Perspective on Risk - Sept. 8, 2023
Downgrading Banking; FDIC (internal) Review of First Republic; Insurance; Climate Scenarios; Securities Lending
Is it really September already?
Downgrading Banking
Fitch warns it may be forced to downgrade dozens of banks, including JPMorgan Chase (CNBC)
Fitch Ratings cut its assessment of the banking industry’s health in June, a move that analyst Chris Wolfe said went largely unnoticed because it didn’t trigger downgrades on banks.
But another one-notch downgrade of the industry’s score from AA- to A+ would force Fitch to reevaluate ratings on each of the more than 70 U.S. banks it covers
Banks in a fractional reserve world are in many ways are extensions of the sovereign. When the possible support from the sovereign weakens, it’s hard not to have that affect the banks. It is also entirely consistent with the decoupling thesis. Bifurcating markets imply a higher cost of equity capital, which is consistent with lower credit ratings.
FDIC (internal) Review of First Republic
Another in the endless series of ex-post navel-gazing whereby the regulatory agencies fall on their swords. FDIC’s Supervision of First Republic Bank. The findings may sound familiar:
Cause of Failure
The primary cause of First Republic’s failure was a loss of market and depositor confidence, resulting in a bank run following the failure of Silicon Valley Bank (SVB) and Signature Bank on March 10 and 12, 2023, respectively. … attributes of First Republic’s business model and management strategies that made it more vulnerable … included: Rapid growth and loan and funding concentrations; Overreliance on uninsured deposits and depositor loyalty; Failure to sufficiently mitigate interest rate risk.
Interest Rate Risk
I find it hard to second guess the examiners. The firm had an interest rate limit system that considered both net interest income (NII) and the economic value of equity (EVE). They had well functioning risk management systems, and active and transparent management.
It’s very worth noting that First Republic KNEW it had a potential MTM interest rate risk issue:
First Republic began identifying risk tolerance and risk appetite breaches associated with the EVE projections in the second quarter 2022. The EVE projection showed that interest rate increases in the 100 to 400 bps range would reduce the value of First Republic’s equity by an amount greater than its risk tolerance or risk appetite thresholds, except for risk appetite in the 100 bps increase scenario.
The ALMCO, other more senior management committees, and Board all agreed to monitor the breaches and take no further action despite the fact that a 200bp rate increase would result in a decrease in the theoretical economic value of equity (EVE) that was greater than First Republic’s equity.
Nevertheless the report concludes:
We concluded that [Division of Risk Management Supervision (RMS) staff] could have been more forward-looking in assessing how increasing interest rates could negatively impact the bank, given its concentration of lower-rate, longer-duration loans and dependence on low-cost funding and continual growth.
RMS could have done more to effectively challenge and encourage bank management to implement strategies to mitigate interest rate risk starting in the second half of 2021, although we acknowledge examiners would have likely encountered pushback from the bank because growth was strong and interest rates were low at that time.
In addition, RMS could have pursued a more urgent supervisory response, such as potentially downgrading the Sensitivity to Market Risk component and/or issuing SRs urging management to develop strategies to mitigate interest rate risk when it learned in August 2022 of First Republic’s interest rate risk scenario results that were far outside of Board-approved parameters. Importantly, examiners did not learn until November 2022 that First Republic’s Board agreed with bank management’s recommendation to not take action to respond to the interest rate risk scenario breaches.
Liquidity Rating
Looks like the onsite team may have blown this one.
FDIC’s decision to increase First Republic’s Liquidity component rating to a “1,” signifying strong liquidity levels and well-developed funds management practices, in the 2021 roll-up [Report of Examination (ROE)], was too generous and was inconsistent with First Republic’s high level of uninsured deposits which ROEs identified as a funding concentration and Supervisory Plans noted were potentially unstable.
Off-site Monitoring
I criticized the Fed and FDIC for their lack of communication between on- and off-site teams in the SVB and Signature reviews. There doesn’t appear to be a problem here.
The FDIC’s off-site monitoring team also seemed to be on top of things. The lowered their assessment of the bank to a “C” which represents which is for “institutions [that]generally represent a heightened risk to the DIF under stress conditions” with a negative forward outlook as of the 2nd quarter of 2020.
Other
Unlike some of the other reviews, staffing did not appear to be a material issue. The issuance of exam findings from the exit meeting to issuance date was generally FAST by regulatory standards; almost always less than 30 days.
The FDIC has estimated that the failure will cost the deposit insurance fund around $15 billion. Sometimes banks fail; seems like the FDIC did a reasonable job here.
Insurance
Effects of Climate Change in Real Time
A lot of digital ink has been spilled lately on insurers retrenchment from certain markets where they have found themselves over-concentrated to certain risks where they cannot earn an acceptable premium. Florida, followed by California, are the canaries-in-the-coal-mine.
Accelerating risks and damage from climate change are spurring private insurers in the United States to limit coverage in a growing number of areas, thus imposing mounting stress on local communities and straining the country’s overall economic health.
In 2023, the president of Aon, a risk-mitigation consulting firm, testified before the U.S. Congress that climate change is already “destabilizing” the insurance industry—in a world that has warmed only approximately 1.2°C (2.2°F) since preindustrial times. A 2021 survey of insurance risk managers found that 60 percent feared climate change would make certain geographic areas uninsurable.1
In Florida, Private Insurers Have Failed or Pulled Out
Florida’s domestic property insurers have been losing money on underwriting — the difference between premiums collected and claims paid — since 2016, according to the state’s Office of Insurance Regulation.2
Private Insurers Are Pulling Away
The two largest homeowners insurance companies in the United States, State Farm and Allstate, announced earlier this year that they would take a break from issuing new policies in California. Farmers Insurance has also decided to cap new policies in California. American International Group (AIG) has reportedly reduced property insurance coverage to homes along the east coast at risk of flooding and those in the western United States at risk of burning. Increased hurricane losses and litigation costs in Florida have driven close to a dozen insurance companies to go bankrupt, while other insurers, including Farmers and AAA, restrict coverage. In Louisiana, insurance companies have declined to write policies in hurricane-prone areas.3
Or Cutting Coverage
At least five large U.S. property insurers — including Allstate, American Family, Nationwide, Erie Insurance Group and Berkshire Hathaway — have told regulators that extreme weather patterns caused by climate change have led them to stop writing coverages in some regions, exclude protections from various weather events and raise monthly premiums and deductibles.
Major insurers say they will cut out damage caused by hurricanes, wind and hail from policies underwriting property along coastlines and in wildfire country, according to a voluntary survey conducted by the National Association of Insurance Commissioners, a group of state officials who regulate rates and policy forms.4
Leading To a Coverage Gap
Today, nearly 15% of all the homes in Florida are uninsured, almost double the national average. … Properties’ exposure base — a measure of the value of what’s insured — is up 25% to 40% since 2020.5
New Areas Of Risk Are Emerging
Major hurricanes are becoming more frequent and hold more intense rains, said Paulo Ceppi, a climate scientist at Imperial College London. Meanwhile, “tornado alley” — an area swarmed by twisters that runs from Texas and Oklahoma through Kansas and Nebraska — is moving east, according to 2018 and 2022 research published in the journals Nature and Environmental Research Communications.6
Govt-supported Insurers Step In
Since the 1960s, state governments and quasi-governmental organizations have stepped in when access to private insurance has shrunk, resulting in state programs becoming the insurers of last resort. With worsening extremes driving higher claims, these backup programs have seen their rolls swell in the past four decades. According to the Insurance Information Institute, the aggregate value of all insurance in force in FAIR Plans—state-created property insurance plans focused on providing coverage to high-risk homes—almost doubled between 2013 and 2022.7
Homeowners insurance in Florida has been in transition for a number of years already. Florida increasingly relies on state-backed Citizens to provide homeowners coverage.
Citizens is designed to be backup for Floridians if they can’t get private insurance for their homes and commercial property. As more and more insurance companies leave the state or go out of business, the company has massively expanded its reach over the state’s insurance market. In 2023, Citizens expects to have 1.7 million clients with $5.1 billion in premiums, compared to under 500,000 policyholders and $877 million in premiums in 2019
Earlier this year, Citizens reported that “due to Hurricane Ian, Citizens’ financial resources have been significantly depleted,” and that its surplus had declined to just under $5 billion. This could mean that Florida policyholders could be on the hook for the state-run company: “If Florida is impacted by a storm or series of storms in 2023, Citizens will need to rely on its assessment capability and/or post‐event financing to meet its policyholder obligations,” Citizens said in the report.
If any of the company’s separate accounts are overdrawn (they’re scheduled to be combined early next year), the company can issue assessments to make up the difference.8
Reinsurance Prices Continue to Rise
Primary insurers buy reinsurance to cover their tail risks.
Moody’s Investors Service has surveyed reinsurance buyers and found that more than 70% of respondents expect reinsurance prices to continue to rise into 2024.
Moody’s said that, “The majority also believe prices will continue to increase beyond 2024 across both casualty (82%) and property (70%) lines, we believe this is likely as a result of climate related uncertainty and the inflationary environment.”
Almost all of the responding cedants see claims inflation as the key driver of price rises, while more than 60% also cited lower reinsurance capacity being available as a contributing factor, Moody’s said.
Moody’s also noted that “climate related uncertainty” is believed to be another factor that will drive reinsurance prices further along their upwards trajectory.9
And CAT Bonds Are Taking More Of The Risk
After record sales so far this year, the total cat bond market now exceeds $41 billion, almost double its 2013 level, according to Artemis, an investment data firm.
Reinsurance companies provide more than 80 percent of the capital that backstops insured risks. But over the past decade, most of the new money devoted to guarding against risk has come from the capital markets, not traditional reinsurance companies, according to Aon Securities, a Chicago-based investment bank.
A series of severe thunderstorms in the United States were responsible for 68 percent of global insured losses in the first six months of 2023, according to an Aug. 9 report from Swiss Re, the Zurich-based reinsurance firm. The $34 billion bill in the United States was the highest for any half-year period.10
What Is Florida Thinking - Wrong-way risk
The Florida state pension plan has about 2 percent of its $48.5 billion portfolio invested in insurance-linked securities, including $95 million in cat bonds, according to Paul Groom, deputy executive director of the state board of administration.
The bottom line is we may be socializing this risk going forward. A major event in Florida would result in politicians scrambling to bail-out Citizens while keeping premiums reasonable for the average homeowner. Not good for those like me who like to see market forces at work. Likely to see this elsewhere in the future.
Climate Scenarios
We haven’t yet even stopped increasing the amount of coal, oil and gas we use globally. If we ever do decide to get serious, the cost now will be severe. With that in mind, I came across this nice piece that advocates for shortening the climate stress test scenario window, enhancing the scenarios for missed and second-order effects, and integrating elements of economic performance.
Noah Smith has a nice, positive piece on the current work to decarbonize in Our climate change debates are out of date. Read it if you’re interested, I just wanted to highlight this thought which aligns with the rest of this segment:
The idea that there’s a tradeoff between the economy and the climate is now defunct.
A less sanguine view is projected in 'Radical and urgent' climate scenario analysis shift needed, USS says. This article points to the need for better scenario analysis to insure we are ready for the future:
No Time To Lose – New Scenario Narratives for Action on Climate Change, suggested that current climate scenarios often understate both the economic damage of climate change and the potential benefits of action, restricting their usefulness for investment decision-making.
The report from USS and University of Exeter is not the first to raise concerns around the current climate analysis underpinning investment decisions, as research previously found that "flawed" climate analysis could be placing pension savers at risk.
Let’s dive into No Time To Lose – New Scenario Narratives for Action on Climate Change.
Shorten the scenario window (to 2030)
Long-term regulatory driven scenarios have successfully highlighted the global systemic challenges posed by global warming. … Since reaching Net Zero in 2050 is widely believed to need emissions to be halved by 2030, this goal calls for plans informed by shorter term scenarios.
Multiple Decision-Useful Scenarios
The limitations of current official scenarios and methodologies, notably from The Network for Greening the Financial System (NGFS) … are failing to capture key aspects of the real world, including acute physical risk, politics and policy, unemployment, finance, asset prices, volatility, tipping points, path dependency and complex feedback loops.
USS has appointed Exeter’s Global Systems Institute to develop ‘Decision Useful Climate Scenarios’ to support its efforts to incorporate climate and transition considerations in its investment and risk management processes. This report presents a new set of four narrative global climate scenarios out to 2030 based on a framework which embraces the radical uncertainties surrounding the potential positive as well as negative tipping points. Assumptions about the key scenario drivers were developed with the help of over 40 experts in geopolitics, climate policy, economics, finance, technology and consumer behaviour.
Four narratives based on degree of policy intervention & market dynamism
Interesting that they have sought to integrate climate developments with economic stress. Their scenario 4 projects a decline in real world GDP between 2023 and 2030
Securities Lending
I hadn’t been aware of this. Securities lenders alleged that the brokers colluded in keeping fees low by their control of Equilend. The banks allegedly colluded to keep business from moving to an independent, more transparent solution. Fascinating if you’re into these details. Hat tip to Tadas Viskanta at Ritholz for bringing this to our attention.
Inside the $499 million lawsuit settlement exposing 'opaque' world of securities lending
In securities lending, pension funds and retirement plans lend out their portfolio shares to hedge funds and other investors, using Wall Street brokers that charge a fee.
The secrecy behind securities lending may be changing: the group of pension funds led by the $40.1 billion Iowa Public Employees' Retirement System, Des Moines, reached a $499 million partial settlement in the antitrust lawsuit alleging that Morgan Stanley, Goldman Sachs, UBS, J.P. Morgan Chase & Co., Credit Suisse, and Bank of America ran a price-fixing scheme using their own joint venture called EquiLend.
In effect, the banks hurt pension funds by keeping fees paid artificially low. That prevented asset owners from earning more revenues when they lent out stock, according to the complaint filed in the U.S. District Court in Southern District of New York.
The case is Iowa Public Employees Retirement System et al. vs. Bank of America Corp. et al, Case No. 1:17-cv-06221, U.S. District Court, Southern District of New York. The case documents and settlement agreement are available online on the law firm's website.