The Downfall of New York Community Bank

Covered up by the Regulators Until the Market said No More

New York Community Bank (NYCB) is on track to be shuttered by the FDIC any day now, possibly by the posting of this article.  As part of the regional banking crisis of 2022, NYCB volunteered (or was ordered) to take over Signature Bank, the failed bank that had none other than Barney Frank, the father of the communistic and destructive Dodd-Frank Law, as a board member.  

 As reflected in the charts below, NYCB’s share price collapsed, and the circumstance has caused contagion as investors now recognize “soft landing” as soft propaganda. With the scales falling from their eyes, investors now see many other banks struggle.

Today the Chief Risk Officer stepped down from his role, possibly onto a sandy beach.  We can imagine that his risk management involved repeatedly asking Barney Frank – “do you think everything is OK?”

A Lack of Hedging as a Consequence of Regulation:

The sins of Barney Frank not only destroyed Signature Valley Bank, but now swallow New York Community Bank.  What sin that Barney committed would destroy regional and community banks? Let me explain: Dodd Frank’s mandate of margin and clearing requirements for interest rate swaps made banks’ hedging of interest rate risk very expensive and risky from a cash flow standpoint.  

If a bank hedged, and the hedge went against the bank during the life of the trade, the posting of additional collateral to cover the hedge’s lost market value would eat into the bank’s cash flow – so most banks decided to avoid hedging once it required the posting of margin.  As evidence see Limited Hedging and Gambling for Resurrection by U.S. Banks During the 2022 Monetary Tightening?

The historical case of Metallgesellschaft provides a clear understanding of the risk of margin payments caused by changes to fair market value mismatching with fixed payment obligations of the hedged asset.  

Metallgesellschaft traded futures to hedge the variable price of oil to then fulfill long term fixed price oil contracts to retail customers.  While the trade would have worked over the long run, interim price volatility of oil in the futures markets triggered enormous margin calls that led to the firm’s futures position being closed and losing $1.3B.  Note, this was back in 1993 when 1.3B meant something.  

What alternative existed prior to Dodd-Frank for hedging transactions?  Well, back then banks with strong credit could enter into swaps to hedge interest rate risk without posting margin – these contracts were called non-margining agreements.  Swaps that hedge risk tend to meaningfully diminish a firm’s credit risk so non-margining agreements often make sense if a firm’s credit risk is reasonable prior to the hedge.  

Also, prior to Dodd-Frank, alternate forms of collateral and less burdensome terms for posting margin existed, such as encumbering assets with liens, or only having margin apply after larger thresholds.  Finally, prior to Dodd-Frank, banks had less concentration in Treasuries and Mortgage-backed securities when banks used to actually be in the business of making loans instead of buying them (but that is a story for another day).

Getting back to current developments in the regional banking crisis:

Going beyond NYCB, the vast majority of banks nationally have suffered outsized losses on interest rate risk from unhedged Treasury bonds and Mortgage-Backed Securities that were acquired in 2019-2021.  They also suffer rising write downs on Commercial Real Estate and rising delinquencies on auto loans and credit cards.  They suffer increased borrowing costs as low-cost deposits shifted to larger banks that are viewed as “Too Big to Fail.”  This smorgasbord of losses and rising costs too much to carry.

And this leads us to the concerns the market has for a host of regional banks.  As shown below, a number of regional bank stocks fell substantially this month, and as the dominos fall, others will join the list:

The Forecast:  Expect the Fed to rapidly shift back to Quantitative Easing and potentially to extend the Bank Term Funding Program (BRFP) facility to continue bailing out troubled banks.

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