Samuel Corum/Bloomberg
U.S. banks need a new version of the Troubled Asset Relief Program to help address a problem that many currently have that is arguably not of their own making and was difficult for them to anticipate.
As of June 30, 2023, U.S. banks had nearly $560 billion in unrealized losses on their investment securities portfolios driven by the Fed’s cumulative 525-basis-point rate increase since March 2022. Over 90% of those unrealized losses reside in 289 banks, each carrying $100 million or more. Those investment securities represent “trapped assets” for those institutions as they have no choice but to continue to hold them, as selling them would almost certainly require raising additional equity. It was Silicon Valley Bank’s announcement that it needed to raise equity after selling securities at a loss that led to a run on that bank in March.
As a result, banks have aggressively borrowed from the Federal Home Loan banks, the Federal Reserve or private equity firms and/or turned to higher cost, more volatile brokered deposits to maintain liquidity. Because the borrowings and deposits now bear higher rates and the investment securities earn lower fixed rates, many are returning a negative net interest margin. Some banks have turned to preserving liquidity by reducing lending, focusing on deposit gathering and selling off assets.
In its recently released draft rules, the FDIC has proposed that large regional banks, those with over $100 billion in assets but below $250 billion, issue $70 billion in new debt to bolster resilience. This proposal would essentially apply to 19 banks; however, the cost of issuing and carrying this new debt is likely to compress net interest margins further at those institutions. The FDIC’s proposal also fails to address the challenges facing institutions with assets below $100 billion. There are currently 257 banks with assets below $100 billion who hold $3.8 trillion in assets, $3.1 trillion in deposits and over $900 billion in investment securities. Those 257 banks are collectively sitting on roughly $103 billion in unrealized losses on their investment securities.
What I am proposing is that a Trapped Asset Relief Program (TARP 2.0) be initiated that would allow banks to replace existing higher-interest-rate debt with net-interest-margin-neutral debt. This debt would be secured by the same high-quality investment securities that currently secure at least some of their Home Loan bank, Fed and private equity borrowings. The interest rate charged would equal the weighted average interest rate earned by the pledged securities, therefore the cost of borrowing would be fully offset by the investment’s earnings.
Since the program’s goal is to reduce the cost of creating liquidity for affected banks, the program would be limited to banks borrowing against their available-for-sale securities only and exclude held-to-maturity securities, thereby matching the intent of banks’ asset and liability committees with those investments.
I estimate that the current rate difference between the interest rates banks are paying to borrow in lieu of liquidating securities and the interest rates the banks are earning on those securities to be roughly 300 basis points. That 300 basis points would amount to $30 billion per year in subsidized interest on up to $1 trillion in potential borrowings under the program.
In order to pay for this program, participating banks would issue warrants to the Treasury for the benefit of the lenders (the Federal Home Loan banks or the Fed) equal to the amount of unrealized losses on the securities pledged to secure the loans. Banks would be required to pay down loans as the underlying securities mature or are sold. In addition, participating banks in the program would also be precluded from paying dividends higher than their historical dividend rates so that they could not reward shareholders on the taxpayer’s dime. Remember, TARP did not cost the taxpayers anything and actually generated a profit for the Treasury. TARP 2.0, if properly enacted, should provide an upside to the Treasury as well.
The objective of TARP 2.0 is to provide some relief to many small to midsize banks that were able to attract more deposits, when rates were low, than they could prudently lend out and instead invested those funds in the best available, safest options available to them at the time. It can be argued that these institutions’ investments in low-rate securities helped drive the economic recovery by helping millions of U.S. homeowners secure long-term, low-fixed-rate mortgages. An additional benefit of TARP 2.0 would be to ensure the profitability and stability of those banks and to avoid them having to take draconian cost-cutting initiatives or drastically curtail lending activities that would only harm customers and employees.
Lastly, TARP 2.0 should not come with any stigma for participating institutions since no one foresaw that the Fed would raise rates as much and as quickly as it did in the past 18 months. Even the largest, most sophisticated banks in the U.S. are impacted to some level by this issue. While 525-basis-point increases or more in the federal funds rate have occurred historically, the rate of increase as a percentage of the prevailing federal funds rate in the prior 18 months never reached the dizzying 132.25-fold increase seen recently.
While there may be some who argue that banks should bear the consequences of their decisions, in this case, the impact of the affected banks’ investment decisions were far beyond their ability to anticipate. Given that the maturity dates for many banks’ available-for-sale securities investments extend ten years or more, it is imperative that a solution be brought forth now, because the only other choice is for banks to wait for the investments to mature and hope that interest rates decline sooner rather than later. As we all know, waiting and hoping are not strategies to solve a problem.
