How the Coming Credit Crunch Could Harm the Economy and Real Estate Prices
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Audible. There's more to imagine when you listen. Go to audible.com slash imagine and discover all the year's best waiting for you. Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I'm your host, David Stein. Today is episode 428. It's titled, The Coming Credit Crunch, How One Crisis Spawns the Next.

A month ago in episode 424 of the podcast, we discussed the collapse of Silicon Valley Bank. It was a classic bank run. 96% of Silicon Valley Bank's deposits were uninsured because they were above the $250,000 FDIC deposit insurance limit.

The vast majority of those deposits were from startups and other businesses tied to the venture capital industry. When word spread that the bank was in trouble, Silicon Valley Bank depositors tried to withdraw $42 billion in one day on March 9th, 2023. That was 24% of the bank's deposits.

The Federal Deposit Insurance Corporation seized Silicon Valley Bank the next day before it opened. It was the second biggest bank failure in U.S. history, second only to Washington Mutual's collapse in 2008. And it took just a matter of hours. That weekend after the bank collapsed, there was a lot of grumbling, if not fear-mongering, by venture capitalists and others about those uninsured deposits.

On Sunday, that weekend, the Federal Reserve and the FDIC, after consulting with President Biden and Secretary of Treasury Yellen, announced that they would make a systemic risk exception and fully protect all depositors. Both the uninsured and the insured depositors would have access to all their money on Monday, March 13th. In the announcement,

The Federal Reserve and the FDIC made a point to let everyone know that the shareholders of the bank and certain unsecured debt holders would not be protected. Now, they're still trying to settle Silicon Valley Bank. The bondholders, the preferred stockholders are negotiating. We'll see what the ultimate losses are.

On that same Sunday, the Federal Reserve announced a new program, the Bank Term Funding Program, BTFP. This program offers loans to banks, savings associations, credit unions that are willing to pledge high-quality collateral, such as U.S. Treasuries, agency debt, and mortgage-backed securities. The purpose of this lending program is to allow banks to meet deposit withdrawals with

without having to sell bonds that they have on their balance sheet and realize losses, like Silicon Valley Bank had to do. They were selling bonds. They had all of these U.S. Treasury bonds and other bonds that had fallen in price because interest rates had increased. By being able to borrow the money from the Federal Reserve instead of selling bonds, then ideally more banks won't go insolvent because they're having to recognize losses on bonds.

Across the banking sector, there's over $620 billion of unrealized losses on bonds that they hold. As of April 5th, 2023, banks have borrowed close to $80 billion under this bank term funding program.

The good news, though, is that while bank deposits have dropped, there hasn't been an all-out bank run. That was one of my biggest fears coming out of the Silicon Valley bank collapse. The most recent data we have is as of March 29, 2023, and it shows U.S. commercial bank deposits were $17.2 trillion, $500 billion lower than what deposits were at the end of February 2023.

That's about a 3% decline in deposits. 13 months ago, at the end of February 2022, deposits are down about $900 billion from then. That means of that $900 billion reduction in deposits in the last 13 months, 55% of the reduction came really in the last four weeks. Now, this data is seasonally adjusted data.

And that allows for better comparison of one period to the next because deposits can change based on, for example, when taxes are due, etc.

If we look at the top 25 largest U.S. banks, their deposits from the end of February through March 29th have dropped about 1.5%, or $157 billion, to $10.6 trillion. Smaller banks, which would be all banks not included in the top 25, have seen a bigger decline in deposits, $250 billion, or 4.5% of their deposits.

Those smaller banks have $5.3 trillion in overall deposits. The fact that small banks have experienced greater withdrawals on an absolute basis and a percentage basis, that's not surprising.

The FDIC and the Federal Reserve stepped in to say that Silicon Valley Bank, a bank that wasn't a super big bank, it had $250 billion in assets, that it was systemically important and it needed to guarantee, the FDIC needed to guarantee all of the deposits upon the bank's failure. Now, if you're a business owner, why wouldn't you be shifting your bank deposits from a smaller bank

to a larger bank that is deemed systemically important, knowing, if that's the case, that even your uninsured deposits will probably be protected.

That's what they're doing. And I'm actually surprised there hasn't been a bigger shift in deposits. We'll see. In our weekly Insider's Guide email newsletter that will go out today, I'll share a chart and you can see the bank deposits for the smaller banks and the larger banks. And you see a big drop off in smaller bank deposits. Well, prior to that, the smaller bank deposits have been fairly consistent.

consistent over the past year, while the larger bank deposits have actually been declined and they've declined a little bit more. But you can definitely see the big drop off in March in smaller bank deposits.

Now, what are the ramifications of banks losing these deposits? Well, first off, because of this new lending program with the Federal Reserve, the banks don't have to sell bonds, recognize losses, and so they remain solvent. They're not going insolvent because they're having to sell bonds that are underwater. But the other big impact is a hit to profitability. Is

as part of pulling together information for taxes, happened to look at the interest rate on our business checking and savings account at Wells Fargo. Wells is paying 0.1% on our checking account and 0.14% on our savings account. Incredibly, like, why even bother? I asked the bank when I was there the other day, do you have like a CD we could buy or something? We

Within the bank that we could get a little higher yield and they really didn't. So we're basically left to pull money out of Wells Fargo if we want to get a higher yield. We haven't done it. Even at our personal bank account, the yield's about 0.5%, which is about the average deposit rate.

Now, there's a reason why banks pay so little on deposits. A common measure of bank profitability is what's known as the net interest margin. And it's the difference between the interest income on loans and the interest paid on deposits. And it's as a percentage of essentially the loan book or the interest-producing assets that the bank owns.

So for example, the net interest margin across all U.S. banks right now is 3.03%. That means basically the interest rate on loans on average is 3% more than the interest paid on deposits. Now, a year ago, at the beginning of 2022, that net interest margin was 2.3%. So it's actually increasing as loan rates start to move up higher.

and deposit rates have stayed fairly steady. But it does take time for banks to raise rates because many of their loans have been in place and they were issued over the last number of years when interest rates were much lower. The jump in rates, particularly short-term rates, has been incredible. The magnitude, basically going from close to zero to approaching 5% in just over a year.

Now, if you're a smaller bank and you're losing deposits, but you don't want to raise money by selling bonds to meet withdrawals, so you take some of the U.S. Treasury bonds, you use them as collateral to borrow from the Federal Reserve as part of their bank term funding program. Now, the problem with that is you're paying 0.5% on the deposits, but the interest rate on the loans from the Federal Reserve is 4.8%. How?

than what you're earning on your loan book. And so that significantly reduces profitability because the low interest rate deposits are leaving and the banks are having to plug the gap by borrowing from the Federal Home Loan Bank at over 4% or they're borrowing from the Federal Reserve. So it's having a significant impact on profitability. Chris McGrady, who is an analyst with KBW, said...

The profitability of the sector has gotten a lot harder in the past month. Bank boards are going to have to discuss whether it still makes sense to be an independent company. There's that type of pressure on banks. Perhaps we'll need to merge because the net interest margin is potentially going to be impacted if depositors continue to pull money from banks.

Now, what do banks do in this situation? Well, one thing they do is they just don't loan money as much. They're more restrictive in their lending.

Small and mid-sized banks provide a very large portion of commercial loans. For example, Capital Economics points out that 43% of loans held by small banks are for commercial real estate. And about a third of loans in the U.S. are granted by banks between $10 billion and $150 billion in assets, sort of that mid-

tier type sector that are really struggling and are seeing the biggest impact on withdrawals. Banks provide 58% of commercial mortgage loans and 32% of loans on multifamily housing.

These holders of these loans, the loans might mature and then they need to refinance them. And if banks are being stingier in terms of their willingness to lend, and we'll explain why in a couple of minutes, why banks are actually pulling back their lending as their deposits flee. But there is the potential because loans are being priced higher, that that will put downward pressure on private real estate values. We've already seen a sell-off over the past year in...

public real estate equity trust or public real estate, or basically these are investment vehicles that invest in commercial real estate, but their prices have fallen over 20%. But if we look at the pricing of equity REITs versus private real estate, private real estate potentially has another 15 to 20% to fall based on appraisals to catch up with where public REITs are

or price data. And one reason is just the real challenge that real estate projects are having in getting loans.

Now, if you have been a longtime listener of Money for the Rest of Us, you're probably saying, wait a minute, David, you have repeatedly said in the past that banks don't need deposits in order to make loans, that it's the opposite, that bank loans create new deposits. And that's true. When a bank makes a loan, it records as an asset the loan receivable, and then it electronically creates the deposit

for the borrower, which is a liability of the bank, and then so we have the asset offset by the liability. But think about it. Most borrowers, when they borrow money for a commercial real estate project, they pull the deposits out, and they spend the money. And when that deposit leaves that liability, that flows through the banking system, and the reserves that the bank has at the Federal Reserve is lowered.

If a bank sees a big drop in deposits, then its reserves at the Federal Reserve keep getting lower, and so the bank becomes reprehensible.

less liquid. Banks have to maintain certain liquidity standards per regulation. Back in episode 270, we quoted Jane Errig, who is, or at least at the time, was the associate director and economist at the Federal Reserve Board of Governors. And she was talking about why the amount of reserves that banks have

have at the Federal Reserve that they say they need is so much higher. Prior to the great financial crisis, banks' excess reserves were only about $20 billion.

Now banks are saying they need between a trillion and $1.4 trillion. Erg writes, the eye-popping increase and the projected level of reserves needed in a large part results from new liquidity regulations, things that were put in place to make banks safer. Now banks need more reserves. So if those reserves are being drained because deposits are exiting, banks are

have to get more deposits to build up their liquidity. So it isn't so much that they need deposits to make loans. It's just that when they make loans, it creates a new deposit that then leaves and then lowers the reserves the banks have. And so if we look at what banks are saying, the least initial surveys, and there'll be a new batch of data coming out in early May, suggest that banks are being more strict in their lending and perhaps not lending as much.

Anirban Basu, who is the chief economist at Associated Builders and Contractors, said, people are for the first time in some time using the C word, credit crunch. What I'm hearing and what I'm beginning to hear from contractors is that credit is beginning to tighten.

I saw some data from the Dallas Federal Reserve, and they were looking at the percentage of banks that are decreasing their loan volume in the past six weeks. And that survey said 47% were decreasing their loan value, while another 25% were reporting no change, and 28% were increasing loan value. So almost...

Half were decreasing their willingness to lend, and 38% reported tightening credit standards. Before we continue, let me pause and share some words from this week's sponsors.

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Shopify.com slash David. Where are all these deposits going that are leaving banks? A lot of them go to money market mutual funds. If we look at money market mutual funds, and what are they? First, they're a type of mutual fund. They're registered under the Investment Company Act of 1940, and they're popular as a cash management vehicle because they pay such high interest rates.

They're also popular if it's a retail money market mutual fund. It seeks to maintain a value, a net asset value per share equal to $1. And we've talked about money market mutual funds at length in episode 333. It's like commercial banks, is private money. It's not explicitly guaranteed by the federal government like banks.

bank deposits are up to a certain level. But when money market funds have gotten into trouble, the Federal Reserve has stepped in and guaranteed deposits at money market mutual funds. Running a money market mutual fund is a very different business model than running a bank. If you run a money market mutual fund, you invest the money, the cash you receive, and the

And then you charge an asset management fee, an expense ratio, which last year averaged 0.13%. That's different from banks. Banks make money by lending and maintaining a positive net interest margin. Being a money market mutual fund manager is a much simpler business model. Where, though, do money market mutual funds invest the cash they receive?

They can buy short-term government bonds. They can buy short-term debt issued by corporations, known as commercial paper. They can buy bank certificates of deposits, and it's only a couple percentage points of money market mutual fund assets. But they can also invest the money with the Federal Reserve using what are known as reverse repos. And repos stands for repurchase agreement.

The Federal Reserve has a program called the Federal Reserve Overnight Reverse Repo Facility. And what it involves is a money market mutual fund gives the Federal Reserve, the U.S. Central Bank, cash, and in return it receives treasury securities as collateral. And then the Federal Reserve pays the money market fund an interest rate. That's very close to the Fed funds rate, 4.8%. Fed Governor Christopher Waller said every day...

Firms are handing us over $2 trillion of liquidity they don't need, most of which is in money market mutual funds. He continued, they give us the reserves, we give them securities, they don't need the cash. Now, if your mind's kind of going, wait a minute, this seems very, very circular. It is. Let's see how we got here.

First, there was the pandemic. And then governments around the world, including the U.S. government, they did massive stimulus programs to keep the economy from completely collapsing. So there were programs just sending businesses and households money. At the same time, central banks, including the Federal Reserve, were out buying government bonds and mortgage-backed bonds forever.

through quantitative easing. We've done episodes and we've described that when governments run a budget deficit and the central bank basically funds that deficit by buying bonds, which they do by just printing money out of thin air, that that leads to an increase in wealth in the economy and an increase in cash, in liquidity. And we saw that. M2, a

A monetary aggregate that's made up of cash, checking, savings accounts, money market mutual funds, CDs. That jumped from $15.3 trillion right before the pandemic to upwards of $22 trillion last year. That's a 43% increase in the money supply. Cash flowing into the economy increased wealth because the government was just sending people money.

We have more wealth, there's more money, and there's some supply constraints for goods and services because of the pandemic and because people during the pandemic want more goods than services because they can't leave their house. And that's a recipe for high inflation. That's what we got. So what does the Federal Reserve do? Well, they start raising the policy rate, the Fed funds rate.

in order to dampen demand so that people are less willing to borrow because interest rates are higher. We see yields on short-term bonds and long-term bonds increase. And their prices fall, including the $620 billion loss on banks' balance sheets.

As interest rates start going up, then the yield on money market mutual funds become way more attractive. Investors pull money from the banks, invest it in the money market mutual funds. The banks then are forced to borrow from the Federal Reserve in order to fund those withdrawals. The banks put up collateral of treasury bonds, give it to the Fed. The depositors take that money and then they put it...

with money market mutual funds. And where do the money market mutual funds invest the money? Well, they just put it back with the Federal Reserve and earn interest and get collateral from the Fed as security. And then because banks have less deposits, they're forced to restrict lending. And now we have a potential credit crunch that could harm the economy.

It's incredibly circular, just money made up, flowing around, sloshing around the system. We've actually been here before. Similar situation back when I was in college. It was the savings and loan crisis that went from the mid-80s to the mid-1990s. 1,043 savings and loans, which are also called thrifts, collapsed out of 3,200. It cost the taxpayers in the U.S. about $100 billion.

It was caused because the Federal Reserve, under Fed Chair Paul Volcker, was dramatically increasing short-term interest rates, the policy rates, in the early 1980s. And due to some deregulations, money market mutual funds were available for the first time.

Deposits started leaving these savings and loans, and yet the savings and loans weren't liquid enough to meet withdrawal. They had to start dumping assets to try to meet deposit withdrawals. They tried to start raising their deposit rates to keep money from flowing out, which killed their profitability, and so a thousand of them collapsed.

In order to sort of unwind the collapsed savings and loans, dispose of the assets, try to recover as much as possible, the federal government established the Resolution Trust Corporation, the RTC. And when I first got into finance and investing, there was a lot of talk about the savings and loan crisis. And there were people, businesses, investors making a ton of money off

off of buying assets on the cheap that were disposed by the RTC, because there were so many in Texas and all around the country. Many hedge funds made a lot of money on those assets because they bought them cheap, they held them, and then they sold them. And ultimately, the losses were $100 billion, which seems small compared to just in the last month, we've had $80 billion borrowed from the Fed by banks in order to...

deposit withdrawals that are flowing back to the Fed through these money market mutual funds. One crisis leads to the next. It's sort of like whack-a-mole. Money is a made-up thing. It's created out of thin air. It sloshes around the economy. It's very circular. And the reality is, as we get one crisis and another, central bankers, politicians meet and they figure out how

How do we keep trust? What can we do so we don't get a bank run on private money, be it commercial bank deposits, be it money market mutual funds? Because at the core, it's trust.

Banks are highly leveraged. And if households and businesses really get spooked and pull their money from banks, it would be an incredible catastrophe. It would lead to a severe recession, if not depression. Fortunately, we're not there yet. There seems to be at least enough trust for now. But as I've said in numerous episodes, that if households, businesses, investors lost confidence in the Federal Reserve,

the central bank, then you really see the potential for hyperinflation because then people don't trust the dollar at all. And you can get a significant drop off in the dollar. And we've seen that in other countries, in Turkey and in Lebanon, where the central bank and the banking system was effectively close to being insolvent. And you saw the currency collapse and a huge spike in inflation because import prices soared.

We're not there yet. Things are holding their own, but we will see a credit crunch, less willingness of banks to lend because of exiting deposits. Hopefully it won't be too severe. We just finished up our monthly investment conditions and strategy report on money for the rest of us plus. And we looked at where conditions were. Economic trends are still red, but they've not fallen off aggressively.

If we look at services, some of the business surveys there, they've actually improved. So while we've seen about a half trillion dollars exit the banking system, there's still 17 trillion dollars there. There is much more that could be pulled if households and businesses got really worried and they're not there yet.

So what the Fed and other central banks have done seems to have stabilized things for now. We'll continue monitoring the data, the anecdotal evidence to see if things change. But what should we do?

Make sure our money that's had banked is under the insurance limit. And if you're a business, maybe if you have more than $250,000 in your U.S. bank account, maybe you do move some to a larger bank and keep the amount at smaller banks under the $250,000.

We want to make sure our money is insured and protected, but we also need to own productive cash flow generating assets that can include real estate, it can include stocks, own real things so that we can earn returns greater than inflation. Because inflation, as we've seen, is embedded in the

the entire monetary system. It assumes that we'll have inflation because the money supply keeps going up. It tends to go up in big jumps when we get a financial crisis and central banks effectively start monetizing the federal debt as big budget deficits are run, as governments try to stabilize the economy. One crisis to the next leads to higher and higher inflation. We need real assets, productive assets,

to help us stay ahead of the game. That's episode 428. Thanks for listening.

I have thoroughly enjoyed teaching you about investing on this podcast for almost nine years now. But some topics are just better explained in writing or with a chart. That's why we have a weekly email newsletter, the Insider's Guide. In that newsletter, I share charts, graphs, and other materials that can help you better understand investing. It's some of the most important writing I do each week.

I spend a couple hours on that newsletter each Wednesday morning as I try to share something that will be helpful to you. If you're not on the email list, please subscribe. Go to moneyfortherestofus.com to subscribe to the free Insider's Guide weekly email newsletter.

Everything I've shared with you in this episode has been for general education. I've not considered your specific risk situation, not provided investment advice. This is simply general education on money, investing in the economy. Have a great week.