DANIEL VAUGHAN: The eye of the economic storm

March 31, 2023

We've entered into a smoother economic moment in time. The turmoil of banks failing has ceded a bit, and we're headed into much tighter credit conditions. That equates to an incoming credit crunch unless the Federal Reserve starts pumping easy cash into the system. It's doubtful they'll do that because that's a signal they've given up on the fight against inflation.

The Wall Street Journal succinctly spelled out the problem: "Banks need deposits to make loans; if deposits fall, lending is almost sure to follow. What's more, the recent turmoil could spur banks to start paying depositors higher interest rates, crimping earnings and further cutting into their lending capacities. And the speed of the recent deposit runs—customers withdrew $42 billion from SVB in a day; Signature lost $18 billion—has bankers stockpiling cash."

Where does that leave us? "The likely result, analysts and central bankers said, is a credit crunch." And while that prediction was only a week ago, we're in the phase where it becomes a reality.

Small banks are losing.

According to numbers from the Federal Reserve and the Wall Street Journal, "The 25 biggest U.S. banks gained $120 billion in deposits in the days after SVB collapsed, according to Federal Reserve data. All the U.S. banks below that level lost $108 billion over the same period. It was the largest weekly decline in smaller banks' deposits in dollar terms on record."

Even with the banking turmoil easing, the Federal Reserve still pumps out billions in emergency loans. They continue to support a system with emergency measures that have been running hotter than at any point since 2008. Shrinking deposits and increasing pressures to stockpile cash means less lending from banks.

The following pressure point in the economy is the commercial real estate sector. Already hammered by the pandemic and the shift to working from home, commercial real estate is taking an even bigger hit.

Commercial real estate is failing, too.

After the failure of Silicone Valley Bank, the FDIC sold the loan assets of SVB. The FDIC did not get the complete value: "The sale of $72 billion in assets from the failed Silicon Valley Bank by regulators at a $16.5 billion discount, which pencils out to about 77 cents on the dollar, offers a glimpse into a new clearing price for commercial-real-estate loans."

High-interest rates are eating into the value of these commercial real estate properties. The losses taken in selling Silicone Valley Bank's assets have reset real estate valuations across the country. If the high-quality property in Silicone Valley Bank's loans no longer has the same value, then it's likely everyone else is sitting on losses too.

Marketwatch interviewed two experts that gave different loss expectations. One said banks could expect 20-25% losses on commercial real estate loans. The other expert said the losses could be as much as 70% of the loan.

But the problems don't end there. If you're an insurance company, you've likely insured commercial real estate for much higher valuations than now exist. For now, they're stuck with that reality. But it's likely insurance companies will seek to reappraise their portfolios and drive up insurance premiums to cover these costs as time goes on.

The problem is that higher insurance premiums will be passed on to the consumer. Some businesses could get forced out of their leases because of higher insurance costs.

Does the Fed stop inflation or an economic meltdown? The Fed doesn't know.

These issues are all expanded by the ever-present problem of inflation. While inflation in essential goods like food and energy is cooling, the same is not true of other sectors of the economy. Inflation is not fixed, the Federal Reserve knows this, which means we're in for ever-tightening conditions or until something more significant in the bank sector fails.

Ripples from the bank failures continue radiating outward across the economy. The White House claims they're on top of things, suggesting that Congress repeal the 2018 easing of Dodd-Frank regulations. The problem is that the issue wasn't the number of regulators but what they were measuring.

The Federal Reserve was not stress-testing banks for the scenario of a high-interest rate environment that we have now. Everyone from the Federal Reserve to Silicon Valley Bank believed the easy money regime of the last fifteen years would hold true. That didn't happen, and we're stuck with the repercussions now.

Everything is peaceful now. But pressure is building underneath the American financial system. That's not a suggestion that everything is collapsing. The economy is overheating and threatening to blow up as the Federal Reserve continues to raise pressures.

For everyone else, we keep riding the eye of the inflation storm, waiting for the next shoe to drop.

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