April 28, 2023 (posted April 30)

This post repeats what I said in the free newsletter mailout that I  sent out on April 28. I am repeating it here because I need to be able to link to it. And I have one correction below.

Last edition [of the free newsletter] I explained how Silicon Valley Bank’s problem was that it had invested a massive 43% of its assets in mortgage securities at low interest rates averaging just 1.63% and with 95% of those securities locked in for more than 10 years. Given the short-term nature of its deposits this was an inexplicable and inexcusable mismatch between assets and liabilities. Bank management and bank regulators were clearly asleep.

Today I looked at the February annual report of First Republic Bank. A huge amount of their loans were interest-only residential mortgages (no payments on principal) and locked in for 15 years or more at an average interest rate of 2.9%. [Correction, after I wrote this I saw that their mortgage loan interest is locked in from one to ten years although the terms are 15 years and longer – so at least eventually those mortgages do reset to higher interest rates which is good for the bank – but they still have way too much locked in at low fixed rates for too long]  And this was funded mostly by no-interest checking accounts that were free to leave with no notice. Again this is a shocking duration mismatch between assets (loans) and  liabilities (deposits).  These loans were well secured by the value of the homes. But’ that’s of no help. The situation now is that with higher market interest rates those mortgages are worth far less than their stated values. And most of the no-interest deposits have fled and even if they stayed they would have now demanded to be paid the going interest rate.  As I write this on Friday April 28, it appears likely that First Republic is headed for receivership with a total loss to share owners. In receivership the Federal Deposit Insurance Corporation is likely to sell off those mortgage loans at a steep discount easily wiping out the bank’s equity.

First service just reported last week that its book value per share was $77. That now seems highly misleading given that they would have known that the market value of those loans was vastly lower than book value and that they were unlikely to be in a position to hold onto those loans with their deposits so badly depleted. Banks are always highly leveraged and so anything approaching even a 10% loss in value on assets (loans) is a total wipeout of share owner equity. This development signals that the financial statements of at least some U.S. banks cannot be trusted. Unless the deposit insurance limit is raised, why would any company keep more than $250,000 in a smaller bank? This is likely to lead to big changes in the regulation of U.S. banks and perhaps to the elimination of hundreds of smaller banks.

In my experience, the Canadian banks do not engage in the kind of asset / liability mismatch demonstrated here. It increasingly appears that the Canadian banks are indeed far better regulated than U.S. banks. Also far better managed than many U.S. banks. Some Canadian banks may indeed face problems with bad loans if a recession occurs and/or if Canadian home prices decline from their lofty levels, but I don’t think any of the publicly traded Canadian banks will will suffer from the kind of interest rate mismatch that has wrecked the two U.S. banks that I mention above.


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