Opinion: Banks managed credit risk, but not interest-rate risk. Now we’re all paying the price.

This “hot potato” behavior is evident in the U.S. economy now. For example, over the past decade, many homeowners refinanced their houses with cheap mortgages. Some of these loans were kept by banks, while others were converted into mortgage-backed securities and sold to insurance companies, pension funds, corporations and consumers. The majority of mortgages are fixed-rate, so consumers’ ability to remain in their homes is not affected by rising interest rates.

However, the risk did not leave the system; it just got transferred from consumers to banks. Long-term mortgages — seemingly low-risk — have declined in value by 20%-30%. Not only mortgages have suffered these declines, trillions in long-term bonds issued by governments and corporations at near-zero interest rates are burning holes in the pockets of those who bought them.

Fighting the last war

The human mind is conditioned to fight the last war. We usually compare inklings of new crises to past ones. Mark Twain famously said, “History does not repeat itself, but it does rhyme.” This is why past wars and past crises rarely repeat verbatim; they merely rhyme in slightly different ways.

The Great Financial Crisis (GFC) of 2008, for example, is still fresh in society’s memory. The U.S. banking system now has higher reserves and more conservative underwriting standards, and is better prepared to avoid or survive through a crisis of the same type and magnitude as the GFC.

That’s what we thought. But with Uncle Sam dumping $5 trillion into the economy during the pandemic, banks were flooded with consumer deposits that either paid no interest (non-interest-bearing) or almost no interest (interest-bearing).

Banks had a dilemma: All this free money (deposits) did nothing for the bank’s profits if it sat idle. So the money was loaned or invested. Banks had learned their lesson from the GFC and did not take on higher credit risk, but they took a different risk — duration risk. And why not? For the past three decades interest rates had gone only one way – down.

Also, this is what banks do — borrow short-term (deposits) and lend long-term. Yet because rates were so low, many banks had to lend very long-term to capture extra yield. This worked for a long time, and banks were minting money. Then inflation spiked, rates went vertical and losses soared as long-term bonds declined 20%-40% in a matter of months.

Bonds, hard places and SVB

Banks suffered on both the asset- and liability side of the balance sheet. If they chose to categorize long-term bonds as available for sale, they had to mark them to market and immediately book losses, reducing their equity, which capped their ability to lend without shrinking their cushion to withstand future losses.

If they categorized long-term bonds in the hold-to-maturity section of the balance sheet, they didn’t have to realize the losses — but the nightmare would reappear for a decade or longer on their income statements.

Silicon Valley Bank (SVB) is a magnified view of what many U.S. banks are facing today. SVB is also a sad demonstration of how volatile deposits are.

SVB was awash with deposits from its customers, mainly startups, raising money in the venture-capital boom. It invested a large portion of these deposits into mortgages and U.S. Treasurys that paid around 2.5%. Then the boom ended, and startups, which are usually in a perpetual state of losing money, began to deplete their cash balances. As they withdrew their deposits, SVB was forced to sell its losing bond portfolio and realize about a 10% loss. With every dollar of deposits withdrawn, it had to transfer 10 cents from the equity (shareholder) side of the balance sheet.

In its final days, SVB was running out of those 10 cents. The bank was going to raise equity (issue stock) to fill in the hole caused by the decline in bonds, but depositors ran for the door, forcing further liquidations of underwater securities. SVB went through an almost-classic bank run. The company ran out of equity, which put it into bankruptcy.

Even if SVB had managed to issue equity, substantially diluting its shareholders, it would have had to find a new way to finance its long-term loan portfolio. While interest rates had gone up a lot — borrowing at 4% and being paid 2.5% is not a sustainable business model.

A similar scenario awaits the U.S. banking system, which is drowning in consumer deposits. If interest rates and prices stay at this level or go higher, American consumers will do what they are unmatched at: withdraw and spend the savings that were given to them by kind Uncle Sam. Thus deposits (both interest- and non-interest-bearing), the banks’ cheapest cost of funding, will leave the banks to pay for the cost of consumer goods.

Also, while interest rates were near zero, consumers did not care if their deposits paid interest or not, as the interest amounted to almost nothing. Yet as inflation has spiked and interest rates have jumped, leaving money in a checking account that pays nothing has become costly.

As consumers shift more money to interest-bearing deposits, then, like SVB, more banks will be paying depositors 4% (instead of 0%) while receiving 2.5% for 30-year mortgages that are in the hold-till-maturity column of their balance sheets.

This has a significant implications for the economy. What we are likely going to experience is the opposite of what we observed over the past 10 years: credit will become dear and financial institutions will not be stretching for yield.

Losses from the decline in long-dated assets will reduce banks’ equity and earnings power. This also reduces banks’ ability to lend, sucking credit out of the economy. The cost of financing of everything from cars to factories will rise, while the decline in banks’ equity weakens the banking system’s ability to handle the higher defaults that will inevitably come in the next recession.

Vitaliy Katsenelson is CEO and chief investment officer of Investment Management Associates. He is the author of Soul in the Game – The Art of a Meaningful Life.

Here are links to more of Katsenelson’s views of the inflation landscape (read, listen) and how to invest in inflationary times (read, listen).  For more of Katsenelson’s insights about investing, head to ContrarianEdge.com or listen to his podcast at Investor.FM.

More: Silicon Valley lost its bank. Expect ‘zombie VCs’ and dark times for startups.

Plus: No regulation or law can fix incompetent bank management, former FDIC chief says