The recent tightening of monetary policy, desperately aimed at curbing runaway price inflation, has backfired spectacularly, igniting a devastating corrective trend in the valuation of financial instruments. Several of America’s most colossal banks have shamelessly exploited an accounting loophole, allowing them to avoid marking assets at their true market value. Instead, they deceitfully employ face values in their balance sheets by deceitfully proclaiming their intent to hold assets to maturity.
The most notorious offender, Charles Schwab, a bank that doubles as a high-profile stockbroker and owner of TD Ameritrade, had the audacity to possess the largest ratio of assets marked as “held to maturity” relative to capital by the end of 2022. Schwab’s staggering $173 billion in such assets dwarfed its capital, which stood at a paltry $37 billion. The difference between the market value and face value of assets held to maturity ballooned to an astonishing $14 billion.
Had these banking giants not relied on such underhanded accounting tactics, Schwab’s capital would have plummeted to a mere $23 billion, less than half of the $56 billion it boasted at the end of 2021. This value represents a pathetic fraction of its assets: less than 15% of those held to maturity, under 10% of securities, and under 5% of total assets. It’s worth mentioning that a tiny 3% increase in interest rates can annihilate 15% of the present value of an asset ten years from maturity, while a measly 1.5% increase can wreak similar havoc on a twenty-year asset.
Long-term interest rates have somehow remained stable in Q1 2023, but don’t be fooled—this house of cards could collapse at any moment. The Federal Deposit Insurance Corporation (FDIC) is scrambling to liquidate long-term assets from the already-defunct Silicon Valley Bank and Signature Bank to salvage its dwindling liquidity. Long-term interest rates are teetering on the edge, vulnerable to the whims of inflation expectations. Higher inflation could spell disaster, necessitating crippling nominal rates to maintain the same real rate. Furthermore, the US Congress’s stubborn refusal to raise the government’s debt ceiling, which is hurtling towards a default on obligations by August, could obliterate the value of treasuries held by banks.
Other banks flirting with financial ruin include the Bank of Hawaii and Banco Popular de Puerto Rico (BPPR). The Bank of Hawaii’s hypothetical shortfall at the end of 2022 exceeded a jaw-dropping 60% of its capital, while BPPR’s assets held to maturity were a ludicrous double its capital. The market capitalization of all three banks—Bank of Hawaii, BPPR, and Charles Schwab—plummeted between one-third and one-half in just a single month.
It’s impossible to say whether these titanic financial institutions are genuinely on the precipice of a catastrophic insolvency, but their suspicious reliance on this questionable accounting method raises serious red flags. The risk of insolvency is now at its most perilous in over a decade.
Central banks might be able to put a Band-Aid on liquidity problems and continue raising interest rates to fight price inflation, but they’re utterly powerless to resolve solvency issues without radically upending monetary policy or resorting to shameless bailouts. These desperate measures would only fuel inflation expectations, exacerbating the calamitous depreciation of long-term assets. In the end, the Federal Reserve may be forced to accept the brutal reality: the most effective way to save the entire financial system is to let these failing behemoths collapse in spectacular fashion.