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 18^th 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.

Source

¹https://ir.silvergate.com/news/news-details/2023/Silvergate-Capital-Corporation-Announces-Intent-to-Wind-Down-Operations-and-Voluntarily-Liquidate-Silvergate-Bank/default.aspx

²https://www.fdic.gov/news/press-releases/2023/pr23016.html

³https://www.fdic.gov/news/press-releases/2023/pr23018.html

⁴Bloomberg. S&P 500 Banks declined 11.2% over the 5 days ended March 17, 2023. See Figure 1.

⁵https://home.treasury.gov/news/press-releases/jy1337

⁶https://www.snb.ch/en/mmr/reference/pre_20230315/source/pre_20230315.en.pdf

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.

⁸https://www.bloomberg.com/news/articles/2023-03-15/bofa-gets-more-than-15-billion-in-deposits-after-svb-failure

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.

¹⁰https://www.nytimes.com/2023/03/15/business/economy/silicon-valley-bank-federal-reserve-regulation.html

¹¹https://www.nytimes.com/2023/03/17/business/economy/economy-banks-recession.html

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.

¹⁶https://www.fdic.gov/news/press-releases/2023/pr23016.html

¹⁷https://www.wsj.com/articles/ubs-in-talks-to-take-over-credit-suisse-ed932b01

¹⁸https://www.fsb.org/2022/11/2022-list-of-global-systemically-important-banks-g-sibs/

¹⁹https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/svb-signature-racked-up-some-high-rates-of-uninsured-deposits-74747639

²⁰https://www.ft.com/content/dff4e577-9282-450c-9ae4-58d6572123e5

²¹https://www.wsj.com/livecoverage/stock-market-news-today-01-05-2023/card/when-held-to-maturity-isn-t-and-why-that-matters-to-silvergate-M3iuQ83zpMGeZLYKQnRv

²²https://www.ft.com/content/dff4e577-9282-450c-9ae4-58d6572123e5

²³https://www.wsj.com/articles/bank-collapse-crisis-timeline-724f6458

²⁴https://www.bloomberg.com/news/articles/2023-03-15/bofa-gets-more-than-15-billion-in-deposits-after-svb-failure

²⁵https://ir.firstrepublic.com/static-files/18c04dea-0d44-43ed-b420-b066d56e1f54

²⁶https://www.nytimes.com/2023/03/15/business/economy/silicon-valley-bank-federal-reserve-regulation.html

²⁷https://www.goldmansachs.com/insights/pages/stress-among-small-banks-is-likely-to-slow-the-us-economy.html

²⁸https://www.goldmansachs.com/insights/pages/stress-among-small-banks-is-likely-to-slow-the-us-economy.html

²⁹https://www.federalreserve.gov/newsevents/speech/barr20221201a.htm Nonbank financial intermediaries, broadly defined, fund nearly 60% of the credit to the U.S. economy.

³⁰https://www.fhfa.gov/about-fannie-mae-freddie-mac

³¹https://www.barrons.com/articles/yield-curve-inversion-bonds-a483aaed

³²Bloomberg – see Figure 3 below

³³Evercore ISI. Weekly Economic Report. March 12, 2023. See Figure 5.

³⁴https://requisitecm.com/pdf/dont-fight-the-fed.pdf

Figure 1 

Figure 2

Figure 3

Figure 4

Figure 5

As of March 21, 2023

February 2023 | Equity Commentary

Published on March, 16th, 2023

The ‘economic good news is bad news’ trade was on in February, with the S&P 500 falling 2.5% for the month. The 10-year US Treasury bond yield rose from 3.5% to 3.9%, essentially reversing January’s move.¹ During the month, we believe inflation readings appeared hotter than financial markets may have expected, and the economy showed few signs of weakening substantially.  This occurred in the backdrop of the Fed having slowed the pace of rate hikes from four consecutive 75bp hikes in June, July, September, and November, to 50bps in December and 25bps in early February.² In testimony before the Senate Banking Committee on March 7, Chairman Jerome Powell said “if the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes,” noting that recent data appeared to mark a reversal in the prior trend of cooling inflation. Interest rates futures markets continue to bid up expectations for the benchmark fed funds rate in 2023. At the last Fed meeting, market expectations were for peak fed funds of 4.9% in May, falling thereafter to a year-end level of 4.3%. By March 6, investors were forecasting a peak rate of 5.5% in September, declining only modestly by year end to 5.4%.³

Inflation data released in February did not offer much encouragement to the Federal Reserve, in our opinion. The Fed’s preferred measure of inflation – the Personal Consumption Expenditures (PCE) price index – increased by 5.4% year-over-year in January, which was slightly worse than December’s 5.3% print.⁴ The Consumer Price Index (CPI) and the Producer Price Index (PPI) continued to show improvements year-over-year, but the pace of deceleration slowed – a point we believe is not lost on market watchers and the Fed. 

The Labor Department reported a 6.4% year-over-year CPI increase in January, which marked only a very modest improvement from December’s 6.5% rate of increase. More worrisome to us was the month-over-month change in CPI, which at 0.5% from December to January was a significant move higher than the previous month’s 0.1% increase. Core prices, which exclude energy and food, were up 5.6% year-over-year, again only a slight improvement from December’s 5.7% year-over-year increase.⁵ Much like January’s CPI report, the January’s PPI improved year-over-year compared to December, but the 0.7% month-over-month from December to January was a sharp reversal from December’s -0.2% decline from November.⁶

We believe the divergence between goods and services continues to be the key sticking point in today’s inflation story. Core goods prices have stabilized while shelter costs (a key component of services) rose at their fastest annual pace since 1982.⁷This inflationary pressure is a byproduct of continued strength in the labor market, coupled with consumers increasingly shifting their spending from goods to services. Consumers spent more in restaurants, bars, and hospitality in January, helping drive a 3% increase in retail sales from December to January – the biggest monthly jump in almost two years.⁸

Energy’s contribution to inflationary pressures also remains high on our watchlist, particularly as the war in Ukraine continues. In response to Western oil sanctions, Russia announced it would cut oil production by 5% in March.⁹ In our view, this move should not impact global oil prices very much, but it does appear to signal Russia’s willingness to potentially disrupt global energy markets.

Regarding the outlook for services inflation, the US labor market continues to look largely unresponsive to Fed rate hikes, in our opinion. Nonfarm unemployment jumped by 517,000 in January, which blew past consensus expectations for a roughly 200,000 increase¹⁰. Initial jobless claims – a proxy for layoffs – were also seen ticking slightly lower in the last week of February, which suggests to us, that employers continue to desperately cling to workers. First-time applications for unemployment benefits fell to 183,000, the lowest reported level since April 2022, and unemployment rate fell to 3.4%, a 53-year low.¹¹ One bright spot for the inflation picture is that average hourly earnings rose 4.4% year-over-year in January, which marked the smallest increase since August 2021.¹²

Economic data in services and manufacturing remains mixed, in our view. In February, S&P Global’s index of services businesses rose to 52.1 pushing it back into expansion territory and marking the strongest reading in eight months. U.S. companies that participate in the surveys reported their first growth in output since last summer and indicated optimism about activity in the months ahead.¹³ 

S&P Global’s February manufacturing index reading rose to 47.3 from 46. in January. While still contractionary, the improvement suggests that activity is contracting at a slower pace, and manufacturers indicated that softer demand has allowed them to work through the backlogs that remain a legacy of the pandemic ISM’s survey also showed contraction.¹⁴ Businesses said they were slowing output in anticipation of weak demand in the first half of 2023, but that expectations were in place for a growth pickup in the second half. A key data point, in our view, from the survey was that the index for input prices moved above 50 for the first time since September, a cautionary sign that price pressures could be creeping higher again.¹⁵

Sources

¹Bloomberg. SPX 500 Index DES. USGG10YR GP Function

²United States Fed Funds Rate – 2023 Data – 1791-2022 Historical – 2024 Forecast

³Bloomberg: Implied Overnight Rate & Number of Hikes/Cuts 12/14/22 and 3/6/23

⁴Personal Income and Outlays, January 2023 _ U.S. Bureau of Economic Analysis (BEA).pdf

⁵https://www.bls.gov/cpi/

⁶Producer Price Index News Release summary – 2023 M01 Results.pdf

⁷https://www.nbcnews.com/business/economy/inflation-rate-january-2023-what-it-means-will-interest-rates-go-up-rcna70401

⁸U.S. retail sales roar back; manufacturing shows improvement _ Reuters.pdf

⁹Russia to cut oil output by 500,000 bpd in March _ Reuters.pdf

¹⁰https://www.cnbc.com/2023/02/03/jobs-report-january-2023-.html

¹¹https://www.wsj.com/articles/january-jobs-report-unemployment-rate-economy-growth-2023-11675374490

¹²https://tradingeconomics.com/united-states/average-hourly-earnings-yoy#:~:text=2%2DYear%20Low-,Average%20hourly%20earnings%20for%20all%20employees%20on%20US%20private%20nonfarm,earnings%20since%20August%20of%202021

¹³Global economic growth accelerates to eight-month high in February _ S&P Global.pdf

¹⁴https://www.pmi.spglobal.com/Public/Home/PressRelease/f982d001dbbe4b4daec4f54d2260874e

¹⁵February 2023 Manufacturing ISM® Report On Business®.pdf

As of March 16, 2023

March Madness

Published on March, 13th, 2023

A series of events last week culminated in the United States Treasury announcing over the weekend that it would take steps to stabilize the banking industry.  These actions included providing access to all depositor funds at two banks which were shut down by regulators, as well as a new funding vehicle to guarantee that all banks have access to liquid funds should the need arise in order to meet withdrawal requests by customers.  The pace at which these events have unfolded is concerning, but we believe these actions by the Treasury should stabilize the banking system and prevent further panic by bank customers.  However, there may be some additional issues which arise in the industry as the full implications of this episode become clearer in the coming days and weeks.

Last week, on March 8^th, the holding company for Silvergate Bank announced that Silvergate would close down and liquidate its operations.  Silvergate was a California-based bank unknown to most Americans that went public in late 2019.¹  The bank described itself as the leading provider of innovative financial infrastructure solutions and services to participants in the nascent and expanding digital currency industry.²  Silvergate also built and operated a 24 x 7 currency exchange where cryptocurrency traders could buy and sell digital currency instantaneously.³  As a result, a large proportion of the bank’s depositors were cryptocurrency traders.⁴

The downfall of Silvergate may have been catalyzed in part by the November 11 collapse and bankruptcy of the FTX cryptocurrency exchange, the details of which are still being analyzed and uncovered.  As a result of the FTX bankruptcy, cryptocurrency investors may have grown more cautious about the creditworthiness of the various entities operating in the crypto world.¹ We believe that as Silvergate’s depositors began to withdraw more and more of their funds, this eventually began to put pressure on the bank’s balance sheet.  (This is referred to as a “run” on the bank.)

In a simple model of a bank’s balance sheet, the bank takes in deposits from customers and uses those deposits to make loans as well as to invest in safe fixed income securities, usually government bonds.   Typically, these bonds are divided into two categories, one of which is very short term and used for funding customer withdrawals, while the other can be thought of as longer term that might be held to maturity.⁵ 

If more withdrawals are requested of the bank than can be funded by the short-term category, the bank must then start to sell bonds from the long-term category.  If those long-term bonds are priced at a loss because interest rates have increased, the bank must realize that loss by selling in order to provide funds back to the customers who are withdrawing their cash.  However, if these realized losses are large enough relative to the net worth of the bank, the bank may end up in trouble.⁵  On March 8^th, this situation appears to have developed at Silvergate Bank.

The very next day (Thursday), Silicon Valley Bank, whose parent is bank holding company SVB Financial Group, also suffered a run by depositors, and its stock price fell by 60%.⁶  That bank’s shares never reopened for trading on Friday and it was seized by the FDIC.⁶ SVB was a somewhat unique bank in that its deposits were largely from start-up companies, many of which had not yet done an IPO.⁷  SVB was also far larger than Silvergate, with total assets at year end of $212 billion compared to Silvergate’s $11 billion.  According to company SEC filings, of SVB’s year-end deposits of $173 billion, just $74 billion were used to fund loans, while the remainder were largely invested in government bonds. 

Just as was the case with Silvergate, SVB’s depositors apparently began to worry about the health of the bank, and many rushed to withdraw their funds.  Ultimately SVB was in a situation where it began to realize losses on its bond portfolio which exceeded the bank’s equity,⁶ which seems to be why it was seized by the FDIC on Friday March 10.  Another bank said to have exposure to crytpocurrency, Signature Bank, was closed down on Sunday by New York state regulators.  Signature Bank had year-end total assets of $110 billion.

The unusual aspect as we see it to the seizures of SVB and Signature Bank is that both banks are apparently not facing problems with bad credit or delinquencies.  Rather, they seemingly faced issues of liquidity and access to capital to shore up their balance sheets in the short term.  We think that is what makes this episode so different, say, than the 2008 financial crisis where there were bad loans that ultimately destroyed the equity capital of many banks in the U.S.⁸  What we saw last week was not a credit problem. We believe that, in general, bank assets are creditworthy, and banks are well capitalized. Many rules promulgated since the 2008 financial crisis have required this, and the Fed conducts annual stress tests on the largest U.S. banks to ensure it.⁹ In our view, those tests were very tough in recent years, and all large U.S. banks passed them.

We believe that the bank seizures, as well as the winding down of Silvergate, can be at least in part tied to the Federal Reserve’s interest rate hikes which began in March 2022 as part of the Fed’s efforts to fight inflation, as well as the reversal of its quantitative easing program, called quantitative tightening.  In past rate hiking cycles, we have often seen that “something breaks” and the Fed has to stop. Examples that we think about include Long-Term Capital Management (1998) and Continental Illinois (1984).

On Sunday March 12, the United States Treasury announced that all depositors of SVB and Signature would be able to access all their funds on Monday. This includes all deposits, even those exceeding the FDIC insured limit of $250,000 per depositor. The Federal Reserve also announced a new Bank Term Funding Program that will lend against Treasury and agency securities at par for up to one year, providing another resource for banks to meet depositor requests for funds should the need arise, in addition to the discount window. For now, we believe these actions are likely to limit further contagion and fears about the health of the U.S. banking industry. That said, it is possible that other factors like rising deposit costs that result from this episode could continue to weigh on at least some banks going forward.

Source

¹https://en.wikipedia.org/wiki/Silvergate_Bank

²https://www.silvergate.com/about-us

³https://www.reuters.com/technology/crypto-focused-bank-silvergate-plans-wind-down-operations-2023-03-08/

⁴https://www.forbes.com/sites/digital-assets/2023/03/02/crypto-bank-silvergate-sees-client-exodus-as-delayed-annual-report-puts-future-in-question/?sh=ceaf9175a197

⁵https://www.imf.org/external/pubs/ft/fandd/2012/03/basics.htm#:~:text=Although%20banks%20do%20many%20things,whom%20the%20bank%20lends%20money).

⁶https://www.wsj.com/articles/silicon-valley-bank-svb-financial-what-is-happening-299e9b65

⁷https://s201.q4cdn.com/589201576/files/doc_financials/2022/q4/Q4_2022_IR_Presentation_vFINAL.pdf

⁸https://www.fdic.gov/bank/historical/crisis/overview.pdf

⁹https://www.federalreserve.gov/publications/comprehensive-capital-analysis-and-review-questions-and-anwers.htm

As of March 13, 2023