Deflating the credit bubble may affect more than banks

Another week, and another wave of concern over American regional banks. The level of panic is thankfully down, as the Federal Deposit Insurance Corporation seems to be backing up the system, by precedent if not law. The problem is attrition. Weak banks are losing their deposits and funding costs while their loans for commercial real estate or risky businesses turn bad.

This means that more consolidation is on the horizon. While this is a good thing in the long run (because it’s crazy that America has over 4,000 banks), there could be some bumps along the way.

As investors and American politicians watch with unease those bank there is a sector that deserves our attention as well: life insurance.

Insurance has been largely absent from the news in recent months. These companies are boring because their assets and liabilities tend to be long-term. The logic suggests that these companies should be winners in a world with rising interest rates, because they hold large portfolios that are long-term and do not need to mark them to market. This means that they can benefit from the rising rates while not posting losses.

Their balance sheets are less predictable at the moment. While this is not a reason to panic for investors, it does highlight a larger problem: A decade of low interest rates has caused distortions in the financial sector and it may take a while to undo them. This attrition issue goes beyond banks.

In the Federal Reserve’s financial stability report, there are some charts that illustrate this issue. The charts show that at the end 2021, insurance groups had about $2.25tn in assets considered to be risky or illiquid. This includes commercial real estate and corporate loans. This is about double what they had in 2008 and accounts for about a third their assets.

This level of risk is not new. The proportion of risky assets has increased in recent years, as insurance companies have been frantically searching for yields during a time when interest rates were low. However, the level was similar just before the financial crisis in 2008.

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”. These deals “offer investors the chance to withdraw money on short notice”.

The IMF’s report from a few months ago noted that there are many data gaps. As an example, “exposures of illiquid private exposures like collateralised loan obligations may disguise the embedded leverage within these structured products”. This means that insurance companies may be more sensitive than previously thought to credit losses.

The Fed points out that the “liquidity of life insurance assets has steadily decreased over the past decade while the liquidity their liabilities has slowly increased”. It could be more difficult for insurers to cope with any sudden increase in claims or withdrawals.

This may not be important. Insurance contracts, after all are more sticky than bank deposits. When the sector suffered its last shock in 2020 during the panic surrounding the launch of Covid, it managed to avoid a crisis by quietly (and successfully) increasing cash “by a whopping 63.5bn”, as separate Fed Research shows.

Analysts at the Fed admit that it’s unclear how exactly this cash surge happened, as “statutory filings” are silent on details. Income from derivatives transactions played a part, but the primary source of the cash surge appears to be loans from the Federal Home Loan Bank System.

It is also interesting because it highlights another important issue that is often ignored: the FHLB, a powerful quasi-state institution, is what is currently supporting many aspects of US finance, not the regional banks. To quote the Fed once more: “Life insurance companies are becoming increasingly dependent on FHLB financing.” So much for American capitalism based on free market principles.

This reliance raises concerns about the future. Especially if funding sources flee or illiquid and risky assets are impaired. This last scenario seems very likely, as higher interest rates have already hurt commercial real estate and corporate loans that are risky.

This is not a time to panic. It is just a long-running saga. A recent report by Barings indicates that “a record 26% of life insurance companies were in a positive interest rate management situation” at the end 2022.

It is clear that regulators need more data and stricter asset-liability standards. While the US National Association of Insurance Commissioners appears to be trying to implement, for example, by curbing insurers’ holdings of CLOs, it will take some time.

Barings notes that “the current environment makes liquid management so crucial,” especially since “rising interest rates can be a contributing factor to insurer insolvency.”