With the Fed’s worst case scenario coming true, “too big to fail” is more than a marketing slogan. The real ominous strains are elsewhere.
A few weeks ago, Wall Street was convinced that at least one the money centers would trigger a repeat of the 2008 credit apocalypse.
And since nobody was sure which bank would crumble first, they were all priced for doomsday.
Would Wells Fargo become the next Lehman Brothers? Or would UBS or Deutsche Bank crumble first?
Add that prospect to what was already becoming a global health emergency, economic shutdown and oil market crash, and it looked mighty scary out there.
That’s why the Fed made such sudden leaps. Having learned from 2008, they were vanishingly unlikely to live through that experience again.
With trillions of dollars circulating, we’re not going to see another Lehman-scale implosion. If you’re too big to fail, they’re not going to let you fail.
But there are a lot of smaller players in the shadows. From what we saw last week, that’s where the real danger is here.
The First State Bank of Barboursville was a little lender with four branches in West Virginia and $150 million in assets. They were already in trouble and finally ran out of regulatory room.
The FDIC took them over and sold them off. Clearly that’s the kind of institution that folds first in this economic climate.
The canary in coal country
The Barboursville bank wasn’t making money even when interest rates were rising. Once the Fed dropped the rate floor to zero, the institution was doomed.
At best there was $1 million in capital left on the books to support the lending book. The FDIC was already trying to create an exit when the rate curve blew out.
Over 300 smaller lenders are also unprofitable. They have somewhat better balance sheets but there’s little hope for them to get much stronger in the next few months.
Many will weaken and join FSB Barboursville in the FDIC’s graveyard. But while there are a lot of them, they’re very small even in the aggregate.
Add up every bank smaller than FSB Barboursville that ran at a loss last quarter and you’ve only got $17 billion in assets.
IndyMac had $32 billion on the books when the FDIC seized it in the early stages of the 2008 crash. It didn’t even make a ripple compared to the disasters that followed.
Every little bank in trouble could crash and barely even add up to half an IndyMac. Bear Stearns had $395 billion in assets to work through. Lehman Brothers was almost twice as big as that.
A pandemic of community bank closures can cause enormous pain around the country. We’ve seen it before with the S&L crash and so on.
But as long as the strong small institutions remain solvent, it’s just not going to crush the market. They don’t have enough heft to create a systemic risk.
Little banks go under. Cleaning up the mess is the reason the FDIC exists.
Stress tests are here
And as for the big banks that could cause Lehman-style disasters, the Fed actually sounds relatively confident.
The “severely adverse” scenario the Fed forces all the strategically important institutions to pass basically looks like the world we’re facing now.
That model tests operations with a 9.9% plunge in GDP, 6.1% unemployment and the Dow lurching below 19,000.
Economic consensus suggests that we’re either already there now or we’re heading there fast. The GDP targets look like free fall. Unemployment could easily crack 10% over the summer.
This is the stress the Fed tested last year. There’s little reason to check in again now except to make sure that the projections actually align with reality.
If so, it’s going to be a bad year for the banks, but not anywhere near as bad as 2008. All the big institutions passed their tests. None crumpled in the simulation.
Even the weakest of them didn’t see Tier 1 capital ratios drop below 6%. That’s enough to keep them on life support in a zero-rate environment.
It isn’t fun. And it’s vulnerable to further shocks, which is why the banks still need to keep at least 10% of their assets in capital for emergencies. But it’s survivable.
Wells Fargo passed. Goldman Sachs was one of the weaker scores, but passed. Even Capital One, which would suffer huge credit card losses if consumer payments stop, will limp along, weakened but alive.
There’s no Lehman crash lurking in the Fed’s worst scenario, which again, is the world we face now.
The question is whether the Fed was too lenient in constructing the tests. That’s why we’ll need to watch the coming earnings cycle very closely to see whether the numbers align with the test scores.
If so, “too big to fail” is going to lose about $410 billion in the next few years. While that’s going to hurt, these are massive institutions.
That $410 billion hole in the balance sheet is only enough to draw about 3% of assets out of Tier 1 capital.
Northern Trust, Bank of New York Mellon and State Street will go on making money. Wells Fargo and US Bancorp might break even.
They aren’t going away. If they do, the Fed has failed and we all have other things to worry about.
So if the 2008 sequel threat is only a shadow, what are we left with? Only a recession, massive government intervention in the markets and that persistent health crisis.
The banking landscape survives. Every question we can resolve provides a little confidence and takes us toward a brighter future.
Who is trouble in the meantime? Not the little people and not the giants. But UBS and Deutsche Bank can feel a lot of drag from what's going on Europe.
The next Lehman may not actually be the FDIC's direct responsibility. In that case, we'll have to ride out other countries' disasters in an interconnected world.
Two of the biggest banks on the FDIC list that aren't making money right now are BBVA and Santander. Spain is in trouble. These institutions are IndyMac sized.
