by David Reavill
The most significant hazards are always the ones you least expect.
The magnificent Ocean Liner was launched nearly 112 years ago, on May 31, 1911. Eleven months later, she lay at the bottom of the North Atlantic. The Titanic had some of the most luxurious accommodations ever seen at sea. The Titanic was constructed with the highest standards of the shipbuilding industry of the day. She had 16 individual water-tight compartments designed to isolate any breach in her hull. Many considered the Titanic to be unsinkable.
And yet, in less than a year, Titanic was gone. Although Titanic was designed to withstand a breach of one or two compartments, the North Atlantic Ice Berg, which sliced along her starboard side, created a gash so large that Titanic could not hold back the water.
Circumstances had overwhelmed the Titanic. The best-laid plans of the ship’s architect and builders had not considered such an eventuality. When the ship traveled at that speed and met a berg of that mass, the outcome was a disaster.
It occurred to me how much the current banking crisis resembles that fateful first voyage of the Titanic. Like those who built Titanic, our Bank executives and regulators are experienced and well acquainted with the storms and tides that may come our way.
The chief regulator for America’s Major Banks is the Federal Reserve Board. Created in 1913, just two years after the Titanic, the Fed has seen its share of disasters, from the Great Depression of the 1930s to the recent Great Financial Crisis of 2008.
In this recent crisis, the Fed adopted new rules and new measures of Bank viability. You may have heard of the most famous of these audits, the Bank Stress Test. The Stress Tests began in 2011 and were designed to ensure that another financial crisis would not threaten the major banks, as did the 2008 crisis.
Many consider the 2008 crisis the worst financial crisis since the Great Depression. Banks faced an old Nemesis that year, disappearing collateral. Or, more appropriately, collateral that was no longer worth what it once was. A collection of players had created a process that looked good on the surface but buried many ills.
First came the politicians, who mandated that Banks expand their Real Estate lending to include people who, in reality, could not meet the mortgage payments. Not to be left out, Wall Street joined in by “securitizing” these risky mortgages into large groups of Mortgage Banked Securities, securities that could be easily bought and sold.
However, while the mortgage-based tranches might have seemed liquid, they held a collection of non-performing loans underneath—mortgages where people were not making monthly payments.
And holding the bag for all this was, you guessed it, the banks. Who ended up with millions of dollars worth of collateral, those mortgage-backed securities, which weren’t worth very much.
So to ensure the banks could survive, the Federal Reserve started its annual Stress Tests. Here is what the Fed is looking for in 2023.
Today the Fed is measuring whether the banks can withstand a “Global Recession.” A Recession that will ultimately see unemployment in the US hit 10%, where collateral prices plummet, corporate bond prices slide, and residential real Estate fall by 38%. In comparison, commercial Real Estate falls by 40%.
In other words, the Fed worries that collateral prices may fall just like they did in 2008. But like the General fighting the last war, the Fed remains focused on 2008. We are 15 years beyond that.
Yes, we have seen a slight decline in corporate bonds, and yes, real Estate, both residential and commercial, is hurting. But nowhere near the levels that the Fed is talking about. Besides, looking at collateral repricing in this environment is to focus on the symptom, not the cause.
There is a reason that Bonds are headed lower. And it’s the same reason that Real Estate is in trouble. And that reason is higher interest rates. As we all know, Bonds trade inversely to interest rates; as rates rise, like they’re doing now, the price of bonds falls. Real Estate is in a very similar situation; sales decrease as the cost of financing property increases.
Unfortunately for the Fed, we all know why interest rates are rising. It’s because of the direct action of the Federal Reserve itself. The Fed has driven interest rates higher and higher in a monomaniacal belief that they will curb inflation.
And the Fed is likely right about that. There is little doubt that the Fed’s Tighter Monetary Policy will eventually moderate inflation. The question is, will our economy join the Titanic at the bottom of the sea when they are through?