Banking Crisis Explained

March brought us news that two of our local banks are in crisis mode. The feds came in and shut down Silicon Valley Bank. Its competitor, First Republic Bank, is still under tremendous pressure at the time of this writing.

Banks are institutions that provide financial services to individuals, businesses and other organizations. In order to make money, they take deposits from customers and use these deposits to make loans to others who pay interest on the loans. They earn a profit by charging a higher rate than they pay on the deposits.

Banks also offer other financial services, such as credit cards, checking accounts, savings accounts, certificates of deposit (CDs), and various types of loans. They may also provide investment services, such as mutual funds and brokerage accounts. Banks make money by charging a fee on these services. They also invest the deposits in various financial instruments, such as stocks and bonds, to earn additional income.

To insure the safety and soundness of the financial system, the Federal Reserve oversees the operations and has rules and regulations in place to prevent fraud, protect consumers and promote financial stability.

What happened in the 2008 banking crisis is different from this time around. In 2008, the underwriting guidelines for real estate loans were loose and easily manipulated. It felt like, if a borrower was alive and breathing, he could get a loan. Bad credit doesn’t matter; no income, no problem; don’t have a job, lenders will create one for you. Corruption was widespread, and it led to foreclosure problems.

Large financial institutions, including Washington Mutual, Wachovia, Bear Sterns, Lehman Brothers and Merrill Lynch, all failed and were absorbed by other companies. The feds had to provide large bailouts to Bank of America, Citigroup, Countrywide, AIG and others to insure that our banking system did not fail altogether. Since then, the feds have made changes and regulations to safeguard against this and it is currently working.

This time around, it is a different problem. We have gone through a very low interest rate environment where the banks can get deposits almost interest free. The Fed Funds rate rose from zero to 4.5% in the past 12 months.

The banks were making investments all this time when their cost of capital was near zero percent. Some financial instruments have long-term yields. Since the Fed Funds rates start increasing, banks have to pay more interest for their funds and thus their returns on their investments started going down. When customers started demanding their deposits back, the financial institutions did not have all the funds available and had to sell their investments at losses, leading to further financial and liquidity issues. To their defense, no bank can withstand a large run on its deposits.

Banks collapsing impact real estate and mortgages through reduced access to credits. Banks are the primary source of lending for mortgages and other types of loans. When they fail, it reduces the supply of credit, and other banks may become more risk averse and tighten up their underwriting criteria. This could lead to a slowdown in the real estate market as potential buyers are unable to obtain financing. In addition, banks might increase interest rates, making it more expensive for buyers, leading to a decline in home affordability, and a demand for housing.

Realizing this, the feds and other larger banks have stepped up at this time to try to prevent this from happening. The feds tried to calm depositors by promising that all funds exceeding the FDIC limit of $250,000 will be guaranteed. Eleven larger banks have come together to lend First Republic $30 billion to try to keep the bank solvent. However, the stock kept going down. Whether this will work, we will see, but this goes to show how much the other banks are vested in the banking system. We cannot have our whole banking system collapse.

The feds met the third week in March and decided to raise rates by .25% in their continual effort to battle inflation. Prior to SVB collapsing, the consensus was that they were going to raise the Fed Funds rate by .5 or .75%. This is an acknowledgement that rate increases possibly led to the current banking issues and hope that this will ease the problem.

Only time will tell what will happen here. My guess is that one of the larger banks will buy out First Republic. But other banks rumored to be in trouble might also need to merge with larger banks. Stay tuned as there is never a dull moment in real estate!

John M. Lee is a broker with Compass specializing in the Richmond and Sunset districts. If you have any real estate questions, call him at 415-465-0505 or email at johnlee@isellsf.com.