Fed-Predicted Recession More Likely Severe than Mild

As recent survey results from the Federal Reserve Bank of Chicago reinforce Fed economists predicting a mild recession from the recent banking crisis, finance professor Albert “Pete” Kyle at the University of Maryland agrees a recession looms –- but more likely as severe. 

The crisis, fueled by SVB’s fast collapse, indicates a costly failure – “likely to show up as a recession which is severe, not mild,” says Kyle, Charles E Smith Chair in Finance and Distinguished University Professor for UMD’s Robert H. Smith School of Business.

Regulatory Failure

Kyle says SVB’s failure resulted from bank supervision. “The Dodd-Frank Act focused more on heavy-handed regulation than on higher capital requirements to make banks financially healthy. Bank regulators must have known about the unrealized losses on mortgage and Treasury securities which crippled SVB’s balance sheet. These are transparently obvious from cursory oversight. They apparently did not do enough to force SVB to recapitalize until it was too late. As a result of this regulatory forbearance, the FDIC, which ultimately uses the money of taxpayers to take over failed banks, faces billions of dollars in losses.

The regulatory failure was not the result of exempting banks like SVB from stress tests. Ordinary bank regulatory oversight, operating independently from stress tests, certainly picked up the problems at SVB well before it collapsed.

The idea that uninsured depositors will monitor banks adequately is known not to work well. Its mechanism of enforcement is bank runs, which—once started—spread to the entire banking system and rapidly send an economy into a recession. The government knows that steep recessions are an absurdly high price to pay for bank monitoring. The entire purpose of the Dodd-Frank Act was to provide a regulatory system which would prevent bank failures without causing recessions. Therefore, it is surprising that the government even thought about wiping out uninsured depositors of SVB as a mechanism of maintaining financial discipline in the banking sector.

Commercial Real Estate Disaster

The commercial real estate sector of the U.S. economy is facing a disaster, Kyle says, as office space lease rates are falling, commercial real estate debt is coming due, and many commercial real estate ventures will likely be insolvent when loans fall due. “This disaster is unfolding slowly because leases and loans typically last five to 10 years,” he explains. “It becomes apparent when leases do not roll over and loans cannot be repaid.”

Much of the risk has probably found its way into the banking system, especially into the portfolios of medium-sized banks, he says. “Since regulators failed to force SVB to fix obvious problems with SVB’s balance sheet, investors and bankers alike are likely to infer that regulators will also fail to force banks burdened with less obvious bad commercial real estate debt to recapitalize promptly.”

Perspective from Previous Crises

As the 2008 financial crisis was largely triggered by bad residential mortgage loans, the bad commercial real estate loans will potentially drive another crisis, Kyle says. “I expect a recession to unfold if and when it becomes apparent that banks are too undercapitalized to function properly. This recession might resemble the recession in the early 90s, which was a delayed response to banking problems within the savings and loan industry.”

Whether this recession unfolds sooner or later depends on the speed with which the government acts to force banks to recapitalize, he adds. “The Fed’s prediction of a mild recession this year suggests they will do too little, too late. Immediate action might trigger a more severe recession now, which would be a small price to pay for a healthy economy a few years later.”

Why ‘Sooner Rather Than Later’

In addition to weakly capitalized banks, the Fed’s commitment to bring the inflation rate down to two percent annually “will exacerbate the debt burden of commercial real estate borrowers because the value of their collateral will fall faster with a lower rate of inflation and high interest rates needed to bring inflation down will make rolling over debt more costly,” Kyle says. However, the Fed’s action is inevitable because (unlike government regulators’ commitments to require banks to be well-capitalized) “if the Fed is unable to rid the economy of inflation, the Fed itself will become obviously insolvent and lose so much credibility that the independence of the Fed will be threatened.”

Underlying Problem

Heavy-handed government regulation leading to regulatory capture represents the underlying problem, Kyle says. “The more that is at stake, the more resources regulated entities devote to influencing government policy. The Dodd-Frank Act, rather than creating a healthy banking industry, has created a noncompetitive, undercapitalized banking system, which has captured its regulators and is prone to collapse.” If governments subsidize risk-taking by allowing banks or other companies to function as if things are normal when they are inadequately capitalized, he adds, “the banks or other companies will embrace poor capitalization because they believe they can keep their gains but dump their losses on taxpayers.”

Warnings from History

Ultimately, many banks and other companies will fail because their bets did not work out, Kyle says, and these failed companies will be nationalized by the FDIC or other government agencies. “During the past financial crisis, the government quickly sold off nationalized companies like General Motors and AIG. It gave banks generous bailouts to avoid formally nationalizing them. When banks and other firms start failing again, we do not know whether the government will hold the failed firms as nationalized companies or let them go public again.”

He adds: “In my opinion, the government allowed banks to remain in the private sector last time because bailing out banks (with cheap equity from the TARP program) did not cost taxpayers too much out of pocket: Bank stocks rebounded quickly from their depressed prices. By contrast, in the savings and loan debacle, getting out from under government ownership took more than a decade because the industry did not rebound as a whole. If regulators allow the banking system to become too undercapitalized, the hole to dig out of will become so big that nationalization may not be followed by quick privatization. The road to socialism is paved with debt.”

Finally, Kyle warns that the collapse of the commercial real estate sector may be accompanied by the collapse of the finances of some big cities. “As the politics of many cities–such as Chicago, San Francisco, and New York–moves to the left, many high-income taxpayers are migrating from these cities to other cities with lower taxes and more business-friendly environments. Some of these cities may face major financial stress in coming years, and this will exacerbate their commercial real estate problems.”