Grant’s Current Yield Podcast
Episode Title: UNRECOGNIZED LOSSES
Date: June 26, 2024
Host: Jim Grant
Guest: Paul Kupiec (American Enterprise Institute)
Co-Host: Evan Lorenz
Episode Overview
This episode delves into the under-the-radar vulnerabilities of the U.S. banking sector, especially surrounding unrecognized interest rate losses and commercial real estate (CRE) exposures. Jim Grant and Evan Lorenz are joined by Paul Kupiec, a seasoned banking analyst, who shares insights from his in-depth, data-driven report on systemic risks lurking beneath the surface despite reassuring headlines from banking regulators. Together, they explore the contrast between regulatory optimism and the more sobering conclusions drawn from a granular, bank-by-bank, mark-to-market analysis.
Key Discussion Points & Insights
1. The Official Line vs. Hidden Risks
[00:50–02:32]
- FDIC’s Positive Report: The episode opens with Lorenz reading FDIC Chair Martin Gruenberg's statement touting banking resilience in Q1 2024, highlighting robust net income, stable liquidity, and “continued resilience.”
- Paul Kupiec's Skepticism: Kupiec cautions against accepting upbeat regulatory statements at face value:
“You can never expect a government regulatory agency who's doing a report on the health of the industry they regulate to tell you it's really in bad shape.” (Kupiec, 02:14)
- He points out that earnings rebounded partly due to banks not having to pay insurance fund losses incurred by previous bank failures in the quarter.
2. Unrecognized Interest Rate Losses: The Trillion Dollar Problem
[02:35–04:12]
- Magnitude of the Losses: Kupiec notes that banks collectively carry over $1 trillion in unrecognized interest rate losses on loans and securities, a direct artifact of earlier periods of ultralow rates:
“The industry has something over a trillion dollars in unrecognized interest rate losses ... not reflected in the bank capital numbers.” (Kupiec, 03:35)
- Regulatory Capital Illusion: These losses are not captured in banks’ regulatory capital—meaning the true capital positions are weaker than official figures suggest.
3. Kupiec’s Mark-to-Market Analysis of U.S. Banks
[04:12–12:43]
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Data Deep Dive: Kupiec’s 61-page report leverages detailed quarterly “call reports” filed by banks, adjusting capital ratios to reflect the real market value of banks’ assets.
- Banks report three asset types: Available-for-sale securities, held-to-maturity securities, and loans & leases—each handled differently for regulatory capital purposes.
- Most smaller banks—about 4,600 institutions—exclude “accumulated other comprehensive income” (AOCI) from capital calculations, thereby hiding the true extent of losses.
-
Methodology: He reconstructs bank capital by including AOCI and marking “held to maturity” assets and loans to market using reported maturity buckets and discount rates.
-
Result: Even using conservative assumptions, this adjustment shifts the distribution of banks’ capital ratios dramatically leftward, revealing hundreds of banks with little or even negative capital.
“[After adjustments] you’ve got, oh, I don’t know, I don’t remember exactly off the top of my head, but 100 firms that have actually no capital or negative capital…” (Kupiec, 12:57)
4. Commercial Real Estate: The Risk Multiplier
[13:59–16:55]
- CRE Concentrations Balloon: When asset values are marked to market, banks’ CRE concentration ratios (CRE exposure relative to true capital) often double or triple—well into red-flag territory.
“Instead of being three, they're seven or eight or nine. And there's literally hundreds of banks with commercial real estate concentration ratios ... that are really at risk if commercial real estate loans start defaulting in large numbers.” (Kupiec, 13:59)
- Potential for Rapid Bank Failures: Even a hypothetical 10% CRE loss rate would render 628 banks (6.1% of bank system assets) insolvent.
“…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 ... all of their depositors ... would just leave instantly.” (Lorenz, 16:23)
- Liquidity Risk in a Digital Age: Runs can occur much faster now—depositors can leave with a tap, as seen in Silicon Valley Bank’s demise.
5. The Limits of Regulatory Response
[16:55–21:49]
- “Extend and Pretend”: Regulators are slow and methodical—unable and perhaps unwilling to resolve hundreds of failed banks at once.
"Regulators do that as well as banks ... when things get really bad, you lie." (Kupiec quoting Jean-Claude Juncker, 19:51)
- True Losses Will Only Surface in a Crisis: If bank weakness is exposed, either by depositors or a change in regulator stance, confidence could erode quickly.
- Kupiec stresses that regulatory metrics are inconsistent with the realities that would face the FDIC if mass failures occurred.
6. Systemic Risk and the FDIC Insurance Fund
[24:07–25:05]
- The FDIC insurance fund covers only a sliver (roughly 0.5%) of total U.S. banking assets. High failure rates could quickly deplete 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.” (Kupiec, 24:10)
7. Counterpoints and Nuance
[25:05–28:33]
- Some market participants, like Ben Mackovak (mentioned by Grant), argue that most regional and community bank CRE loans are conservatively underwritten (excluding office space). Kupiec acknowledges this but stresses his findings are about exposure, not specific predictions of defaults.
“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…” (Kupiec, 26:09)
8. Wave of CRE Maturities: A “Can-Kick” or a Catalyst?
[28:33–30:36]
- Many CRE loans come due in 2024–2025, just as property values and cap rates move against borrowers. Owners can and do “hand back the keys” when their equity is wiped.
- Banks might restructure some troubled loans, but this amounts to “extend and pretend.”
9. The Fragile 27%: A Summary of Systemic Exposure
[30:36–32:21]
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Headline Finding: 2,667 banks, holding 27% of system assets (including 231 with zero or negative capital, mark-to-market) are at significant latent risk—a tipping point could be a recession, sustained higher rates, or stubborn inflation.
“That to me suggests a serious latent problem. The catalyst … might be a recession ... higher interest rates, might be an unscripted rise in inflation…” (Grant, 30:36)
-
Kupiec’s Bottom Line: If rates stay high and inflation persists, the structural weakness will be exposed. If rates can be cut, the problem may shrink.
Notable Quotes & Memorable Moments
- “You can never expect a government regulatory agency ... to tell you it's really in bad shape.”
— Paul Kupiec, (02:14) - “The industry has something over a trillion dollars in unrecognized interest rate losses ... not reflected in the bank capital numbers.”
— Paul Kupiec, (03:35) - "If you actually mark their assets to market, the situation looks a lot different ... their real capital position is far weaker than the regulators would like to admit."
— Paul Kupiec, (03:50) - “…628 banks holding 6.1% of all banking system assets [would be] just insolvent. They would be dead.”
— Evan Lorenz, (15:42) - “Regulators do that as well as banks ... when things get really bad, you lie.”
— Paul Kupiec, quoting Jean-Claude Juncker, (19:51) - “If commercial real estate loans start defaulting ... it would be a problem for the deposit insurance fund in my opinion.”
— Paul Kupiec, (24:10) - “I’m not predicting a recession, ... I’m just saying when you look at the true market value of capital ... 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.”
— Paul Kupiec, (27:49) - “This debate ... does the Fed hold interest rates high or do they lower them because they got problems in the financial system ... If there is no let up in the inflation rate, then, then you've got a real problem...”
— Paul Kupiec, (31:26)
Important Segment Timestamps
- [00:50] — FDIC’s official, optimistic statement
- [02:14] — Kupiec responds: regulators’ incentives and spin
- [03:35] — The scale of unrecognized losses
- [12:49] — Charting the mark-to-market hit: distribution of capital ratios
- [13:59] — CRE exposures and supervisory ratios (and what they conceal)
- [15:42] — The domino effect if CRE losses materialize
- [16:23] — Liquidity risk in the digital age (reference to SVB)
- [19:51] — The regulatory instinct: extend, pretend, and conceal
- [24:10] — The vulnerability of the FDIC insurance fund
- [25:05] — Alternative view: Conservative CRE lending among small banks
- [26:09] — Kupiec: The limits of prediction, the reality of exposure
- [30:36] — The “fragile 27%”: Systemic risk summary
- [31:26] — The Fed, rates, and the constraints of monetary policy
Tone & Takeaways
The tone combines Grant’s signature dry wit and skepticism, Kupiec’s technical precision, and Lorenz’s incisive questions. Despite the irreverent delivery, the message is sobering: the U.S. banking system—especially at the regional and community bank level—may be sitting on far greater risk than quarterly headlines suggest. The true resilience of the sector, especially if a recession or a new wave of defaults materializes, is highly questionable given the enormous pool of hidden/unrecognized losses and the limited capacity of systemic backstops like the FDIC insurance fund.
Conclusion:
While the guests stop short of predicting imminent collapse, they argue convincingly that reported headline strength vastly overstates the sector’s real ability to absorb losses if conditions deteriorate, particularly in commercial real estate and amid persistent high rates.