The first quarter of 2023 likely will be remembered as the quarter in which banking issues bubbled to the surface. In the case of SVB Bank and Signature Bank, those bubbles went pop. What other things are going on beneath the relatively placid surface of the market? Join us as we climb aboard the BSW glass bottom boat for a better view below.
The TLDR (too long; didn’t read) is as follows:
- The current banking issues largely stem from a rapidly changing interest rate environment. Unlike in 2008/2009, credit quality does not seem to be the concern for now.
- Banks of all sizes are losing deposits at a historically swift pace. This is due to the differential between rates they offer on deposits and those of comparably safe money market funds.
- Given the outflows of deposits, bank liquidity is being squeezed.
- The Federal Reserve has put in place a temporary borrowing program that should help banks meet deposit requests without having to take losses on their fixed income portfolios.
- In our view, large banks should come through this relatively unscathed, but we see smaller banks continuing to be pressured.
- Unless the Fed pivots and starts lowering rates rapidly (doubtful in our opinion, due to their ongoing war against inflation) small to mid-sized banks may be forced to cut back on lending and/or will need to raise their lending standards. This may result in a headwind for the economy going forward.
Digging Deeper into the S&P 500 Performance in Q1 2023: Is the Market Really as Calm as It Seems?
The surface of the public markets has been fairly calm this year – especially considering the swells and white caps that punctuated last years’ wild ride. The S&P 500 finished Q1 with a respectable 6.46% return, net of dividends. However, a closer look reveals that, of this return, 5.97% of it was produced by only 8 large stocks.
Signs of a healthy market usually include gains across a broad range of stock types. So far, in 2023, the other 492 S&P 500 stocks have collectively gone nowhere.
Watching the Bond Market: Spreads, Lending Standards, and the Outlook for Corporate Debt
The bond market on the surface has also been relatively serene. Despite the continuation of additional Fed hikes this year, the 10-year bond has spent the past 5 months in a range between 3.80% and 3.38%. However, we are closely watching the spread between safe treasury bonds and corporate bonds. A wider spread indicates investors are requiring more yield to hold relatively more risky corporate bonds. While elevated, in our opinion spreads are not sending out alarm bells yet.
We will touch on this a bit below, but as banks potentially start tightening lending standards, the same highly indebted companies that tapped the corporate debt market 2-5 years ago and now need to refinance, likely will be facing much higher interest costs on new debt. Obviously, this creates more stress for their already precarious operations – operations that may have been kept afloat for years on the tide of near free money.
BSW and our fixed income managers largely have steered clear of corporate debt over the past few years and have instead focused on highly rated investment grade taxable municipal bonds for non-taxable accounts. In most cases, we believe clients are getting higher yields with commensurately less risk. Municipalities are still flush with cash from government COVID assistance programs and therefore appear to be in excellent financial shape.
Behind the Latest Banking Crisis: Examining the Causes and Implications for the Economy
We’d like to spend a little time explaining the why behind the what when it comes to the latest banking crisis. Contrary to some of the media coverage, BSW does not believe the latest banking problem centers on bad actors and failed oversight of the system.
The collapse of SVB may have awoken a certain amount of PTSD in those of us that invested through the Great Recession and the crumbling of Lehman Brothers and Bear Sterns. In our view, this time is fundamentally different. However potentially costly, BSW feels the Federal Reserve will not and cannot afford to let contagion happen at this point in the debt cycle.
To set the stage for how we got here, we need to rewind the calendar to 2020 and put on our banker’s hat. At that point in time, pandemic relief actions were in full force. People were being paid good money by the government to stay at home. Very few were spending money. Bank deposits went through the roof – thank you direct deposit!
Being the astute banker that we are, we took a good portion of that deposit cash and looked to invest it. Remember: the U.S. banking system is a fractional reserve system. This means that we only need to hold a small percentage of that pile of cash ready to pay back to depositors – if they choose to ask for it back. Prior to the Great Recession, this liquid reserve portion averaged about 7-8% of total assets. Now it is closer to 15% – plenty right? Depositors have been conveniently complacent for years – what could go wrong?
Bank’s Investment Dilemma in 2020 and Beyond
Our options to invest the money in 2020 were basically to lend it out directly to small businesses, lend it to folks wanting to buy a house, etc., or we could purchase safe government bonds that will earn us more money than we pay our depositors – which was (and still largely is) essentially nothing. Since a COVID vaccine was still uncertain and the economy was essentially shuttered, our risk averse mindset naturally gravitated to the safe bonds.
The added benefit of buying government backed treasuries and mortgage bonds was that, since the increased regulations of 2007/2008, banks were encouraged by rule to buy these bonds. Bankers can load up on these bonds and, since they are government backed, they do not need to hold many reserves against them. For instance, if we instead decided to loan money to small businesses or folks wanting to buy a used car, then we would need to hold more liquid reserves against these riskier assets. Therefore, banks were encouraged to buy government bonds and discouraged from holding too much in the way of reserves to pay back depositors!
Being in the for-profit business of running a bank, we look around at our options in 2020 when it comes to safe government backed mortgage bonds. We can either purchase 2-year FHLB (Federal Home Loan Bank) bonds at a measly 0.25%, or 10-year bonds at 1.18% (these were the going rates in June 2020). Our fickle shareholders expect us to make money with our money, so we purchase primarily higher yielding 10-year bonds of course. In 2020, inflation was next to nothing and had not been a threat for over 20 years. The economy was in the doldrums and the Fed was still printing money. What could go wrong?
Fast forward to 2023 and things look very different. Inflation peaks at 9.1% in 2022 and is still at a suborn 6% in Q1 2023. The Fed has raised interest rates the fastest in history after seemingly waiting too long to start its fight against inflation. We look at our bank computer screen and realize that the current issue FHLB 10-year bonds now yield well over 4%. This means the pile of our bonds that we purchased at 1.18% in 2020 are no longer worth 100 cents on the dollar – they need to be discounted to yield the same as the new 4% bonds. Our screen says our bonds are now worth only 75 cents on the dollar. No big deal, right? They will mature at par and we will get our money back.
But wait, since we are still paying our depositors 0.02% on their deposits and most money market funds are now paying 4%+ we are bleeding deposits. This means we need to raise cash to satisfy these unexpected withdrawal requests that are running above what we have modeled – based upon experience. If we sell the FHLB bonds that are underwater, our bank will take a loss and we could be forced to either raise more capital through dilutive equity sales or further debt issuance, both of which could signal that our bank is weak – potentially leading to more capital flight.
Having painted this picture, we believe it is easy to see that the Fed and regulators perpetuated this current bank dilemma from both sides of the equation – raising interest rates too fast and encouraging banks to favor “safe” government bonds. What does not seem to have been contemplated 2 years ago was the exact scenario we just went through – where deposits increased as they did in 2019/2020 and interest rates rise from 0%-5% in the span of one year.
All banks (some to a greater extent than others), are now faced with the same reality. Most of their bonds (assets) are underwater, and depositors (liabilities) are fleeing.
Liquidity is the risk to a bank’s earnings and capital arising from its inability to timely meet obligations when they come due without incurring unacceptable losses. Bank management must ensure that sufficient funds are available at a reasonable cost to meet potential demands from both funds providers and borrowers. – Treasury Department
Examining the Impact of New Technology on Bank Runs and the Federal Reserve’s Response
We have already discussed why assets are underwater. Let’s move to the liability or deposit side of the equation and peer through the plexiglass floor of the S.S. BSW.
When the new rules around liquid reserves were put in place in 2014, we believe that the Federal Reserve did not take into consideration the new ease by which money flows through the system. It used to be that deposits were incredibly sticky. If you wanted to move your money between banks, you needed to go to the bank, stand in line and fill out forms. Now, with the touch of a button, cash zooms out of banks, into brokerages, across the ocean. Almost every bank has an app that lives on our cell phones – probably right next to our social media apps.
From the Federal Reserve website: “Institutions must have enough unencumbered assets to cover any potential net cash outflows over the next 30 days.”
Bank runs used to be hard. The pictures of depositors in the 1930s queuing outside the physical bank building pushing and shoving to belly up to the teller say it all. Now bank runs can be instantaneously precipitated by a social media posting. SVB faced an outflow of $18B in mere hours – followed by another wave of another $24B by day’s end. That night, another $100B was requested – in total representing over 80% of SVB’s deposits. The social media postings worked their magic on panicked depositors.
It is our understanding that even if SVB was able to sell all its mortgage bonds at market prices, due to the haircut on these bonds, it would not have been enough to satisfy the requests. Adding to the precarious situation, SVB depositors were mostly businesses, many of which held cash well above the FDIC insurance limits. This also fed into the outflow frenzy.
We now know how this story ends –all SVB depositors were covered, no matter what their balances had been. Enter the government’s latest “temporary” financial backstop – the Bank Term Funding Program (BTFP). It’s important to understand how this program works. With the stroke of a pen, the Fed has put a giant Band-aid on the issue of those government bonds being underwater.
Having had discussions with both the Federal Home Loan Bank of Topeka and the Federal Reserve, and also having read through all the rules around the new BTFP, BSW has confidence that this new lending program can serve to solve the problem of banks timely meeting obligations when they come due without incurring unacceptable losses.
If you’ve taken off the banker’s hat by now, you might want to put it back on. Facing withdrawals well above what we modeled over the next 30 days, we can now take our stash of FHLB bonds trading at 75 cents on the dollar and give them to the Federal Reserve’s BTFP program. In return, they will give us back 100 cents on the dollar. This is not considered a sale of assets, rather a pledge of assets. Therefore, we do not have to report a loss to our nervous shareholders.
This gives us the immediate liquidity to satisfy withdrawal requests. The Fed will wire us money within minutes of requesting it in most cases. This cash does not come without a cost though. The Fed will charge us almost 5% for the right to use this program – again, well above what we are earning from our current asset base. And this program only runs through March 11, 2024. At that point, we either need to pay the loan back, or default – in which case the Fed keeps our FHLB bonds.
Our bank now has a dilemma. We can choose to raise our deposit rates to stem outflows, which will eat into profitability, or we can hunker down and hope that in a year from now interest rates have come down to a level that reverses this whole pickle. We have a known negative versus an unknown one year down the road. We choose to punt and hunker down. This means holding more cash than we ordinarily would, given the uncertainty of withdrawals. We also seriously curtail originating the types of loan assets that are not eligible for the BTFP – namely our bread-and-butter direct loans to businesses and the community.
There is evidence that this is exactly what is happening. The use of the BTFP by banks jumped from $34.6B in the first week of its operating to $62.6B in its second week. Including the BTFP program, banks borrowed $570B over the last 2 weeks from all Fed programs. This level of borrowing over such a short period has never been seen before. Of this $570B, $320B still remains on bank balance sheets as cash, presumably to buffer withdrawal requests.
Small and Mid-Sized Banks: The Life Blood of the Economy
The problem, as we see it, is that small and mid-sized banks, like our fictious example bank, are the life blood of the economy as shown below. They are the primary lenders of commercial real estate loans and a big part of the residential lending market.
BSW expects this dynamic to continue to play out through at least this year and be a headwind to economic growth. Keep in mind that when the Fed set out last year to squash inflation, this is believed to be what they wanted to happen. Their only tool in the toolbox to tame inflation is to slow the economy by tightening liquidity in the system. From our view, the problem is that rates were raised too quickly. The faster rates move, the more difficult it is for the system to absorb them. A slow and steady rate hike regime may not have resulted in so many bank assets being underwater at once.
In terms of the recent 500bps interest rate increases, BSW doesn’t believe the real economy has begun to feel the ramifications. Milton Friedman’s lag doctrine of 1961 proposed that interest rate policy works in “long and variable” lags. “When the Federal Reserve System takes action today, the effect of that action may on some occasions be felt in 5 months from now and on other occasions 10 months from now, on other occasions 2 years from now.”
Tying this all together, BSW believes that large banks, which have been the beneficiaries of much of the deposit flows from small banks, will be fine. Even if they face deposit flight going forward, on a percent of asset basis, they hold more of the high-quality government bonds that are eligible for the Fed’s liquidity programs. Importantly for many BSW clients, this is also the case for Charles Schwab Bank; as BSW CEO, David Wolf, nicely summarized this in a blog post earlier this week.
It is the small and mid-sized banks that may hold more of the assets that are ineligible for the Fed program that might get squeezed, should deposit flight continue. In our opinion, this might result in further bank consolidation as larger banks absorb smaller banks that find themselves in a bind.
Interestingly, the U.S. is unique in its vast number of banks. Despite the U.S. having more banks than other developed countries, the U.S. has gone from over 13k banks in 1970 to around 4k today. Prior to 1994, there were laws in place that created obstacles to banks opening branches in other states – obviously contributing to the sheer number of banks across the country. There are more banks in North Dakota than in all of Canada.
BSW feels that unless interest rates go down over the next year and liquidity in the system improves, programs like the BTFP might become another one of those temporary government programs that becomes more permanent in nature. It is also likely that The Fed will need to stop or ease back on their current QT (quantitative tightening) program -where they are allowing bonds to mature and roll off their balance sheet; further draining liquidity.
Challenges Facing the Economy
We believe the economy is also facing another sucking sound this summer/fall when the Treasury General Account needs to be replenished after the debt ceiling gets eventually raised. This is estimated to drain ~$500B out of the economy over a short period of time.
We do not envy Chair Powell right now. He and his Fed committee face the impossible task of restoring financial stability and liquidity to the banking system while simultaneously remaining restrictive with money to fight inflation that is still stubbornly high. The best-case scenario is that inflation comes down fast enough for the Fed to start cutting rates and restoring liquidity within the system.
In the meantime, the stock market has proven resilient – possibly latching onto the notion that the Fed will continue to perpetuate the “everyone gets a trophy” economy. With debt levels at historic highs, a massive wall of refinancing that needs to happen and banks in a fragile position, they may not have a choice.
BSW has navigated far more uncertain waters in the past and, no doubt, will in the future. We hope that looking below the surface was a worthwhile drill. Yes, there are some threats, but in our view none are so big as to threaten our collective boats or the course we have plotted for our clients.
Thanks for reading.