March Madness: Part Two – Bracket Busters
Published on March, 21st, 2023
After a tumultuous week that saw a California-based crypto-focused bank (Silvergate Bank) wind down its operations1 as well as the seizure by U.S. regulators of two other banks (Silicon Valley Bank2 and Signature Bank3), the following week many college basketball fans gathered to watch their teams play in the NCAA tournament. At the same time that many fans saw their brackets implode as a result of surprise losses, investors in the banking sector experienced their own shock and disbelief as bank shares generally continued to decline.4 Concerns of both depositors and investors appear to remain elevated despite actions by the Treasury that it had hoped would stabilize the situation.5
At present, we believe bank investors may be asking the following questions:
- Will there be more bank runs necessitating government intervention or seizure?
- Could Credit Suisse – or another “too big to fail” institution – be among them?6
- Will banks somehow be forced to realize heretofore unrealized losses on bank balance sheets that will materially impair their shareholders equity?7
- Might many bank depositors grow so concerned that they shift their deposits to the largest banks?8
- Will the Federal Reserve continue to hike interest rates despite recent turmoil in the banking sector?9
- Do the recent bank seizures mean that smaller banks are going to see much more stringent regulations that will crimp their margins and ability to lend?10
- Is this episode going to cause a pullback in lending by smaller banks, slowing the U.S. economy enough to cause a recession?11
At this point we cannot know if there will be additional bank failures. We are monitoring a number of items to help us assess the situation. Each week, the Fed shares information on its balance sheet, including bank borrowings at the Fed’s discount window, as well as usage of the new Bank Term Funding
Program the Fed created on March 12 to help provide funds to any banks needing them.12 Once things calm down, we would not expect to see much activity here. We are also monitoring changes in the spread between the overnight lending rate set by central banks and the three-month interbank lending rate; this spread changes from minute to minute and over the past week it has been quite elevated.13 We believe its current level prices in a significant amount of fear and risk aversion; if this spread were to fall considerably, we would take it as a sign that concerns have eased.
Moreover, in our view, bank stock prices can be a signal in themselves. George Soros coined the term “reflexivity” to indicate the strange concept which is the opposite of what we believe to be true most of the time – that corporate fundamentals drive the price of a security.14 With reflexivity, a security’s price can drive fundamentals15 – in this case, a rapidly falling bank stock price might induce fear in depositors, adding to their concerns and convincing them that withdrawing their money and placing it in another bank is the right course of action. This can become a vicious cycle, we believe, as more withdrawals may lead to a lower stock price, and so on. Additional policy and/or funding announcements from the Federal Reserve may also act to change investor sentiment regarding the possibility of further bank problems.
Our team has been delving into these issues ever since the FDIC seized control of Silicon Valley Bank.16 While the situation is still developing, it appears that over the weekend of March 18th the Swiss government is encouraging UBS to take over all or parts of Credit Suisse (CS)17, which in our view may forestall further problems that might otherwise develop if CS was left to sink on its own. It seems unlikely to us that CS would be allowed to fail, given that it is a global systemically important bank18 and we believe the Swiss central bank has the means and the will to save it. If this transaction is agreed to, one significant ‘problem child’ of the last two weeks would be removed from the list of investor concerns, in our view.
We believe U.S. banking analysts over the past ten days have been laser focused on several metrics to assess the likelihood of additional problems arising in the banking system. In our view these may include the average deposit size at a bank and whether it is above the FDIC’s $250,000 insured amount, and relatedly, the percentage of a bank’s deposits which exceed that amount, the “uninsured” deposits.19 With this information, analysts may seek to assess a given bank’s risk of having larger depositors potentially move their funds elsewhere due to concerns about being over the insured level.
We believe analysts are also scrutinizing bank balance sheets to determine if their bond portfolios have experienced losses, and if so, how large those losses might be relative to shareholder equity.20 Current accounting rules permit banks to hold bonds that have unrealized losses without negatively impacting equity, as long as those bonds are designated as “held to maturity.”21 By focusing on this measure, analysts may hope to determine the risk that if a bank is forced to sell bonds in order to meet depositor withdrawals, that it might have to realize these losses, and what the impact upon the bank’s equity might be.22 If equity is wiped out by realized losses from selling bonds, a bank may become insolvent. We believe this was the situation that management of Silicon Valley Bank found themselves in when depositors rushed to withdraw huge amounts of deposits from the bank in a very short period.23
It’s difficult to know in the aggregate how bank depositors have been reacting to recent events. Banks are not required to report deposit levels daily, so over the course of the last week it is impossible to know – unless a particular bank decides to make a public disclosure24 – whether that bank is seeing depositors take funds out, move funds in, or leave them be. It seems likely to us that the largest banks have been seeing inflows, given that they are considered too big to fail. In our view, the recent announcement by a group of the largest U.S. banks to shift $30 billion of their deposits to First Republic would seem to indicate that those banks may have experienced significant deposit inflows, and therefore were comfortable participating in efforts to help a peer recover from what may have been material deposit outflows.25
We are concerned that smaller banks may see higher costs of funding, increased regulation, and potentially changes in how ratings agencies assess their level of credit risk.26 Collectively these changes could cause headwinds for the U.S. economy, since smaller banks have been more significant engines for loan growth than larger banks.27 As credit becomes more difficult to access at smaller banks, borrowers may seek loans from larger banks. However, lending is a relationship business, and larger banks generally will not have the same relationships with these borrowers that their smaller bank lending officers did. We believe this is likely to result, in the aggregate, in a decline in the extension of credit.28 Offsetting this pressure to some degree, a lot of loans made in the U.S. economy come from non-bank institutions, such as insurance companies, private equity firms, and other alternative asset management firms.29 In addition, we believe mortgage lending is less likely to be impacted by this particular issue, given the government’s involvement in purchasing conforming mortgages and packaging them into mortgage backed securities.30
Could a decline in credit extended by smaller banks tip the economy into recession? Many investors have been concerned about the possibility of a recession since the middle of 2022 when yield curves began to invert.31 We believe the recent bank failures increase the odds of recession. One offset is that the Fed is now more likely to be less aggressive with future interest rate hikes, and in fact the futures market is telling us at this time that investors now expect the Fed to cut rates as soon as June32. Some of the prior rate hiking cycles saw the Fed hike into a serious problem or crisis, and as a result the Fed paused and sometimes reversed, and this succession of events did not result in a recession for many years into the future.33
Martin Zweig, the respected investor and market forecaster, coined the phrase “Don’t Fight the Fed” in 197034, explaining his view that Federal Reserve policy can drive the market’s direction. If we are indeed approaching a point where the Fed will be cutting interest rates to offset a recession or period of slower growth, then we may also be approaching a point where investors might feel more comfortable about investing in the stock market.
4Bloomberg. S&P 500 Banks declined 11.2% over the 5 days ended March 17, 2023. See Figure 1.
7https://www.fdic.gov/news/speeches/2023/spmar0623.html The total amount of unrealized losses on bank balance sheets was $620 billion as of December 31, 2022.
9https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html As of March 17, Fed Funds futures markets are pricing in a 62% chance of an interest rate increase at the Fed’s next meeting on March 22, 2023. See Figure 2.
12https://www.federalreserve.gov/releases/h41/20230316/ Federal Reserve Statistical Release H.4.1 showed that, as of March 15, 2023, there were $12 billion of BFTP loans and $153 billion of discount window loans on its balance sheet. There were also $143 billion of other credit extensions to banks in FDIC receivership.
13Bloomberg. The Forward Rate Agreement-Overnight Index Swap spread was 0.47% on March 17, up from 0.03% on March 8. Its five-year average is 0.22%. See Figure 4.
14“The Alchemy of Finance” by George Soros. pp. 2-3. “The Concept of Reflexivity.” Wiley. 1987.
15“The Alchemy of Finance” by George Soros. pp. 2-3. “The Concept of Reflexivity.” Wiley. 1987.
29https://www.federalreserve.gov/newsevents/speech/barr20221201a.htm Nonbank financial intermediaries, broadly defined, fund nearly 60% of the credit to the U.S. economy.
32Bloomberg – see Figure 3 below
33Evercore ISI. Weekly Economic Report. March 12, 2023. See Figure 5.
As of March 21, 2023