//Jeff Marsico remarks to the 2023 New Jersey Bankers' Association Annual Convention: May 19, 2023//
Four decades ago, the prolonged savings-and-loan crisis devastated the industry. Between 1980 and 1995, more than 2,900 banks and thrifts with collective assets of more than $2.2 trillion failed. More recently and by comparison, the mortgage meltdown and subsequent global financial crisis took down more than 500 banks between 2007 and 2014, with total assets of nearly $959 billion.
Outside of those two crisis periods, American banking failures have generally been uncommon, at least since the end of the Great Depression. Between 1941 and 1979, an average of 5.3 banks failed a year. There was an average of 4.3 bank failures per year between 1996 and 2006, and 3.6 between 2015 and 2022. Before SVB, Signature, and First Republic, in fact, it had been over two years since the last bank failure.
Because our industry has been fairly stable except for a few extraordinary periods, doesn’t mean we can’t learn from tough times as both crises had long germination times and were predicated on factors that were both known and observable.
The recession of 1990 was caused, in part, to the decade-long S&L crisis. The crisis stemmed from a variety of factors, but none contributed to the meltdown more than inflation and the attendant interest rate increase. The early 1980s was a difficult time for the United States, as consumers faced rising prices, high unemployment, and the effects of a supply shock—an oil embargo—which caused energy prices to skyrocket. The result was stagflation, a toxic environment of rising prices and declining growth, sinking the economy into recession.
To fight inflation, the Fed raised rates aggressively (familiar?). And S&L’s had long-term, lower yielding mortgages funded by shorter term deposits. The old borrow short, lend long strategy. Struggling to raise asset yields, S&L’s turned to commercial real estate, junk bonds, even art to combat rising deposit costs.
I want to read to you the FDIC’s conclusion from their An Examination of the Banking Crisis of the 1980’s and Early 1990’s. This will be fun.
“The regulatory lessons of the S&L disaster are many. First and foremost is the need for strong and effective supervision of insured depository institutions, particularly if they are given new or expanded powers or are experiencing rapid growth. Second, this can be accomplished only if the industry does not have too much influence over its regulators and if the regulators have the ability to hire, train, and retain qualified staff. In this regard, the bank regulatory agencies need to remain politically independent. Third, the regulators need adequate financial resources. Although the Federal Home Loan Bank System was too close to the industry it regulated during the early years of the crisis and its policies greatly contributed to the problem, the Bank Board had been given far too few resources to supervise effectively an industry that was allowed vast new powers. Fourth, the S&L crisis highlights the importance of promptly closing insolvent, insured financial institutions in order to minimize potential losses to the deposit insurance fund and to ensure a more efficient financial marketplace. Finally, resolution of failing financial institutions requires that the deposit insurance fund be strongly capitalized with real reserves, not just federal guarantee.”
My lesson learned to the regulators, read your past lessons learned. To you, manage your interest rate risk. Before becoming desperate and trading interest rate risk for credit risk. This crisis hatched the more sophisticated ALCO tools we have today. Currently, not many (if any) financial institutions have experienced negative spread as they did in the early 80’s. Yet.
The dot-com bubble recession began in March 2001 and lasted only 8 months. High-tech employment fell from 12.1 percent of all jobs in 2001 to 11.3 percent in 2004, a decline of 1.1 million jobs, as the high-tech sector was harder hit by the bursting of the bubble and its aftermath than other sectors of the economy. By comparison, non-high-tech industries lost 689,000 jobs between 2001 and 2002 but recovered the lost jobs by 2004.
What caused a dot-com bubble? In the late 90s, low interest rates made speculative equity investments more attractive than bonds, and at the same time, innovative internet companies grew in popularity among retail investors, professional traders, venture capitalists, and the like (familiar?). When the Taxpayer Relief Act of 1997 passed, the top capital gains tax rate was lowered, providing yet another incentive for equity speculators to pour money into the fledgling internet industry. The Y2K scare also had companies pouring money into tech firms.
Between 1995 and its peak in March 2000, the Nasdaq Composite stock market index rose 800%, only to fall 740% from its peak by October 2002, giving up all its gains during the bubble. Lesson learned, meteoric rises are often accompanied by gravitational falls. And it is so difficult to be the odd-one out at the cocktail party full of those that participated in the ascent… during the ascent. Taking your own punch bowl away when the party is getting good takes fortitude.
The Great Recession, in contrast to the relatively short dot-com bubble recession, officially lasted from December 2007 to June 2009, the longest recession since the Great Depression. What caused it? Economists cite as the main culprit the collapse of the subprime mortgage market — defaults on high-risk housing loans — which led to a credit crunch in the global banking system and a precipitous drop in bank lending. Who would’ve thought lending $1 million to a San Francisco cab driver to buy a house at 100% loan to value would go bad?
And quite frankly, I did not know there were so many tranches to mortgage-backed securities. Although community banks did not lend to sub-prime borrowers in any meaningful way, did we participate? In many respects, community banks were caught in the cross-fire through the purchase of those mbs instruments – and subsequent trial through public sentiment. We took a serious reputational hit.
According to the FDIC, the causes of the 2008-09 financial crisis lay partly in the housing boom and bust of the mid-2000s; partly in the degree to which the U.S. and global financial systems had become highly concentrated, interconnected, and opaque; and partly in the innovative products and mechanisms that combined to link homebuyers in the United States with financial firms and investors across the world. Capiche? (credit default swaps anyone?).
In 1991 FDICIA was passed into law. It had a provision that prohibited assistance to failing banks if FDIC funds would be used to protect uninsured depositors and other creditors (hmm, think about that in light of recent events)—but the act also contained a provision allowing an exception to the prohibition when the failure of an institution would pose a systemic risk.
In 2008, by relying on the provision that allowed a systemic risk exception, the FDIC took two actions that maintained financial institutions’ access to funding: the FDIC guaranteed bank debt and, for certain types of transaction accounts, provided an unlimited deposit insurance guarantee. In addition, the FDIC and the other federal regulators used the systemic risk exception to extend extraordinary support to some of the largest financial institutions in the country in order to prevent their disorderly failure, setting precedent for what we now know as Too Big to Fail (TBTF), or Systemically Important Financial Institutions (SIFI).
Although community banks did not play a significant role in subprime lending, the runup and subsequent decline in real estate values had a profound impact on their safety and soundness. Most of the more than 500 financial institutions that failed were community banks. When your construction loan is greater than what a builder can reasonably recover, when your home or commercial mortgage is larger than its value, you’re going to have bad loans. We knew there was tremendous hubris in the subprime market. We thought since we were only tangential players, we were insulated. What we found out is the interconnectedness of real estate values and the contagion that it can cause.
Remember K Bank in Maryland? In 2006, the then $686 million in asset bank made $8.8 million, or 1.38% on assets and 16.38% on equity. They were killing it in construction and development loans. At industry events they had that wry grin saying, “yeah, we perform better than you.” After losses of $24 and $23 million, respectively in 2008 and 09, the regulators in 2010 said enough is enough. M&T assumed their $411 million of loans and securities with a $289 million FDIC loss-share agreement. Let those numbers sink in a bit. It didn’t take long for the profit GOAT to become, well, an actual pig. Lesson learned, beware of how a runup in asset prices might impact your assets and diversify accordingly.
After the Great Recession, we had over 10 years of economic expansion, albeit anemic economic expansion. Economists were rubbing their crystal balls trying to accurately predict when the next recession would begin so that they could seal their celebrity on CNBC. But it never came. Instead, Covid came.
So many extraordinary things happened during Covid that I’m not certain if they will ever repeat themselves in our lifetimes. Most lessons were for bureaucrats. I think we have enough experience to know bureaucrats don’t learn well. They learn short, forget long.
A substantial yet brief recession ensued. Followed by extraordinary government support that came in multiple trillion dollar plus fiscal stimulus packages so competing administrations could outdo one another on government assistance funded by ridiculous sums of debt, largely purchased by the Fed. Money supply expanded wildly. This amount of stimulus shielded our loan books from experiencing any material losses.
And what happens when the government prints money? Inflation. I think I learned that in economics 101 or reading anything written by Milton Friedman. Perhaps bureaucrats would benefit from a brief stroll through an econ book. Not written by Paul Krugman.
Recall that the S&L crisis was caused, in part, by inflation and the subsequent rapid rise in interest rates orchestrated by the Fed. Well, this time, the Fed raised rates faster because they misdiagnosed inflation as transient. Or, the cynic might read it as, our Chairman is up for renomination and we won’t raise rates until he owns the gavel.
The Fed Funds rate was zero in December 2021. It didn’t take a rocket scientist to predict rates would go up. And we positioned our balance sheets accordingly. And in December 2021 our liquidity positions were so strong we didn’t know what to do with the money. Good times.
Some of us took our liquidity and bought longer-term bonds – at historically high prices - to try and increase yield. Most banks consider their securities portfolio as first and foremost for liquidity. When you elevate yield over liquidity, bad things can happen. Don’t get me wrong, giving up yield for liquidity could also be bad. But there are different degrees of bad. But, no worries, right, AOCI was excluded in regulatory capital ratio calculations, and we could hide some of that interest rate risk in HTM securities.
Then we realized we needed a special exemption from our FHLB’s regulator to borrow money from our FHLB if our GAAP equity or tangible equity was below zero. I remember being at a Bank CEO Network event in Denver when CEO’s learned of this knowledge nugget. Some seemed panicked.
But we still had plenty of liquidity, right? Rates were rising fast, but we weren’t raising our deposit rates accordingly. Our deposit betas were phenomenally low. We thought our customers would stay with our bank, no matter what. We bragged about it in our earnings releases.
Then depositors woke up. First municipalities and larger commercial customers, and more sophisticated retail depositors. Even I started to wake up. I don’t get angry at my bank that often, but when I found out I was earning .01 percent on my money market account when the Fed Funds rate rose to five, I was angry. My bank was taking advantage of me because I didn’t babysit my money. They will not be my bank for long. I – like many – will use technology to move my money but keep my account open – costing the bank money.
But what of SVB, Signature, and First Republic? Three different banks and business models. All were enviable in some sort of way. All suffered extraordinary runs on their bank due to large unrealized losses on both HTM and AFS securities, peculiarities in the p/e world, uninsured deposits, crypto, and old school panic via new school technologies and social media.
For community banks, it’s not as much about the uninsured deposits or even the AOCI. We were concerned about the panic. The extraordinary measures taken by our government and us in employee and depositor communications, makes panic less likely.
Our pressure on deposits was because we let the difference between what we paid depositors and what they could earn in alternatives become too large. And we should’ve been able to predict this – but we did not want to be honest and thought our customers were all ours. At the end of tightening cycles, deposit betas have risen like hockey sticks. And given the transparency of deposit pricing and the ease of moving money from our bank to alternatives, why did we think it would be different?
Our lesson learned in this most recent crisis, in my opinion: don’t let market rates get too far ahead of what you pay depositors, unless you think it’s worth those two or three quarters of superior cost of funds to aggravate your depositors and force them to seek alternatives and lose trust in you. Be extremely cautious elevating yield over liquidity in your securities portfolio… I would’ve liked to have been a fly on the wall at SVB when they decided to deploy their extraordinary liquidity position in long-term (and relatively low yielding) bonds without hedge. Revise our contingency funding plans to ensure that the liquidity will be available if 400 of our banking friends are waiting in line at the same time and at the same window. And ensure our business continuity plans or crisis management plans includes a communication plan to employees and customers to restore confidence in our bank even when confidence in banking has been shaken.
So, to summarize my lessons learned from every crisis in the last 35 years:
- Manage your interest rate risk;
- Meteoric rises are often accompanied by gravitational falls. Recognize the rise;
- Beware of how a runup in asset prices might impact your assets and diversify accordingly;
- Don’t let market rates get too far ahead of what you pay depositors;
- Be extremely cautious elevating yield over liquidity in your securities portfolio;
- Revise our contingency funding plans to ensure that the liquidity will be available if there is a run on your liquidity resources;
- Ensure our business continuity plans or crisis management plans includes a communication plan to employees and customers to restore confidence in our bank.
So what of the next crisis? Will it be non-residential real estate? We’ve had pretty frothy real estate runups – in terms of rental rates and insurance expenses despite increasing vacancy rates. Will it be commercial office space as the pandemic chased workers out of office buildings only to have them slowly return, if they return at all? Will it be retail commercial real estate, as the pandemic accelerated our preference for online shopping making zombie mall owners desperately looking for alternatives? Spread of the Ukraine war?
So many questions that we at The Kafafian Group toyed with the idea of having a fun conference to debate emerging risks to banking called “Predictapalooza” where we would have industry pro’s stand up and make some “what if’s” to help us shape our risk management practices. Outside the box what if’s, such as what are the chances and how should we prepare for, I don’t know, a worldwide pandemic?
I don’t know what the next crisis will be. And I’m skeptical about those that say they know.
What I do know is that almost everyone in this room has been through every crisis I discussed. They were all different. They all forced us to learn from them and make adjustments on how we managed our balance sheet and our banks. And they’ve all made us better bankers and more capable to handle what “crisis” comes next.
We learn and we move on. It’s all we can do.
