Week Ending 31st March, 2023
After the events of the past couple of weeks, this week saw some calm return to markets as intervention attempts to stem deposit outflows seemed to be working. It has been a return to “risk-on” with Equities higher, Bond prices lower, Volatility lower, US$ lower, Commodities higher……and Bitcoin higher.
Where do the events of the past two weeks leave us – in particular, has the banking problem gone away? We fear not! In an attempt to quash inflation the rising rates saga, of the past year, has highlighted some key considerations & risks:
The deal announced by First Citizens BancShares (FCB), to acquire Silicon Valley Bank (SVB), is not quite what it seems. Not highlighted particularly well is the extent to which this deal had to be sweetened in order to get the sale done. FCB acquired $72bn in SVB assets at a discount of $16.5bn (per Federal Deposit Insurance Corporation (FDIC)). Even post closure, it is FDIC that remains liable to dispose the majority of SVB’s assets (some $90bn) which are being kept in receivership. In FDIC’s eyes, the deal was taking longer and longer. The more stale it would become, the bigger the discount (sweetener) that would need to be applied. For FCB, it doubles its asset size to $219bn and acquires all the loans and deposits plus all 17 branches. The sale excludes investment securities as SVB’s bonds remain with FDIC – and these have dropped in value. FDIC has agreed to a 5y loss sharing arrangement on the commercial loans FCB is taking over. On top of all this, FDIC is giving FCB a $35bn loan at just 3.5% to finance this entire transaction. For this, FDIC receives equity rights. Put it altogether, this deal costs FDIC around $20bn. It will be funded by higher fees on US banks that are protected by FDIC. It’s a great deal for FCB but what kind of precedent does it set for further rescue packages?
Since inflation & rates began rising, some $600bn in deposits have left banks – and it has come almost entirely from small banks. At present, flows have stabilised as fear has dissipated this week. Comparing the weekly net lending and deposit flows of Large US banks vs Small US banks, prior to this week, shows a very divergent picture. For the large banks, deposit outflows have not been too severe while loan books have grown at a modest pace. For small banks, the mismatch has gapped – deposits have tumbled while loan growth has been marginally positive. MM (Money Market) funds have picked up massively (to about $5tn). These are NOT guaranteed by the Government! Where a bank’s assets are held in government bonds, the risk here is pretty much zero – hold to maturity assuming of course the Government in question doesn’t default. It seems the trigger was when bond yields, especially the 1y and 2y Treasury bonds, were both in excess of 5% (circa 5.25%) while the 10y and 30y Treasuries were close to 4%. Bloomberg referred to it as a “Malcolm Gladwell” moment (“The Tipping Point: that magic moment when an idea, trend or social behaviour crosses a threshold, tips and spreads”). Bond market returns became (and still are!) attractive for Depositor monies to go to.
What else is on these small/mid-sized Bank balance sheets? Commercial Real Estate (CRE)! An analysis by Trepp puts small bank exposure to CRE at $2.3tn (includes rental-apartment mortgages). This is some 80% of commercial mortgages held by all banks. This year is key as about $270bn of commercial mortgages are set to expire and most of these are held by banks with less than $250bn in assets. So if the rising rate scenario spills over and results in a large number of defaults – forcing banks to write down values – this will be another Malcolm Gladwell moment. A study by Columbia Business School had estimated the value of loans and securities held by banks is circa $2.2tn LESS than the book value shown on their balance sheets. These mortgages are not publicly traded, and their values vary by type of building, location, etc., so assessing their values is not easy. Trepp also reported the delinquency rate ticked up +0.18% to 3.12% in Feb, the second largest increase since June 2020. Furthermore, the distress in the office market is starting to spread to high-end buildings as the combination of remote work and rising rates fuel defaults and vacancies. The share of US office space vacant in the 50 largest US metro areas has been rising, since 2000, to now stand at 18.8%. The last peak was only slightly above this but under 20% and that was around the late 1980s/early 1990s.
….and what about beyond the banking sector? For corporate borrowers, it hasn’t really started. In 1990, Fed data showed interest paid, by non-financial businesses as a share of their outstanding debt (= proxy for average interest rates) was 13.3%; by 2021, this figure was 3.6% - the lowest level since the late 1950s. Over the same period, yields on Baa-rated corporate debt fell from 10.4% to 3.4% respectively. The inflation fight has meant corporate bond yields and rates on business loans have risen fast. Moody’s estimates it at 5.1% for 2022 and an average of 5.6% this year. The debt maturing this year is not small - Calcbench has it at $73.6bn. They estimated the weighted average interest rate, on that same debt, to be just 2.65%. This debt resetting is the next factor waiting to fall. For 2024, debt maturing is estimated at $710bn, $2025 is $862bn and 2026 is $880bn. Companies typically – but not always – refinance some 12mths to 18mths before maturity.
What’s the solution?
- Pause rate hikes: This is a very likely option, especially given this week’s inflation data which show some substantial declines at a headline level due to similarly substantial declines in energy inflation. A pause is possible in May, but we still have more inflation to come between now and the next FOMC session (May 2nd – 3rd). Talk of this as well as the “flight-to-safety” triggered by this month’s banking fallout has resulted in a big drop in bond yields. The same bonds referenced above (1y, 2y, 10y and 30y) are yielding 4.63%, 4.09%, 3.5% & 3.70% respectively. The Europe is a different story - ECB Board member, Isabel Schnabel, highlighted that despite recent declines in energy, inflation may not come down as fast as some would like to think. This is clearly evident in the CORE inflation numbers which remain highly persistent on both sides of the Atlantic. A good example of this is Spain where March headline Inflation plummeted to 3.3% y/y (vs Feb: 6.0% y/y) as energy costs retreated but core inflation (ex-food & energy) is at 7.5% y/y (Feb: 7.6% y/y). In other words, core inflation there is more than double headline inflation.
- Rate cuts? Very unlikely! Powell has firmly ruled this out this year. The Fed is undecided on whether to pause – what hope for rate cuts! However, given the corporate debt and subdued growth outlook, the Fed will certainly be priming themselves for cuts at some point to try and head off debt maturing in 2024.
- Depositor guarantees: We need a resolution quickly. Confidence means different things to different people. For Depositors, they need to know their money is safe – at the moment we have an uneasy calm. This is the time to come up with extra measures. In the US, FDIC desperately needs to extend the protection to all deposits. Last week, we mentioned that there are some $7tn of uninsured deposits in the banking system. To extend protection to all deposits requires Congressional approval and the cost will be huge as extra taxes will have to be levied on all banks. Obtaining Congressional approval will be virtually impossible – especially with Friday’s news Trump has been indicted. It will more than likely toughen the resolve of hard-line, right-wing Republicans.
- Keep getting inflation down: …..and there’s the double whammy. That would require further, more severe rate hikes which will sure as hell tip the whole small/mid-sized banking cohort over the edge.
So where do the events of the past two weeks leave us? In a highly, precarious situation…..and we still haven’t seen a resolution to the debt ceiling crisis yet!