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The BIG BADABUM is coming? Unrealized losses, regulatory dilemmas, and the Silicon Valley Bank saga, January 10,2024

recession is coming

Unrealized losses within the echelons of American banks have burgeoned to astronomical proportions, presenting a formidable threat that precipitated the demise of Silicon Valley Bank (SVB) in the preceding year. At present, these unrealized losses constitute an astounding 33% of the aggregate equity capital of banks in the United States, culminating in an eye-watering sum of approximately $700 billion. This financial quagmire primarily emanates from bonds whose valuation witnessed a precipitous decline concomitant with the ascension of interest rates.

To contextualize this fiscal conundrum, even during the nadir of the 2008 financial crisis, unrealized losses merely accounted for a paltry 5% of the equity capital. Prior to the regional bank crisis in the United States, this percentage stood at 22%, but since then, there has been an unprecedented surge in the realm of unrealized losses.

The regional bank debacle, culminating in the ignominious collapse of SVB, compelled financial institutions to divest themselves of unprofitable securities, setting off a financial panic in the incipient stages of 2023. While a bank retains the intent and capacity to retain an investment until its maturity, the unrealized loss remains a theoretical construct. However, there exist exigencies, as exemplified in the SVB case, wherein divestiture becomes an inexorable imperative.

SVB, a lending institution hailing from the sun-drenched environs of California, found itself ensnared in the throes of unrealized losses attributable to government bonds and mortgage-backed securities, constituting a substantial fraction of its capital reservoir. In a desperate bid to extricate itself from this fiscal quagmire, the bank was compelled to liquidate these bonds, thereby incurring tangible losses. The Federal Reserve, cognizant of the exigency, intervened by instituting the Bank Term Fund Program (BTFP), proffering additional financial succor to depositary institutions with the avowed purpose of assisting them in meeting the exigencies of their depositors.

In essence, the BTFP serves as an auxiliary fount of liquidity, obviating the imperative for expeditious liquidation of distressed securities during epochs fraught with financial tension. Nonetheless, it is imperative to underscore that this intervention constitutes more of a palliative measure than a sweeping and comprehensive transformation.

The SVB debacle may well serve as a catalyst prompting regulatory bodies to forestall the recurrence of such financial maelstroms in the future. Nonetheless, the overarching dilemma persists as banks continue to accrue losses that ostensibly do not leave an indelible mark on their profit margins. The crux of the matter lies in the classification of these securities on the proverbial ledgers of these financial institutions.

The initial and ostensibly straightforward option involves the classification of securities predicated on their prevailing market value, a practice typically reserved for assets deemed likely to be divested in the immediate term. The second avenue involves the categorization of securities as "held to maturity," signifying that their disposition is not currently on the institutional agenda. These securities, in this case, remain ensconced within the bank's balance sheet at their acquisition cost augmented by any negligible adjustments.

According to the International Monetary Fund (IMF), approximately 10% of the global banking assets fall under the rubric of "held to maturity." Banks, by and large, tend to overlook unrealized losses and gains stemming from market vicissitudes concerning these securities, relegating them to mere footnotes in their accounting narratives. It is precisely these ephemeral paper losses that have undergone an astronomical escalation.

As of the third quarter in 2023, per the Federal Deposit Insurance Corporation (FDIC), unrealized losses stemming from "held to maturity" assets in U.S. banks reached an apogee, amounting to a staggering $390 billion.

The third prong in this intricate triad involves the acknowledgment by banks of assets as "available for sale" (ATS). In this scenario, banks report unrealized losses, albeit without any consequential impact on their profit margins. Regulatory bodies in the United States, in calculating regulatory capital ratios, ostentatiously overlook these positions concerning all banks except the most colossal entities.

Pertinently, under recently proposed regulatory paradigms, a more stringent dispensation may soon be applicable to all banks wielding assets that transcend the $100 billion threshold. The crux of the matter is rooted in the banks' subjective interpretation of the dichotomy between HTM and ATS assets. Investors, ensnared in a mire of uncertainty, find themselves unable to discern whether a bank indeed harbors the intention of retaining a given bond until its maturity. This issue remains dormant until such time as the bank finds itself coerced into procuring additional liquidity, as exemplified by the Silicon Valley Bank.

The disquietudes assume paramount significance, especially in the case of smaller banks reeling under the weight of substantial unrealized losses, relying on a paucity of deposits. For behemoth investment banks like Goldman Sachs or JP Morgan, the issue assumes a less precipitous character.

One prospective panacea could entail compelling banks to appraise all assets at their prevailing market prices, thereby obviating the labyrinthine realm of ambiguous or "creative" accounting. However, effectuating such a transformation would likely necessitate a protracted and arduous procedural labyrinth, coupled with a seismic shift in accounting standards. Anticipate vociferous opposition from the banking milieu, given that these changes would ostensibly deleteriously impact their financial standing (at least on paper).

In the words of Adam Kobeissi, an analyst at The Kobeissi Letter, "Four years ago, banks were perched on a precipice with approximately $100 billion in unrealized gains. Presently, this precarious precipice has metamorphosed into a chasm, with banks teetering under the weight of $700 billion in unrealized losses. The looming question is: what will ensue when the ephemeral reprieve offered by BTFP dissipates in the ensuing months?"


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