The deflating credit bubble could hurt more than just the banks
Another week, another wave of worry about American regional banks. Thankfully, the level of panic has dropped somewhat since the Federal Deposit Insurance Corporation appears to be backstopping the system — by precedent, if not by law. But the problem now is one of attrition: weakling banks are losing deposits, watching funding costs rise while their loans to commercial real estate and risky companies turn sour.
That means more consolidation looms. And while that is welcome in the longer term (since it is crazy that America has 4,000 plus banks), this could create bumps in the short run.
However, as investors — and American politicians — uneasily watch those banks, there is another sector that also deserves our attention: life insurance.
In recent months, insurance has largely stayed out of the headlines. No wonder: these companies tend to be boring because they are supposed to hold long-term assets and liabilities. Logic suggests that they should win in a world of rising interest rates because they have large portfolios of long-term bonds that they do not usually need to mark to market, meaning they can reap income gains from rising rates without posting losses.
However, their balance sheets are becoming a little less predictable right now. And while this is no reason for investors to panic, it highlights a bigger problem: a decade of extremely low rates has created distortions across the financial world and it could take a long time for these to unwind. That attrition problem goes far beyond the banks.
The issue at stake is captured in some charts buried in the Federal Reserve’s recently released financial stability report. These show that insurance groups held about $2.25tn of assets deemed to be risky and/or illiquid, including commercial real estate or corporate loans, at the end of 2021 (apparently the latest available data). In gross terms, that is almost double the level they held in 2008, and represents about a third of their assets.
This level of exposure is not unprecedented. Although the proportion of risky assets rose in recent years as life insurance companies frantically hunted for yields in what was then a low-rate world, it was at similar levels just before the 2008 financial crisis.
But what is notable is that there has also been a rising reliance on what the Fed notes as “non-traditional liabilities — including funding-agreement-backed securities, Federal Home Loan Bank advances, and cash received through repos and securities lending transactions”. And those deals often “offer some investors the opportunity to withdraw funds on short notice.”
It is unclear how big this mismatch is, since there are large data gaps — as the IMF noted in its own recent report. For example, “exposures to illiquid private credit exposures such as collateralised loan obligations can disguise the embedded leverage in these structured products”. In plain English, this means insurance companies could be far more sensitive to credit losses than thought.
But the key point, the Fed notes, is that “over the past decade, the liquidity of life insurers’ assets steadily declined, and the liquidity of their liabilities slowly increased”. This could potentially make it more difficult for life insurers to meet any sudden rise in claims – or indeed withdrawals.
Maybe this does not matter. Insurance contracts are, after all, far stickier than bank deposits. And when the sector last suffered a shock, during the panic at the onset of Covid in 2020, it avoided a crunch by successfully (and quietly) orchestrating “a whopping $63.5bn” increase in cash, as separate Fed research shows.
Fed analysts admit it is unclear exactly how this cash surge occurred, since “statutory filings are silent” about the details. But income from derivatives deals played a role, while the main source appears to have been loans from the Federal Home Loan Bank system.
That is interesting, since it underscores another crucial issue that is often overlooked: it is the mighty, quasi-state entity that is the FHLB which is propping up many parts of US finance today rather than the regional banks. Or to cite the Fed again: “Life insurers are growing more dependent on FHLB funding.” So much for American free-market capitalism.
Such reliance also raises questions about the future, particularly if funding sources do flee, or risky and illiquid assets become impaired, or both. The latter seems highly likely, given that higher rates are already hurting commercial real estate and risky corporate loans.
Once again, I am not suggesting that this is a reason for panic; this is a slow-moving saga. While a recent report from Barings shows that “a record 26 per cent of life insurers were in a negative interest rate management position” at the end of 2022 (in other words, they had paper losses on bonds), these do not need to be realised unless the companies go bust.
But if nothing else, regulators clearly need better data and tight asset-liability matching standards. And while the US National Association of Insurance Commissioners is apparently trying to implement this — for example by curbing insurers’ holdings of CLOs — it will take time.
Hence why “today’s environment makes liquidity management so critical,” as Barings notes, particularly since “rising rates can be a factor contributing to insurer insolvency.” In other words, it is not just the US regional banks that risk becoming victims of today’s deflating credit bubble.