We had a somewhat technical but interesting discussion in our Domestic Team meeting today on what’s going on in financial stocks. It’s been a quick move, but banks have gone from outperforming the market circa mid-February to pushing towards new 52-week lows today. There is a formal bankruptcy/unwind of a bank catering to the crypto crowd, Silvergate Capital, which has not happened in a long time (since the 2008-09 time frame). Another more mainstream bank, Silicon Valley Financial Group, has effectively been shut down by regulators as a result of outsized deposit flights.
What’s going on?
The issue pressuring bank stocks is asset liability management and the rapid repricing (lower) of securities portfolios. Bond yields are higher and could go (still) higher on a higher terminal rate from the Fed as unemployment/labor slack remains more or less non-existent despite their aggressive moves. Most bank securities are packages of loans, such as mortgage-backed bonds or packages of commercial loans, whose prices will track very closely government bond yields and commercial yield spreads. This means these securities are down a lot in price. Though many banks intend to hold their investment securities to maturity, should a bank need to sell some positions for liquidity-management purposes, they will book losses, impinging on capital ratios.
The business of a bank is pretty simple: take deposits (liabilities), make loans (assets), and earn a spread, or alternatively take deposits and buy books of loans (also assets) as securities. The primary risk that investors are familiar with for banks is credit risk – what if the loans go bad and are not worth 100% of par? Should credit losses become too large, a bank can find its capital position eroded, necessitating a capital raise or outright insolvency if the gap is too large. But there are other risks. If asset and liability positions become unstable, it can quickly create a liquidity problem, which is not supposed to create a capital problem but is at present for some weaker banks. The liquidity risk issue is why the Federal Reserve exists. Should a bank need liquidity (cash) to satisfy depositors who demand their money all the sudden, the bank need not firesale its loan or securities positions; rather it can pledge these as collateral to the Fed, and thereby receive cash for the depositors. But what if the value of securities books are deeply underwater because interest rates have gone up suddenly after years and years of trading in a narrow range? Well – that can be bad. And that’s exactly what’s happening right now. Securities are being sold to satisfy depositor outflows, leading to realized losses, leading to capital pressure. Depending on how extensively the deposit outflows are, the bank in question may not be salvageable or may need to dilute its shareholders (never a good thing).
For Silvergate, a bank that specializes in providing services for crypto-industry clients, it requires little imagination to see why depositors may be spooked. It appears likely that this company won’t exist in a couple of months time, perhaps indicative that regulators/the Fed won’t provide assistance to you if you do a lot in crypto-land.
Banks as a group are down in sympathy. Deposit-base stability is becoming the ground zero of the banking sector given the speed of Fed hikes and the speed by which depositors can move money into higher-yielding deposits. We don’t believe the issue is existential for bigger diversified banks with extensive depositor bases. However, should bank liquidity preservation issues become more widespread, the economic impact can be quick and decisive.
Another unique post-COVID wrinkle is the massive inflow of deposits into the banking system over the last several years (due to QE in 2020-21). These excess deposits were invested in securities, as the flood was too rapid to make loans. This is amplifying the securities book valuation issue. The securities book has repriced much quicker than expected and impinges on capital if sold given market losses. The speed of the Fed hikes is the issue. Normally a securities book put together under such circumstances is shorter duration, so as it rolls over cash can be deployed into higher-yielding new investments. However, even a shorter-duration book is underwater. Meanwhile, the deposits are now in outflow, forcing sales at a loss, leading to capital and liquidity questions. Not good.
Would we step in and buy banks here?
For now we are just watching…
This may take a while to clear up, and we sense better risk/rewards elsewhere in the market.
Cambiar has been cautious about U.S. banks since early 2022 and has held conservative allocations in our domestic strategies. Down the road, we harbor concerns that some asset quality problems are unavoidable in sectors that benefited from the (now ended) lowflation era, such as commercial real estate and private capital-related activities such as leveraged loan books. These are not fatal, they just are not positive. The asset-liability management issues were not top of mind in early 2022, as we did not expect the Fed to become as aggressive and reactive as it has been. But clearly, that’s what we have, and the implications of an unpredictable Fed in a $300+ trillion fixed income universe should not be trivialized.
We do expect the Fed Funds rate will top out in the 5.25-5.5% range, by which time broader economic weakness should discourage further hikes. But we don’t envision cuts until some time in 2024. Our sense is the liquidity and securities valuation issue will persist until the Fed is clearly done raising rates.
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