Cheap deposits have become a painful pandemic hangover for US banks

The failure of Silicon Valley Bank and the subsequent liquidation of US banks highlighted the enduring dangers of a strategy used by many lenders 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 could not profitably lend them out. 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 rates have jumped over the past year, the bonds that banks have bought with their abundance of cheap deposits have lost value, creating up to $600 billion in paper losses. As a result, investors have a better idea of ​​the risks some banks have taken with their excess deposits.

In extreme cases, such as with SVB, these paper losses can lead to a death spiral in which anxious depositors force banks to liquidate their portfolios, turning these paper losses into real losses that may be too great for some banks. small or even medium. . That seems to be what has been spooking bank stock investors for the past few days.

“I’ll quote my high school economics teacher who said there’s no free lunch,” said Greg Hertrich, head of US deposit strategies at Nomura. “I think there was more bias to think about the additional income that can be earned by having longer duration assets, in return for this new peak deposit pot.”

Beginning in April 2020 and peaking two years later, nearly $4.2 billion in deposits were made in U.S. banks, according to FDIC data. But only 10% of that amount ended up funding new loans. Some banks simply held these new cash deposits. But much of the money, about $2 trillion, was invested in securities, mostly bonds. Before the pandemic, banks had just over $4 billion in securities investments. Two years later, these portfolios had increased by 50%.

What may have made low-yielding bonds more attractive than new loans, at least low-yielding or government-guaranteed government bonds, was the perception of low credit risk. And for a time, these new obligations ended up weighing on bank profits. But in retrospect, it now appears that the banks may have bought at the top of the market. And that’s what’s causing the problem now. Last year, the value of lenders’ bond portfolios plunged, creating some $600 billion in losses, but because banks are not regularly selling their bonds, much of those losses have yet to be realized.

“The banks have fallen asleep. No one expected this continued inflation,” said longtime banking analyst Christopher Whalen, head of Whalen Global Advisors. “Banks with big Treasury books have the most problems.”

Among the big banks, JPMorgan was more cautious than the others. As interest rates were low, Chief Executive Jamie Dimon told investors it was “difficult to justify the price of US debt” and that he “wouldn’t touch (Treasuries) with a 10 foot pole”. While JPMorgan received just over $700 billion in new deposits post-pandemic, its holdings of securities during this period grew by only $200 billion.

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

Analysts, however, point out that most banks can avoid losses by holding securities until maturity. This is especially true for the country’s largest banks, which can draw on wholesale funding to cover deposit outflows, and where securities losses remain small relative to their overall size. Yet, at a time when banks have to offer higher interest rates to depositors, the fact that they have to hold onto low-yielding bonds to avoid those losses is likely to squeeze profits.

“We think the big banks will do very well this year,” said Gerard Cassidy, banking analyst at RBC Securities. “It’s definitely a headwind.”

But what is just a headwind for the nation’s biggest banks could be a tornado for some smaller lenders betting heavily on their bond portfolios. This is largely what happened at Silicon Valley Bank, which racked up $15 billion in losses in its bond portfolio, barely less than the bank’s overall value.

PacWest, which is based in Beverly Hills, Calif., for example, racked up $1 billion in losses in its bond portfolio, enough to wipe out more than a quarter of its $4 billion in equity. PacWest shares plunged 50% last week.

“Most banks aren’t insolvent,” Whalen said. “But every bank is sitting on losses.”

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