Looming Liquidity Crisis

Clickbait title. But, I just learned about 12 CFR 1266.4(b). Banks with negative tangible capital have no access to new FHLB advances. Could be an issue for anyone with significant AFS investments due to all the unrealized losses floating around in AOCI. Not an issue for the big boys though, I believe most of them designate investments HTM instead of AFS.

what

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I thought that this was going to be about the drought.

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The regulation prevents FHLB banks, which fund most community bank mortgage production and contingency funding plans, from issuing new funds to banks that have negative “tangible” capital.

Community banks are experiencing dramatic upticks in unrealized investment losses due to the rapid rate increases. This is significantly reducing their “tangible” capital, and a few have actually broached negative tangible capital. The calculations for tangible and regulatory capital are different, so these banks “should” be fine. But deposit growth is slowing and even starting to reverse, which will limit their ability to fund profitable assets without FHLB access.

So for my dumb ass that doesn’t know much about financials, if I had a million bucks lying around, what would I do in this situation? Short some particular community banks with high exposure to sub prime or some ■■■■? Or some particular end markets that are most dependent on loans from these banks, which I’m assuming are in construction or some ■■■■?

Shorting now would be presumptive. It won’t be a significant issue for most small banks unless several things come together to cause a perfect storm. (1) the Fed Funds rate reaches 4-4.25%, (2) core deposit run-off accelerates, causing a return to pre-pandemic liquidity levels, and (3) some sort of market event (or poor management) leads a bank to have dangerously low on-hand liquidity and activate their contingency funding plan.

This is noteworthy because for most small banks, FHLB funding comprises 80-90% of their planned emergency liquidity, with correspondent lines of credit / Fed Funds Sold making up the remainder.

There’s a website that scrubs individual bank call reports for a lot of financial data. I can’t remember the name of it at the moment though.

The bigger takeaway at the moment is probably for M&A. Credit unions and midsize banks have been snapping up small banks for the past several years. With the investment portfolio depreciation driving down tangible capital, will buyers be willing to pay what sellers want for what the sellers perceive as a temporary equity decline? I know of at least 1 bank purchase deal that collapsed this summer because of it.