It’s extraordinary how the world can turn upside down in just a few days. Up to and including 9th March, Fed Futures were pricing in at least 0.25% of rate hikes. The real debate was around a possible 0.50% rate hike! Then, last Friday 10th March, Silicon Valley Bank (SVB) erupts resulting in a gruelling week in markets with endless contagion talk of this spreading to other Banks. At first, that seemed to be the case as Signature Bank (SB) failed. On Monday 13th, thanks to the announcement of a joint Fed-FDIC-Treasury led programme to protect Depositors and take control of SVB and SB, things looked like they were calming down and markets began rallying. Instead, fears spread very quickly across the Atlantic to Credit Suisse (CS), renewing fears it too would collapse. The latter witnessed several hundred million euros of outflows by Depositors. For decades, arguably centuries, Banks have adopted a common business model: they take in deposits and lend to those in need of credit. Nice idea but it has one problem. The deposits tend to be short-term in nature (Overnight to say 2y fixed). They use these monies to make loans as well as to invest in assets (typically but not exclusively Government Bonds & Government-Backed Securities). The loans are longer-term (often multi-year). So what’s the problem? After all, they earn more on the loan rates than they pay on the deposits and meanwhile the assets are safe, right?! First, it creates a liquidity mismatch so when Depositors get spooked, they run for the door creating a run on the bank. The Bank has to honour the withdrawals. As it only maintains a certain % in reserves, Banks are forced to liquidate assets – after all, they can’t just pull the rug on the loans advanced as these are contractual…..and there’s the second issue, it results in fire sales which depress these asset prices. In the case of SVB, it was incurring several billion dollars of losses due to these fire sales. Finally, there are thousands of Banks – so the likelihood is there will be more than one Bank undergoing pain. Sure enough, SB and First Republic Bank (FRB) failed too. There are mechanisms in place to limit damage and indeed strengthen their balance sheets – the biggest being regular stress-testing scenarios and the provision of adequate Capital (referred to as Tier 1). These are essentially a way of maintain adequate Capital Adequacy to cover for a jump in defaults. The riskier the loans, the more capital Banks must keep. And both SVB and SB held risky assets given their Tech start-up and Crypto lending focus. FRB is a regional Bank. The trigger, for this collapse, was quite simply fast, rising interest rates due to fast, rising inflation. Markets can generally handle most things thrown at them – what they struggle with is a sudden change in speed and direction. That’s what has been happening these past twelve months. The Fed and other CBs have been so obsessed with raising rates to bring down inflation, we think they underestimated the impact of their actions on the ultimate transmission mechanism – namely Banks, especially the smaller and/or boutique, specialist ones!
So, first an update on where things stand today re this casualty list:
SVB & SB: FDIC has a broad mandate to sell SVB and SB at the best possible price. It asked banks to submit their bids by Friday 17th – be it whole or piecemeal. Bloomberg reported Apollo Global, Ares Management, Blackstone, Carlyle and KKR were among those looking to acquire. We already witnessed the speedy acquisition, for a humble £1, the acquisition of SVB UK, by HSBC, in a deal facilitated by PM Rishi Sunak, the BoE and the FCA. So the sale of the main US book should not be difficult. In fact, it may not even go as cheaply as first thought. SVB has a book of some $74bn. Over half ($40.5bn) comprises credit lines backed by capital call commitments from its investors with maturities between 1 to 2 years. This book has low interest rates and default rates (only one net loss since inception with non-performing loans = 0.18% of total loans in 2022 vs 1.57% in 2008). This portion of the book won’t likely go at a big discount. There’s real value in buying this kind of book – especially in terms of forming new networks for the acquirer(s). Seeing as FDIC is responsible for its sale and is temporarily acting as a funding conduit while it works things out, it’s most unlikely these assets go in a fire sale. With Depositor monies secured under the Fed-Treasury-FDIC initiative, it’s now all about securing the start-ups. The equity and bondholders, in between, are dispensable.
CS: The Swiss National Bank (SNB) pledged to bankroll CS by extending it a CHF50bn liquidity line (on Thursday 16th). CS has been surrounded by rumours and worries of collapse since Q4 last year (when $120bn in deposits left). This has increased a further $450mn over 13th to 15th March (Morningstar) on the back of Retail and Institutional withdrawals. It is now down to CS’s management to come up with a credible plan. Management wants to diversify business from investment banking (which revenue slumped -88% in Q4 2022) & trading securities to managing money for High Net Worth clients. The size of this support package is substantial and worries that CS may well draw upon all of it has sent its shares down -10% yesterday, Friday 17th (on Thursday: +20%, on Wednesday: -24%). Data, since the 15th,has yet to be collected but will be keenly watched to see if the rot has stopped.
FRB: As of 15th March, its cash position was $34bn. On Thursday 16th, large US Banks injected around $30bn in deposits as part of a rescue to shore up its capital base. FRB’s shares have slumped -70% over the last, nine trading sessions. FRB is a regional lender and, in its statement, the big US banking names include JPM, Citi, BoA, WF, GS and MS. The deal was brokered by the Treasury (Janet Yellen), the Fed Chair (Jerome Powell) and JPM (Jamie Dimon)
What does it all mean?
There’s no denying the strain on the banking system. Yesterday’s price action (Friday 17th) confirms that. The tech-heavy NASDAQ was down -1.19% on the day while the S&P 500 was down -1.10% on the day. Investors retreated from FRB and other, Regional bank shares. The same was true of CS. In a further sign of stress, for w/e 15th March, Banks borrowed a combined $164.8 billion from two Fed facilities post SVB. The Discount window (effectively the Fed’s traditional lender of last resort facility) borrowing shot up to $152.85bn (from $4.58bn the week before; its all-time high is $111bn). Despite all the measures executed so far, the Fed has still not convinced investors of stability. Confidence is still missing!
….and the trigger for all this? As mentioned earlier, fast, rising rates over these past twelve months. Central Bankers are still undecided over the future path and speed of rates hikes! Latest betting odds (Fed Fund Futures) have a 0.25% rate hike on the cards but some FOMC voting members are still calling for a hawkish move. ECB hawks are pushing for more rate increases despite its 0.50% hike on Thursday 16th. However, there was a change in their statement….they removed an explicit signal to increase interest rates further and instead replaced it with “further tightening was now dependent on three criteria: (i) incoming economic and financial data, (ii) the dynamics of underlying inflation and (iii) policy transmission mechanism”. This suggests financial market turbulence, if sustained, would affect prospects for more interest rate rises”. Currently, a +0.25% hike expected on 4th May.
The BoE, already signalled before the SVB situation, further rate hikes were not a certainty. The change in tone was clear. Traders are placing a 60% chance it will lift rates 0.25% to 4.50% while 40% have them on hold come 23rd March. The main concern is the mortgage market where 40% of fixed rate mortgages reset by year-end.
CBs around the world have been reassessing Bank risk and have been quick to reassure markets there is no cause for concern. Examples include the RBNZ which issued a statement saying “our banks operate different business models that mean they are not as exposed to the risks that have led to recent events…..our rigorous stress-testing has shown they are well-placed to deal with far more adverse situations than what we are currently experiencing”. The Philippine CB said the local banking system remains safe and sound stating “our banks do not have any material exposure to the failed institutions”. Vietnam plans tighter limits on the stakes that can be held in banks. Currently, the individual limit is 5% and the proposal is to bring it down to 3%. Institutions would see it drop from 15% to 10% (but did not specify how much time they might be given to accomplish this in). This is not good for foreigners.
Meanwhile, US inflation data offered little respite (see Tuesday 14th summary below). The reduction was tiny while core inflation remains hard to shift. Certain categories, such as rents and OERs (Owners Equivalent Rents) have yet to show signs of decline. Encouragingly, there are signs rents are beginning to come down in some states as gluts appear in some rental markets.
GS has raised its recession probability to 35% (from 25%) over the coming twelve months citing: (1) near-term concerns around stresses being faced by small banks which, in turn, have increased uncertainty about the economic outlook and the path for the Fed; (2) SME banks play an important macroeconomic role, accounting for roughly 50% of US commercial and industrial lending, 60% of residential real estate lending, 80% of commercial real estate lending and 45% of consumer lending; (3) A moderate further tightening of lending standards in response to recent events and (4) the expectation these events will deduct -0.25% to -0.50% from 2023 US GDP. Data thus far suggests deposits have begun to migrate from small banks toward money market funds though liquidity provisioning appears to be helping banks meet near-term funding needs and funding commitments. It will take time to assess the impact on lending and its impact on risk to growth.
The authorities have done enough for now and have the weapons to do more if required. The biggest challenge they face is restoring confidence – if that goes, then Banks (and others) will collapse in a chain reaction. It may not come to this and we’ve outlined some of the reasons below: A very useful indicator (of Bank and any other credit risk) is the CDS market. CDS stands for Credit Default Swaps and essentially represent the cost of insuring yourself against the risk of debt defaults. Think of it as the cost of insurance. A really interesting chart by Deutsche Bank looks at various Bank CDS prices (in an index called the iTraxx CDS EUR Financials). It is clear, that with the exception of CS, the cost of CDS (i.e. insurance) has only risen slightly. That of CS has risen nearly 10X because of a perceived risk that there would be a run on the bank. Instead, the CHF50bn liquidity provision from the SNB effectively isolates and shores up support for it. That risk now has effectively been removed.
Despite the daily fall mentioned above in the S&P 500 and Nasdaq on 16th March, they are still up +1.43% and +4.41% respectively on the week. Why does this matter? Because it shows no shortage of bargain hunters ready to step in and buy into the technology sector! Meanwhile, it is clear big Banks are busy shoring up balance sheets of troubled banks.
Citadel announced a $5.4bn investment into Western alliance (a regional bank) facilitated by UBS. UBS issued a statement saying it believes contagion risk has passed.
There is now a question mark over the magnitude and frequency of further rate hikes. SVB – and the collapse that has ensued – has given Central Bankers and Politicians the perfect “get out of jail card” i.e. suspend additional rate hikes until further notice. The UK is a good example as referenced above due to upcoming mortgage renewals. Meanwhile, we would question the efficacy of rate hikes in the US given that (1) median consumer net wealth remains at an all-time high since 2008 despite last year’s market sell-off; (2) less than 5% of mortgages are floating while the remaining 95% are fixed at 15y and 30y rates (90% of fixed rate mortgages are fixed for 30y); (3) wages continue to rise albeit below the rate of inflation – most consumers don’t even know the distinction between nominal and real rates anyway and (4) savings are still quite plentiful taking into account both the current savings rate plus pandemic leftovers. So, if anything, the Fed has overcooked it on rates – to the detriment of the likes of SVB, Signature Bank and FRB, and perhaps more! It – and other CBs – has to be very cognisant of its actions from here.
Commodity prices have fallen significantly, especially energy prices. At some point, the lag will pass and this will feed through to consumers helping to ease their outgoing expenses at a headline level. Core inflation will remain sticky for years to come but we will just have to adapt.
The problems encountered these past few days have been entirely idiosyncratic. Such crises can be isolated and this is an important point here. In 2008, the problem was systemic. This is not the same – the system itself does not face an existential threat.
MARKET SUMMARY Given all the above, Global cash funds saw inflows of over $112bn in the week to 15th March. Global equity funds were largely unchanged registering a small, net outflow of -$26mn; $2.3bn went into global bond funds and $600mn into gold funds. $9.8bn went into Treasuries (flight-to-safety) with EM debt recording outflows of -$3.1bn.
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