A (2:32)

No.

C (2:35)

So I thought, you know, as the earnings in the industry rebounded, in large part because the large banks did not have to. They've already paid back the insurance fund losses from the year before on First Republic and SBB bank and that the fact they didn't have to pay it this quarter made their earnings rebound. So that was also part of his quarterly bank profile news. One of the more important things, they're not really missing it. They have told you that unrecognized interest rate losses actually increased. And I think they report something like 39 billion in the quarter ending in March. They're significant. The industry has something over a trillion dollars in unrecognized interest rate losses on loans and securities and every fixed rate asset that they have because most of these were purchased and struck back when interest rates were very low. And most of these losses are not reflected in the bank capital numbers. And so the regulatory capital numbers look pretty good. You don't find too many banks with low regulatory leverage ratios because the true value of their capital is overstated. If you actually mark their assets to market, the situation looks a lot different that their real capital position is far weaker than the regulators would like to admit, I think.

A (4:12)

Well, I ask you this question, Paul, because readers of Grants know and as the listeners to our current yield will presently know, you are the author of a 61 page report, as we said in Grants Copiously Documented, the title of which is Commercial Real Estate and Bank Systemic Risk. Commercial Real Estate and Bank Systemic Risk. And the headline over our piece quoting you and summarizing some of your findings, well, was the Case of the fragile 27%. And to begin, would you explain to the listening audience how you came to do what you did? This long report was based on something called call reports, a very important regulatory derived information on the, on the health or lack thereof of the banking system. And you comb through these documents and you came up some findings that I think will strike many people as news and indeed for many people is also kind of counterintuitive. The banking crisis of last year being last year's news, so it would seem. Tell us if you please, how you did what you did and what the conclusions were.

C (5:30)

So every quarter banks have to fill out reports called condition of income reports and conditions of income reports or call reports as they're known. And they're very extensive. There's three depending on what kind of bank you are, there's three different versions of the call report form and they're, they include, there's a tailored one for small banks that has less detail. And of course the biggest banks have the most detail, but they file these every quarter. And there's a wealth of information in them. And from this information you can figure lots of stuff out if you're willing to take the time and the effort. All these data are made public roughly six weeks after the end of every quarter. The fdi, they're put out by the ffiec, the Federal Institution Advisory Council. They're actually collected and processed by the fdic. And the fdic. Shortly after the data become public, do a briefing on it, which you quoted from earlier when we first began. And that's known as the Quarterly Banking profile where the chairman of the FDIC will run down the latest numbers and the headlines. And it's all at the aggregate level. But aggregate numbers, just overall numbers, sometimes hide true things that are going on inside the system. And so what I did in this paper that you mentioned is I did a bank by bank analysis of of their conditions after I marked their assets to market. Now it turns out that banks have essentially three kinds of assets and record them in different ways. They have securities that they buy and they can hold them in two ways. They can hold them in something called an available for sale book in which they're supposed to be recorded at market value. They can hold them in a held to maturity book which is recorded at amortized cost or historical cost, if you want to think about it that way. And then they have loans and leases which are held at historical cost, less an allowance for credit losses. Tier 1 regulatory capital. That's the measure. That's kind of the basic measure that regulators use to determine the capital adequacy of banks. It's the kind of the base capital measure, the most solid measure in their view, that does not include lots of unrecognized interest rate losses. And I'll explain where they come from. So in the available for sale books, only the largest, most complex banks have to include what's the gains and losses on their available for sale securities in their capital number. It's called accumulated other comprehensive income. The difference between the amortized cost and the market value of an available for sale flows into accumulated other comprehensive income. And the largest banks have to include that when they calculate their capital. So if they make money on their available for sale securities on a mark to market basis, that would raise their capital. If they lost money, that would lower their capital. But some time ago, back around, I don't know, it was 2015 or so, the regulators gave smaller banks the option of excluding accumulated other comprehensive income from their tier one capital measure. And something like 4600 some odd banks chose not to include it. And that could cut either way. If interest rates were to drop and they would have big gains on their available for sale securities, then they would not be including those in their equity in their, in their regulatory capital number. But in, in the case we have right now, interest rates have increased quite a bit since they bought all their security. So they have big losses in their accumulated other comprehensive income account and they do not have to include that in their regulatory tier one capital calculation. So the first thing you do when you mark a bank's book to market is you've gotta, you've gotta back, you've gotta put back in accumulated other comprehensive income gains or losses into the regulatory capital number. That's sort of the first thing you have to do. Then you gotta go to the helda maturity securities book and banks have to report their historical amortized cost and their market value estimates of these securities. They have to report both of those in their call reports. So you can actually calculate their unrecognized interest rate loss and deduct that from Tier 1 capital. The regulatory Tier 1 capital reported in the last category is loans and visas, which the banks in their call reports do not have to report fair market values for only historical, well, amortized costs, less the allowance for credit losses. But you can calculate a rough market value estimate for fixed interest rate long maturity securities using the numbers that banks report in their call reports. So it turns out they have to, they have to put their securities into maturity buckets. There's six different maturity buckets. They put all their marketable securities in those maturity buckets, the outstanding balance, and you've got both the historical cost for those securities and the market value of those securities. So you can calculate average discount rates across the banking system for each of those six maturity buckets. And they have to put their loans in the same six maturity buckets. So if you take the security discounts, the average security discounts, and apply them to the average loans and leases in each maturity bucket, you can come up with a rough estimate of what the market value of, of the loans and leases would be. And it's really kind of in being a little more generous because the loans, whole loans and leases are not as liquid or easily easy, easy to sell as, you know, standardized securities that have liquid markets. And so you're really, you're really kind of downward by biasing your estimate of the market value loss on the bank's books. But when you, when you make those, those calculations, you can, you can adjust bank regulatory tier 1 leverage ratios for the unrecognized interest rate losses on their books. And you can come up with new ratios. And the new ratios look quite a bit different.

A (12:43)

Paul, can you summarize the results from all that work with respect to tier one capital?

C (12:49)

Well, I summarized it in a chart. So how do I explain a chart? It's a distribution.

A (12:55)

Just hold it up to the microphone.

C (12:57)

Hold it up. That'll work. So you just think about a distribution where you've got a histogram, a distribution where you've got a bunch of firms that look pretty well capitalized, around 10% capital. And there's a few firms that around 6% tier one leverage ratios. And then you've got a tail where there's some firms that have a lot of capital, 20%. Say, take that whole distribution and move it way to the left where you've got, oh, I don't know, I don't remember exactly off top of my head, but 100 firms that have actually no capital or negative capital, you just move the whole thing to the left. And that's kind of what the banking system looks like after you make the mark to market adjustment, it's moving the whole thing over to the left.

A (13:43)

So what you've done, in addition to marking capital to market, is to look at real estate as a percentage of the, of the assets of the bank and as a percentage of the capital and a few well chosen words. How does that look?

C (13:59)

Well, the regulators like to monitor commercial real estate concentrations using the ratio of a bank's total commercial real estate exposure to its tier 1 regulatory capital, plus its allowance for loan and lease losses. So that's kind of the concentration ratio. So when you replace the regulatory Tier 1 capital number with the mark to market Tier 1 capital number, the ratios are much, much larger than the supervisory numbers that they're looking at. Instead of being three, they're seven or eight or nine. And there's literally hundreds of banks with commercial real estate concentration ratios on a market value loss absorbing capacity type measure that are really at risk if commercial real estate loans start defaulting in large numbers. Now, so far the data on commercial real estate loans, most of the categories, doesn't really show this wave of defaults that a lot of people are expecting and that we see in news reports mostly from the security side of commercial real estate lending, the loans that are done outside the banking system. But some of those are making their way into the banking system. And this measure of commercial real estate concentration, after you mark the bank's capital market, regulatory capital to market is a much more sensible way to look at the risk that commercial real estate defaults might have for the banking sector, you.

B (15:42)

Focus on the risk that mark to market losses that banks have on their interest rate sensitive assets and also the potential losses that commercial real estate might have on banks. And I think one of your findings was a 10% across the board CRE loss rate would render 628 banks holding 6.1% of all banking system assets just insolvent. They would be dead. But one thing we saw last year was now Silicon Valley bank wasn't a well run bank. They got a bunch of deposits from Silicon Valley valley startups during 2020 and 2021 during the everything bubble. And they invested them in the lowest yielding securities in the history of the United States. But their demise was brought forward rapidly because as soon as people got worried they were able to do an electronic run in the bank. A decade or two ago if you wanted to run to the bank, you had to stand in line and actually get your money from the bank. Now you can just open up an app and take all your money out. And it seems like you wouldn't have to realize a loss of 10% for those 628 banks to die. You would have to have a whiff of people being concerned and then, and then all of their depositors who are above the FDIC limit of $250,000 would just leave instantly. How does kind of this liquidity risk that's being layered on top of very, very real solvency risks amplify or make it more risky?

C (16:55)

This is an aspect of the issue I haven't analyzed yet. So it is what happened in Silicon Valley bank, it was a run on the bank. So what I'm looking at in this analysis is the probability that a bank would experience a run on the bank if investors actually realize the exposure is going to be driven by this market value concentration ratio. Because if you have a market value adjusted CRE concentration ratio of 10, it only takes a 10% loss on your CRE, your commercial real estate loans and basically you've wiped out capital on a market value basis. There's no buffer anymore. Now the bank could continue operating as long as, as you point out, people keep their deposits in the bank. If they don't run and the bank's regulatory capital requirement is still above the minimum needed, the bank could keep open and operating and keep, keep attracting insured deposits. And that, that effectively is what happened during the savings and loan crisis in the 80s. We, they kept deposit insurance in place and the regulators didn't Close the banks. The banks kept borrowing insured deposits and investing in new things and losing more money. And that could happen. So the exposures don't necessarily on a market value basis don't necessarily mean the bank will fail. The bank has a higher probability of failing if, if it's investors who are uninsured realize the exposures, the true size of the exposures on a market value basis, they know they're not protected. The bank has no capital left in real terms, in market value terms. But it also depends on if the regulator actually makes a move and closes the bank. So if you have hundreds of banks potentially market value insolvent, there's no way the regulator is going to be able to close hundreds of banks all at once. We've seen this in many banking crisis. They approach it systematically and close them as they have the resources and the staff. It becomes then a whole confidence issue on the banking system. So if people see the weakness in the banking system and they see hundreds of problem banks and the slow motion resolution process, this doesn't engender lots of confidence. I don't think. As we learned in prior crisis, you.

B (19:35)

Were the director of the center for Financial Research at the FDIC for almost a decade. When you talk to your former colleagues about this, what do they say when they're not being quoted in a press release talking about the bank's first quarter earnings, Are they concerned about this?

C (19:51)

I haven't spoken with them directly on it and I don't expect they would want to engage me directly on it. In general, there's famous quotes extend and pretend. Regulators do that as well as banks. And I think one of the most famous statements at all, one of my friends and co authors Alex Pollack always uses was Mr. Junker, I think who was the head of the European Commission or European Union said when things get really bad, you lie. So regulators don't always want to. Nobody's called me and said I'm wrong and I don't think they could actually. I think that the numbers are what the numbers are and I'm not making it up.

A (20:41)

Well, how long did it take you to do this exercise?

C (20:43)

Oh, probably longer than it should. Have Downloaded all the data and put it in Excel. It probably. And I had to figure out what I wanted to do and how I wanted to put the story together. So I would say it took a good six weeks of going blind, crunching Excel spreadsheets and trying to figure out all the numbers I needed to calculate to put the story together and figure out was there Really a problem now or is it an exposure problem that is yet to materialize? And so it took a while after.

B (21:25)

Silicon Valley bank failed its regular, which was the Federal Reserve did a mea culpa report. I think it was like a 60 or 70 page report where they went over exactly how the bank failed and how the Fed as its regulator missed the warning signs along the way. Do you think the good people of the FDIC are aware of the problems percolating under the hood or do you think that they're unaware just given just like the Fed was with Silicon Valley Bank?

C (21:49)

I think they must know what I did in this report isn't all that high tech. I think there's plenty of good examiners that probably have made similar conclusions in their own banks and told people and I think I'd be very shocked if they didn't have similar type information. The Fed, the OCC and most of the exposures though are the smaller banks. So it's probably more an FDIC direct issue, not only because they're the federal regulator or the smaller banks by and large, but because they have to resolve them as well. If you want to focus on regulatory capital and people like I've had this discussion before with folks like Bill Seidman who says, well, you can't mark loans to market. No, but you can't do that. You can't have bank accounting where you mark loans to market. Well, if you're, if you're the agency in charge of resolving banks, I would think you would want to know the mark to market value of their loans because that's going to be a basis for what determines your loss rate if you actually have to close them. So while the regulatory numbers ignore all these interest rate unrecognized interest rate losses, you would, you would certainly hope that the agency responsible for knowing how to, how to resolve them and what the losses would be if they had to do it would, would want to do these kind of calculations. Now did they ever do calculations like this when I worked there? No, not that I'm aware of. But we didn't have this huge increase in interest rates after near zero interest rates for more than a decade. Pretty much we had a blip or two where rates were up, but we didn't have a situation like this where most of the loans were struck at really low rates. And then we had a burst of inflation that caused the Fed to have to tighten. So we never had a situation like this. So I don't ever recall anybody ever worried about marking bank assets to market back when I was working there. But you think they know this now.

A (24:07)

Paul, Is the FDIC insurance fund at risk?

C (24:10)

The FDIC insurance fund has just a fraction of a percentage of. It's a little over half a percent of the value of the fund is half a percent of the assets in the banking system. And when banks fail the loss rates on their assets are pretty high, 20% or more. So if you had a lot of bank failures it could run through the FDIC deposit insurance fund pretty quickly. In fact, just two bank failures last year really hammered the deposit insurance fund. They assessed the large banks for it. If commercial real estate loans start defaulting in the ways that some people anticipate it would be a problem for the deposit insurance fund in my opinion.

A (25:05)

Yeah, we talked to an investor in bank stocks, a good friend of this business, his name is Ben mackavack and he manages a fund that owns bank stocks mostly rent, regional and community banks. And his response to this as we mentioned in Grants was that loan value ratios for CRE loans across the board he thinks are pretty conservative because away from office buildings, the kind of real estate that many of the smaller banks own that is, you know, I don't know, industrial buildings, Chipotle's restaurants and strip shopping center things that are in four story office building things that are not in the news, these properties, says Ben, have continued to appreciate and the loan to value ratios on them are conservative. And that the office business he says is confusing people about the breadth of the real estate problem consensus rather narrower than the headlines would suggest. Do you have any comment on that?

C (26:09)

Yeah, I, I think he could be right. And one of the things I don't do in this paper is I don't predict lots of CRE loan defaults and bank failures. What I'd say is if there are CRE loan defaults in any kind of size, they're going to endanger banks. I don't have a crystal ball on CRE loans, the office loans and shopping centers. I think the exposure so far primarily at larger banks who could probably handle it. I mean there, there is some evidence that non owner occupied, non farm, non residential loans are the ones that are the, where the non performing loan rates are rising the fastest and they're at the bigger banks. And I think FDIC says that in their, in their QBP and my numbers say that. But you also have to keep in mind that I think they're closing down all kinds of these Chipotles or similar in California because they just raised the minimum wage above $20 an hour. And if we had any kind of recession at all, the oil started sucking quite a bit of air. So as I try to point out in the paper, commercial real estate is more than just in loans to commercial real estate for banks is more than just offices and shopping centers. There's all kinds of properties here. Multifamily got a lot of press, but that was focused on rent controlled buildings. I think in New York when one bank had problems with that and had to write down. So there are mitigating circumstances. So the regions in the country don't always behave the same way. But, but in any kind of banking crisis, commercial real estate is always one of the leading causes of losses. And right now the economy's holding up. If we were to fall into recession, other types of CRE would come under pressure. And I'm not predicting a recession, I'm not really predicting any of that. I'm just saying when you look at the true market value of capital in the banking system and in individual banks, they do not have the loss absorbing capacity that the regulatory capital numbers would lead you to believe. Half of that's gone outside of a recession.

B (28:33)

A high proportion of commercial real estate loans actually come due this year and next year. And we've actually seen real estate owners who don't offer personal guarantees with their loans like Blackstone actually hand back the keys to banks for not just office, but multifamily properties. And not just multifamily in New York where there's rent control. But part of the problem with multifamily was when cap rates were down like 3%, a typical owner might only put 50% equity, but now the cap rates are 5 or 6%, that equity is essentially vanished. So instead of putting good money after bad, they just hand the keys back over to the bank. So we have a high proportion of these loans coming due this year and next year. Is this a catalyst for kind of a lurch downwards or do banks have the wherewithal to make sure the owners don't just give them the keys and kind of shift the problem to them and extend the loans and kind of kick the can down the road?

C (29:20)

Well, there are troubled debt restructuring processes and banks could restructure some of these loans and if they continue performing and the regulators allow them to, I would imagine you'd see some of that on the side of defaults. Most of the, you know, the work I'm doing is looking at what banks exposure is and I don't really have a lot of information about the quality of Each individual bank's properties how I'm not in a position to have that. So there is some extended pretend evidence from the troubled debt restructured loans. In some categories it's mainly at. There's two categories. I think it was what you would think of as probably offices. I didn't see it in multifamily so much but it could end up there. Yeah, we could. I mean there's the potential, the exposures are there and the capital to cover it. The banks don't have a lot of, the banks don't have capital covered. There are number of banks that are in good shape, but there's a lot of them that aren't. If these things do come to, if these default predictions do come to pass.

A (30:36)

So we began this segment of Current yield Paul, with quoting the headline the case of the fragile 27% and the substance behind the 20 or the number, the absolute number behind the percentage is 2,667 banks managing 27% of the banking system's total assets, including 231. I'm reading from our report on your report. 231 banks with zero or negative capital value adjusted. Tier 1 capital is value adjusted. And that to me suggests a serious latent problem. The catalyst for which might be a recession. It might be, might be higher interest rates, might be an unscripted rise in inflation that does not allow the drop in funding costs that Wall street is fairly begging for.

C (31:26)

This, I mean this brings up the debate that's been going on for a while among some people about does the Fed hold interest rates high or do they lower them because they got problems in the financial system and this would be one of the latent problems. You've got to think the Federal Reserve is aware of these kinds of issues, at least to some degree. And certainly after I put out my paper, I would imagine they read it. This is this. Yeah. If, if, if there is no let up in the inflation rate, then, then you've, you've got a real problem. Right. I, I think if, if they're successful and, and they bring inflation down and, and you know, they can bring rates down, then some of this problem probably goes away. But I think as you say, if, if, if they're not successful at that, we've got a problem.

A (32:21)

Well, Paul Kupie, I guess we say here at Grants we'll know more in 10 years.

C (32:26)

Well, how is it? We'll wait for the data dependent analysis. We'll wait for the new data.

A (32:33)

Yeah, that's another topic. Paul Copia, this has been terrific and as was the opportunity to get a look at your work a couple of weeks ago. And I felt it's a great privilege for us to be able to bring it as best we could to the readers of Grants. So thank you for that and for being with us today and just keep on doing these things, Paul, because you have a fan base here that is just insatiable.

C (33:06)

Well, I appreciate appreciate the kind words and I'm glad that you guys pick up on it and alert your investors because people in the private sector have to do this kind of work because the regulators certainly aren't going to tell.

A (33:27)

You they're busy people.

C (33:29)

PAUL they are. Jeff.

A (33:32)

Well, thank you, Paul Kufayev. Thank you, Evan. Thank you, Henry French, and thank you, ladies and gentlemen, most of all for listening. This is Jim Grant on behalf of Current YIELD and talk to you soon.

C (33:43)

SA.