Are we heading for another Credit Crunch?

In 2008, the world global banking system went into meltdown after the bankruptcy of Lehman Brothers. It stemmed from a toxic combination of falling house prices, rising interest rates and sub-prime mortgage debt. To relive the 2008 Credit Crunch – see this article on Credit Crunch Explained (which was one of my earlier articles as an economics blogger)

In 2023, we have some similarities and some differences. Interest rates are rising, bond values have fallen considerably and small and medium sized banks look vulnerable. Silicon Valley Bank failed and required a bailout from the Federal Deposit Insurance Scheme.

The biggest global bank to fail was Credit Suisse a pillar of the supposedly stable Swiss Banking system. It was convicted of allowing money laundering and was criticised for having “lackadaisical attitude towards risk” and “failed at multiple junctures to take decisive and urgent action,” The value of its assets have fallen in recent years.

asset-growth-credit-suisse

After receiving a clean bill of health from regulators, it failed in less than a week. (Bloomberg)

Its rescue involved writing off $17bn of bonds, which freaked out many investors who assumed that kind of bond secure. Global bank shares have lost $459bn in a market rout and one recent paper suggested the assets of American banks are $2 trillion less than their balance sheets suggest. It leaves many small and medium sized US banks facing real stress as investors look for safety. Why is the banking system under pressure yet again, and could it lead to a new credit crunch like we saw in 2008?

Problems at Silicon Valley Bank

The main problem of Silicon Valley Bank is that they simply ran out of cash. During the period of low interest rates, they bought government bonds. But, they were badly caught out by the rapid rise in interest rates.

inverse-relationship-bond-yield-vs-bond-price

As interest rates rise, the value of bonds falls. Therefore, their assets declined so much that when customers became nervous and started to withdraw cash, they couldn’t meet the demand. The rise in interest rates led to unrealised losses. Even the US Federal Regulator, stated at the end of 2022, US banks were sitting on unrealised losses of $620bn.  Unrealised losses is like when you buy a house for £200,000 and it falls in value to £180,000. You have negative equity of £20,000.

house-falls

If you had to sell and repay the mortgage loan, this paper loss of £20,000 would become a realised loss. This is what banks are facing on a much bigger scale.

Silicon Valley Bank made bad decisions and relied ona small number of high risk investors in the tech industry. But, the question is how many other financial institutions are at risk of the unexpected rise in interest rates?

Economists at S&P Global Ratings forecast that corporate default rates in the US and Europe on speculative debt will double this year alone (Bloomberg). Furthermore, the economy is struggling with weak demand due to high inflation and rising interest rates.

uk-inflation-march-23

Higher interest rates at a time of bank anxiety

Whilst Central Banks have to worry about bank failures, they also still face the spectre of high inflation. UK inflation unexpectedly rose to 10.4% last month, on the back of food shortages, but it is not just a UK experience, inflation is still a global issue. Despite inflation set to fall later in the year, Central Banks are still nervous about allowing inflation to become embedded. The problem is that it means they are walking a narrow tightrope, on the one hand they fear inflation and want to increase interest rates. On the other hand, a credit crunch puts pressure on them to cut interest rates.

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Yesterday the Fed increased rates despite growing concerns about the banking sector. You could argue it is a foolhardy mistake to increase interest rates when credit is becoming tight because of bank collapses. But, they didn’t want to panic investors by changing course.

Inverted Yield Curve

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Another problem is that Bloomberg report a deeply inverted yield curve is threatening to reduce banks interest margins and this could lead to a credit crunch. What on earth do they mean by that?

It means that yields on short-term treasuries are higher than those on long-term ones. In the past an inverted yield curve has often been a reliable indicator of recession.  If interest rates are lower on long-term bonds, it means markets expect interest rate to fall over time – indicating a weak economy.

inverse-yield-curve

There was an inverted yield curve for much of 2006, precedeing the recession of 2007. There was also a brief negative yield curve in August 2019, the US went into a Covid induced recession in 2020.

It means that banks expect long-term interest rates to fall because they expect recession. But, in the short-term interest rates are high to deal with inflation.

This is bad for banks because they usually borrow on short-term bonds and lend on higher long-term lending. An inverted yield curve means their usual profit margin is lower.

The economist reports that Deposits in American commercial banks have shrunk by half a trillion dollars. The reason is that investors are moving out of commercial banks and depositing money at the Federal Reserve who are offering 4.5% on short term deposits – much higher than measly 0.4% on bank deposits. This is partly a result of QE that left banks awash with cash. Current interest rates make it attractive to put money in the Federal Reserve

On the other hand, it should be pointed out that rising interest rates can also increase the banks net interest. If they can hold onto low interest bearing deposits and lend out at higher rates, their profit can increase. It is notable than many banks have not passed the Central Bank interest rate onto deposit customers. Recently UK banks have made an extra £7bn through higher base rates not being passed onto customers. Whilst we talk of a credit crunch, it is important to bear in mind the big banks have been highly profitable in recent years.

How does 2023 compare to 2008?

So far the scale of problems in 2022 is not like that of 2008. In 2008, the US was writing off billions in sub-prime mortgage debt that had ballooned during the boom years. Banks are less exposed to this kind of debt than in the past.  The bankruptcy of Lehman Brothers was worth $600bn. US Treasury Secretary Janet Yellen claims the banking system is “sound”. Bank failures also quite common in America – there have been 513 since 2009, though what is different this time is the size of the asset losses.

It is important to bear in mind that the bailouts of Silicon Valley and takeover of Credit Suisse did not involve taxpayers money directly – However, the high cost will eventually be borne by bank customers who will face higher costs as banks reclaw their losses. The problem will come if there is further contagion and a deeper recession than prediction.

swedish-house-price-collapse

Another potential issue is that as well as falling value of bonds house prices are overvalued. Countries like Sweden, Canada and New Zealand have already seen falls in the region of 10-20% house price falls, and the US housing market is vulnerable after years of rising price to income ratios and now rising interest rates.

us-house-price-earnings

However, although house prices may fall, the mortgage market is better regulated than the sub-prime days of 2006. But, even a modest credit crunch would be very impactful for housing markets as any decline in the availability of mortgages on top of higher rates would shrink the buyers market even further.

Optimistic Scenario?

An optimistic scenario, is that inflation will fall this year and we get a ‘soft landing’ – falling inflation, but a recession avoided. This lower inflation rate will allow interest rates to fall. And increase the value of bonds to reduce the amount of unrealised losses.

The Struggle to regulate Banks

But, why do Americans in particular struggle to regulate their banks? As a result of the credit crunch there was a regulatory reform which forced big banks who were considered “too big to fail”, to hold vast amounts of cash or similarly safe reserves to survive a future financial crisis. Medium sized banks were supposed to be part of this but in 2018, the Trump administration raised the size of banks that had to implement the regulations. Silicon Valley were free to invest its deposits in bonds, without holding any security should markets change.

 

Even though the Federal Reserve took the unusual step to guarantee all deposits even those over $250,000 it has caused a loss of confidence in the smaller and medium size banks. There has been an outflow of money into bigger banks and money markets. The effect, is that firstly bank lending rates have increased. There is a now a bigger spread between mortgage rates and base rates. What it means is that even if Central banks keep their base interest rate the same, there is an increase in the actually interest rate faced by mortgage holders and banks. At the moment, the effect is relatively small but, given the tight economic circumstances, a further rise in interest rates will have a significant effect on reducing demand. The concern is that more financial institutions are still to feel the full effect of higher interest rates on their business model.

Are we heading for credit crunch

So are we heading for a credit crunch? I agree with Paul Krugman in his recent newsletter that we don’t really know. America has had bank collapses in the past – without a major credit crunch, but we live in uncertain times, and the dichotomy of high inflation, bank failures leaves policymakers with an unenviable situation. The global economy is on a narrow tightrope and could easily fall into the chasm. We should never forget how bank runs can be catastrophic for the economy and were a major factor in the great depression – check out this video on bank bailouts.

Further reading

 

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