Another day, another downgrade for America. Today it’s the banking sector

Another day, another downgrade for America. Today it’s Moody’s Investor Service, one of the three major credit rating agencies alongside Fitch and S&P.

Last week Fitch downgraded the sovereign debt rating for the United States of America. And late yesterday, Moody’s downgraded the ratings of several US banks.

The implication? The seismic activity that we saw in the banking sector back in March isn’t over. This is no surprise for our readers– we’ve talked about the ongoing risks in US banks several times since then.

The bottom line is very simple: higher interest rates are bad for banks… and it’s easy to understand why:

Banks typically own vast portfolios of bonds, including US government bonds, commercial real estate bonds, housing bonds, municipal bonds, and more. And one of the key influences over these bonds’ values is interest rates.

If you know nothing else about bonds, just keep this one simple rule in mind: when interest rates rise, bond values fall.

Remember that banks spent most of the pandemic buying up huge amounts of bonds at record low interest rates… as little as 0%. But now interest rates are MUCH higher than they were a few years ago.

This means that all the bonds that banks purchased back in 2020 and 2021 have lost an enormous amount of value.

In finance this is known as an ‘unrealized loss’. It’s similar if you buy a stock, but then the stock price falls. You haven’t actually lost money yet because you haven’t sold the stock. But on paper, you’re down.

It’s the same with the banks; their bond portfolios have lost a ton of value because interest rates have risen so quickly. So on paper, they’re down. A lot.

According to FDIC data, banks across the US had $620 billion in unrealized losses at the end of 2022, equivalent to roughly 30% of total capital. That’s a big number.

But banks actually account for their unrealized losses quite dishonestly. Yes I know it’s shocking to think that banks would be dishonest about anything, but it’s true. I’ll explain–

Banks have the option to categorize their bond portfolios in one of two ways. The first category is called Hold to Maturity, or HTM. By classifying a bond as HTM, the bank is essentially saying, “Hey, we will never sell this bond and intend to keep it until the bond matures.”

So if the bank buys a 30-year US government bond and classifies it as HTM, it means they intend to hold that bond on their books for three decades.

The other category is called Available For Sale, or AFS. Bonds that are classified as AFS are, as the name suggests, available to be sold on the market. So if the bank needs to raise some quick cash, it can liquidate some of its AFS bonds.

There is a key difference in how banks account for these different categories, though. Because AFS bonds might be sold, banks are required to revalue them every quarter and record a gain or loss.

So if the value of their AFS bonds decreases, for example, because interest rates keep rising, then the bank will record a big loss.

HTM bonds, however, don’t have to be revalued. No matter how far the HTM bonds may fall in value due to rising rates, banks never have to record a loss.

Naturally, bank executives don’t want to record losses. Losses mean falling stock prices, which mean lower bonuses and compensation.

So, instead of being intellectually honest about their bond losses, banks hide their AFS bond losses by magically reclassifying them as HTM.

This is a huge scam; it means that banks are deliberately understating their losses and overstating their financial strength.

Remember, the losses that the banks are actually reporting amounts to $620 billion. But how big would the unrealized losses be if they were actually honest?

Well, according to one recent working paper from the National Bureau of Economic Research, the real estimate on potential losses is $2.2 trillion.

This is a number so big that it virtually wipes out all the equity in the US banking system. Incredible.

Not to be outdone, the Federal Reserve is sitting on close to $1 trillion in unrealized losses– also thanks to the rapid increase in interest rates that they themselves are perpetuating. It boggles the mind.

So it’s quite possible that the largest, most systemically important central bank in the world is hopelessly insolvent, and the US banking system has wiped out all of its equity.

The larger point is that the problems in the banking sector that we saw unfold several months ago haven’t gone away. In fact, given that interest rates are even higher than they were when Silicon Valley Bank went bust, the problems in the banking system have gotten worse.

Almost everyone (except for us) has been happy to ignore the growing risk in the banking sector. The Fed. The FDIC. The Treasury Department. Financial media.

Moody’s has finally pointed out that the emperor obviously has no clothes, citing the banks’ “sizable unrealized losses”.

Now, don’t get me wrong… I’m not suggesting that another major banking collapse is imminent. A house of cards can stand for a really, really long time as long as nothing disturbs it.

But don’t kid yourself and assume that banks are risk-free. The risks are obvious, regardless of whether anyone wants to admit the truth.

Fortunately there are alternatives; many banks (especially smaller banks and some foreign banks) have much safer balance sheets and take less risk. But there are also options to hold savings outside of the banking sector altogether, including cash, gold, and crypto.

It’s also worth noting that many major banks in the US were recently reprimanded by the FDIC for deliberately manipulating data in an attempt to downplay the risks of their uninsured deposits.

These institutions are clearly pathological liars with no respect for their customers’ dignity. Coupled with the ongoing risks to their bond portfolios, it certainly makes sense to consider alternatives.

Source

Simon Black is an international investor, entrepreneur and permanent traveler. His daily letter is both educational and entertaining, and we suggest that those who want unbiased, actionable information about global opportunities sign up for Sovereign Man’s free, actionable newsletter at http://www.SovereignMan.com.

From Simon Black of SovereignMan.com