The U.S. Federal Reserve has recently dropped a financial bombshell that has left many in the banking sector scratching their heads. In a surprising revelation, it was reported that a shocking 722 banks had experienced unrealized losses surpassing 50% in the third quarter of 2022. This unprecedented situation has many questioning what implications this could have for the U.S. banking system and probing the reasons behind this drastic downturn.
To start unraveling this complex situation, we first need to clarify what exactly "unrealized losses" are and how they bear upon banks. Essentially, unrealized losses are losses that a bank sustains but doesn't acknowledge because they are registered as "Held to maturity securities". In an environment where financial markets only seem to be moving up, this may not seem like a significant concern. After all, in such a scenario, people are less likely to panic and withdraw their money, averting the possibility of a bank run.
However, in the event of a bank run, a large volume of withdrawals, banks are forced to liquidate their assets to provide people their deposited money. Due to the nature of the fractional reserve banking system, banks don't have this money available at all times. Instead, they have invested it in assets in an attempt to maximize their profits. And as we've all seen, if banks lose hundreds of billions of dollars due to poor risk management, the FDIC steps in to bail them out, leaving taxpayers to bear the cost.
But why do bond prices and yields fluctuate? This is closely tied to the actions of the U.S. Federal Reserve. When the U.S. stimulates the economy by maintaining low-interest rates, bond values generally hold steady or even increase. However, when the Fed decides to raise interest rates, bond values decrease, reflecting the inverse relationship between bond yield and price.
This led us to the recent failures of three U.S. banks: Signature Bank, Silicon Valley Bank, and First Republic Bank. Shockingly, the sum total of assets belonging to these three banks alone surpasses the combined assets of all banks that went under during the Global Financial Crisis!
For a little perspective, the failure of the Washington Mutual Fund and all other bank failures in 2008 amounted to $524 billion. In contrast, the three banks mentioned previously totalled a staggering $532 billion! If fear takes hold and people begin withdrawing money from banks suffering massive unrealized losses, this sum could balloon even further.
This is an unsettling prospect, to say the least. However, there is still hope that inflation will decrease and the FED will cease increasing interest rates, preventing the price of bonds from plummeting further. Once the FED begins cutting rates, the financial conditions will ease, and with any luck, this will help to contain the banking crisis, especially if these rate cuts are implemented soon.
The economic landscape is shifting, and the banking sector is in uncharted territory. Understanding these dynamics is more crucial than ever. Stay informed and let's navigate these tumultuous financial waters together.