to distinguish spin from substance. Facts and information may come out later that may change the narrative. Were these mistakes or intentional acts and what are the lessons to be learned? Who are the villains, heroes, and innocent bystanders in this story? You can find all kinds of narratives from expert financial writers with valid complaints about what went wrong. I’m sure you’ve heard many of these stories already; (i) bad bank risk management[3]of interest rate and liquidity risks, (ii) misplaced[4]or missing government regulatory supervision and oversight, and/or (iii) VC and crypto depositors who acted in concert to flame the fire of the bank runs.[5]
The blame game is going to ramp up between those who say (a) bank management failed in its interest rate risk and liquidity and was too focused on DEI and ESG objectives, (b) the government failed to supervise and enforce basic CAMELS ratings (particularly the L and S of that[6]) and/or relaxed supervision in 2018 of mid-sized banks, and/or (iii) uninsured customers of these banks were undeserving of sympathy and too correlated as depositors and cozy with the bank and/or failed to do their own homework and/or diversify their banking relationships.
All of that makes sense, but doesn’t give me the kind of resolution I feel I need for this narrative. There’s one thing, however, I keep coming back to that seems totally clear to me.
Bank runs are bad
“Systemic risk” is bank regulator-speak for a contagious financial panic. Regardless of why it happens, one thing is certain: banks are going to fail when there is a run on their deposits. If you haven’t seen the financial panic movie play out before,[7]spoiler alert; it ends badly for everyone[8]. The psychological effect is clear: one bank has a problem that causes a run, everyone hears the music stop, and tries to grab a chair. Per New York Times writer David Leonhardt, “Bank runs are especially dangerous because they feed on themselves, sowing panic as people worry that their own deposits may be at risk. Even healthy banks can become endangered.”
When everyone panics and wants their money under the mattress instead of at their bank, a capitalistic economy is dead in the water. So, if you are in charge of the banking system like the FDIC, job one is to never allow the bank run panic contagion to spread to the whole banking industry because it will bring down the whole economy.
“Where’s my money George?”
Maybe you never thought of it this way, but when you put your money in a bank you are really lending your money to your bank. In fact, when you make a deposit, your money becomes a liability on the bank’s balance sheet[9]that must be repaid on demand. In essence, the bank borrows money from you and promises to repay it when you ask. Depositors must trust that when they put their hard earned[10]money in a bank, that they can get it back whenever they need it.[11]
Banks, of course, don’t just keep your money in a vault. They take that money and invest it in loans and investments that pay interest over a longer term. As a result, no bank ever has enough cash on hand to pay everybody’s deposits back at once. As best explained by George Bailey when his depositors all showed up for their money on the same day in Bedford Falls, “Your money is in Joe’s house.” Yes, the only bank in world history to actually ever survive a run on its deposits on its own[12]is the Bailey Building & Loan in Bedford Falls.[13]That narrative can happen only in Hollywood in a Christmas movie.[14]
The FDIC
In real life, the only way to save a bank from a bank run is to prevent the run in the first place. This explains FDIC insurance. With the federal government’s explicit $250,000 guaranty, there should be no reason to ever panic that your bank won’t be able to pay you back. Simply put, federal deposit insurance is there to avert bank runs.
Seeing the second bank run[15]at a California bank in weeks, however, and fearing “systemic risk”, the government stepped in, wiped out SVB’s and Signature’s[16]management and shareholders, but made sure all depositors were made whole, not only insured depositors.[17]They then offered credit lines to other banks designed to assure you and other lenders that there is no need to panic about getting your money back.[18] We aren’t totally out of the woods yet, but it seems the panic of systemic risk has been minimized by these actions.
Moral hazard
Moral hazard can be described as lack of proper incentive to guard against risk. Another definition is having insurance to do something bad. Back in 2020, I was concerned about moral hazard in connection with COVID forbearance encouraging borrower defaults that would come back to originators in the form of repurchase losses.[19]
Do the special measures taken by the government with the S banks create a moral hazard? The shareholders, bond holders and management of these banks all lost everything. So, those people at other banks all still need to worry about the consequences of failing to address risks; there’s no moral hazard with those folks.[20]The FDIC insurance fund, however, has never reimbursed uninsured depositors before. In the past, uninsured depositors were protected in a bank failure by the FDIC only because the bank was purchased by another bank that assumed those deposit liabilities (i.e., they wanted to keep those customers and deposits).
Moral hazard, implicit guaranties and crisis averted
But with these resolutions, similar to the pre-conservatorship buyers of mortgage-backed securities guarantied by Fannie and Freddie,[21]bank regulators have essentially told uninsured depositors they should feel safe putting money in any bank with FDIC insurance, regardless of amount. So, if your assessment is that it is important for large depositors (or small) to realize they are a lender and think about the bank’s risk of failure, you will think the FDIC’s actions pose a moral hazard.
Bloomberg’s Matt Levine, on the other hand, suggests that regulators disagree with that moral hazard assessment, and don’t want depositors thinking they are lenders to banks, “the modern bank-regulatory view is that the point of a bank deposit is that you shouldn’t have to worry about it, and that it is a failure of bank regulation if depositors of any size have ‘to actually give a moment’s thought to the riskiness’ of a bank.”
I am coming around to this thinking too in the interest of preventing bank runs. Lenders may jump first if they think they have a short term information advantage over another lender.[22] So, depositors doing homework on their banks may actually be more likely to precipitate a bank run than do any good.
So, the regulators have grabbed the wheel and took risk management responsibility away from all depositors at FDIC insured institutions. But no other bank has stepped up to buy the S Banks, at least not yet,[23]so the costs of the uninsured depositor bailout will be assessed across the banking industry.
For now, at least, the bank panic virus appears contained.[24]Uninsured depositors have an implicit federal guaranty (just like the MBS investors) while those with $250,000 or less still have an explicit guaranty. We have, at least for the time being, dodged the systemic risk of economic collapse due to widespread bank runs. We can thank the Federal Reserve and FDIC for averting bank runs, but we now will need to address how the uncertainty of an implicit guaranty will be managed both in terms of depositor expectations and bank oversight and expense.
Mortgage Industry Impact
Unlike 2008, the default risk of loan assets had virtually nothing to do with this S bank crisis. Asset quality (credit risk) was not at issue.[25] Still, even though, as former FHA Housing Commissioner and MBA CEO David Stevens observed, “independent mortgage bankers are not the concern here”, the mortgage industry will not be able to avoid the fallout. Every bank failure crisis results in new bank regulations, and the narratives offered by people like Elizabeth Warren aren’t likely distinguish much between banks and mortgage bankers.
Congress has avoided talking about housing finance for 15 years while Fannie and Freddie wallow in conservatorship. No offense to the last few FHFA Directors, but those individuals (and thier staff) should not be in the role of determining housing finance policy in the US. But there may be no way to avoid the topic in the aftermath of the S bank failures. In particular, the role of the Federal Home Loan Banks in lending to Silvergate is already being scrutinized and that comes at a time when the FHFA is reexamining the role of the FHLBs in providing housing related liquidity generally. I expect it’s all going to be on the table just like it was during the Dodd Frank time frame, so it will be vital for the mortgage industry to have a seat as the legislative process unfolds. Housing finance policy will finally get the airing in the political arena it deserves, but it will be done through the lens of these banking issues.
Now is a good time to renew your membership in your trade associations.
[1] What are the odds they’d all start with an “S”? Please, don’t remind me about my middle initial.
[2] My perspective on this topic is shaped by being a 15 year veteran of a bank that failed in 2017 after the 2008 meltdown decimated the market value of its assets. Yet, there was never a run on that bank, and it limped along for 8 years before the regulators inexcusably shut it down without notice. I left the bank in 2009.
[3] In particular, SVB not having a chief risk manager for months isn’t going to play well in hindsight.
[4] Many say that regulatory attention has been diverted in recent years to consumer protection and fair lending concerns instead of safety and soundness.
[5] There were some irresponsible VC guy Twitter statements that, frankly, should cause some bankers to pause before accepting the speaker as a customer.
[6]Prudential bank regulators rate banks on a 1 to 5 scale known as the CAMELS rating system: Capital, Assets, Management, Earnings, Liquidity and (rate) Sensitivity. Weakness in the last two measures (L & S) clearly are what drove these bank failures. The “M” (Management) can probably be blamed too for not anticipating these problems. I would be very curious to have seen their Interest Rate Risk shock test modeling pre-failure.
[7] I guess I’m an “old-timer” because I lived through the 2008 meltdown and the fallout from the S&L crisis of the late-1980s. Everyone knows about October, 1929, right?
[8] The only time it didn’t end badly was in an actual movie.
[9]Again and again, I have been accused of wanting to be an accountant. If I was, however, I would be a very frustrated accountant, but I do know what a liability and a balance sheet are.
[10] In this case, hard earned from the “sweat of the brows” of tech venture capitalists and crypto investors. Not exactly the It’s a Wonderful Lifehard working crowd, but still, was their misplaced trust in the S banks unreasonable?
[11]It’s more than just trust. You have a legally enforceable deposit agreement and explicit or implicit deposit insurance from the government.
[12] That is, without government assistance or a white knight buyout.
[13]Can you imagine all those VC guys or crypto folks working together to save their favorite S bankers by only taking a portion of their money when everyone else is panicking? “Merry Christmas!”
[14] Don’t @me about some idealistic pure cooperative social action utopia that just hasn’t been tried yet. Bank runs worldwide prove self-interest always trumps collective action. Only intervention can stop a bank run. Not even Israeli Kibbutzim could survive a banking crisis without government intervention. The dangers of self-interest unchecked is the best reason for bank regulation by the federal government.
[15]Silvergate is in the process of self-liquidating without government financial assistance..
[16]There is some question about the timing of Signature Bank’s closing in relation to the liquidity funding measures put in place shortly thereafter, but, hey, Barney Frank, was on the Board of Directors for Signature, so no one can say that there were favorites played by the Democratic banking regulators in New York or the Biden Administration. Note, however, to the next bank looking for credibility by having a famous banking industry firebrand on your board: Maybe having Barney Frank on your Board isn’t exactly the shield from the government interference you expect.
[17]It would be entirely proper to say the government “bailed out” the uninsured depositors. You can bet, however, the government is not calling it a “bailout” because that wouldn’t be good for their narrative.
[18] Ironically, the failures of SVB and Signature rallied the interest rate markets in a flight to quality resulting in improved valuations for the low interest treasuries and mortgage-backed securities held by all S banks thereby lowering the costs of resolution. In other words, the S Bank’s assets value increased precisely due to their collective failure. Now that’s actually ironic, unlike an SVB parody video of the Alanis Morrissette song that was making the rounds until it went private so I can’t offer a link.
[19] I have been wrong about that so far, but the jury is still out with life of loan reps and warrants.
[20] Although, it does cause one to wonder about the 4 “too big to fail” banks. What kind of moral hazard(s) does being too big to fail cause?
[21] Similar to SVB’s and Signature’s shareholders, Fannie and Freddie’s preferred and common shareholders didn’t fare so well.
[22]This is something for mortgage bankers to consider in light of their warehouse lender relationships.
[23]Why not, is an entirely different and interesting discussion. I will defer to Matt Levine on that as well.
[24] I consciously chose to use the word “contained” rather than use a vaccination metaphor here.
[25]By all accounts S bank asset quality was extremely good. The problem was that their yield on assets was significantly lower than their expenses (including inflation) so they were having or going be having earnings issues.