- Don’t panic; this is not 2008. Various government authorities will staunch bank runs and sustain financial stability. It’s their job to do that, and they do have the tools.
- The end of the rate-increase cycle by Central Banks is closer if not already reached. The economic impact will likely include yet-tighter lending standards by banks and a lot more regulatory scrutiny.
- The Malinvestment bubble from COVID and the 2010s is still deflating. 14 years of 0% interest rate policy and Q.E. have led to a classic malinvestment bubble in various pockets of the world economy.
- In 2023+, we anticipate rolling pockets of asset price deflation (including, but not limited to, regional banks with terrible asset-liability management) as various bubble beneficiaries deflate or implode.
Recent developments in the global financial sector have triggered an elevated range of questions: what to do, impacts, investment opportunities, and risks, etc. The situation on the ground is fluid and likely to change in the coming weeks. However, we do have a clear enough roadmap to share at this time (week of March 20th).
Beyond these observations, we would caution readers against over-extrapolating recent events into the future. There are no entrenched playbooks for emerging from a once in a century global pandemic, bond bubble, hyper normal monetary policy swings, and de-synchronization of global economies all at the same time. While we are not of the view that the U.S. stock market, valued at ~19x 2023 estimated earnings has much upside, it may be more of a market of stocks than a (synchronized) stock market going forward. There are plenty of opportunities to make and to lose money as we see it. Let’s start with the basics…
Why are there (suddenly) bank runs from depositors?
The closure of Silicon Valley Bank (SVB), Signature Bank, Silvergate Capital, the forced merger of Credit Suisse with UBS, and the likely demise of an independent First Republic Bank (FRB – this one is unresolved as of this writing) are all caused by bank runs (depositors demanding their money and moving it elsewhere). The affected banks’ capital positions had become thin to zero owing to interest rate increases crushing the value of bond holdings. Banks such as SVB and FRB grew their deposits very rapidly in recent years, which created an investment problem for them – where do you invest all this deposit money to earn adequate interest? They bought government bonds, mortgage-backed bonds, and other government agency debt in large quantities at the peak of the bond bubble in 2020-21. While there is no principal risk to these holdings, there is considerable interest rate risk should rates rise quickly – the bonds would lose value if long-term treasury bond yields broke out of the sub-2% range that they have resided in for most of the last 14 years. This of course is exactly what occurred over the course of 2022, and until this month looked to continue in 2023.
Most banks hedge their bond holdings’ interest rate risk via swaps and other derivatives. For some reason, these banks did not. While this risk was lying in plain sight in late 2022, people took notice in early March 2023, and then largely via social media, created a panic. Given that most depositors can access or transfer bank account funds via smartphone apps these days, the speed of the runs has been exceptional.
Why these banks?
Each of the banks experiencing high depositor outflow has its own unique dirty laundry, and we suspect more will come into view soon. The deposit base of SVB was notably concentrated among tech V.C.s, with many accounts well above the $250,000 notional FDIC deposit insurance cap. This made the run unusually quick and decisive. SVB famously went without a chief risk officer and removed some scant interest rate hedges in early 2022; retaining either of which may have prevented the catastrophic outcome. First Republic appears to be a similar (concentrated deposits) situation. Silvergate and Signature Bank are different – both handled fairly large amounts of crypto transactions.
crypto-oriented financial companies are unlikely to receive government agency help if they have funding or capital problems
At Cambiar, we are not vocal about crypto, but perhaps it’s time to be more upfront in our views. We don’t see cryptocurrencies as being capable of supplanting real world currencies and are highly skeptical of the value proposition for regular folks. Maybe they can serve as a store of value like collectible baseball cards for enthusiasts, though the phenomenon mostly seems like a 3-card Monty game on a global scale.
These views aside, there does not appear to be any sensible case for government agencies to spend taxpayer resources to regulate crypto into respectability, as this would seem to defeat the whole purpose of it (that it is independent of any government sponsor). On the other hand, crypto is quite possibly the greatest thing that has ever happened to money laundering, which bank regulators are highly motivated to prevent. Banks that handle large sums of crypto are likely to be unwitting or occasionally witting participants. Thus, when deposit outflows accelerated at FDIC-insured banks Signature and Silvergate that more than just dabbled in crypto and had some anti-money laundering (AML) issues, they were seized immediately versus being backstopped in some form. There is a harsh lesson here regarding the (nearly instant) demise of these banks: crypto-oriented financial companies are unlikely to receive government agency help if they have funding or capital problems. Credit Suisse (which is about to become a sub-holding of crosstown rival UBS) is a far more complex story. From where we sit,
Credit Suisse had become a reputationally wounded investment bank many years ago, lurching through a series of problems and gaffes for years that impaired profitability and capital generation, yet somehow had not scaled down its range of activities. Funding stress/depositor stress quickly made it impossible to continue forward on its own. The Swiss government has in effect, socialized most plausible losses of Credit Suisse’s portfolio of assets.
Is this a “systemic event”?
The point here is whether terrible risk management or AML concerns, there are justifiable company-specific reasons why these banks are now gone, making this not a systemic event. To amplify the point, the Fed, the Treasury department, the FDIC, etc. pulled out some MAJOR tools over the weekend of March 11-12th, such as providing unlimited access to liquidity via collateral pledges, where the collateral can be pledged at par versus whatever the current mark to market is, and more or less committing to unlimited depositor guarantees until things chill out, whenever that is. This has been underplayed by the financial press thus far. Valuing below-par collateral at par is an almost unbelievable step, though consistent with the regulatory treatment of investment securities. Depending on the magnitude of runs, the generous collateral terms could mean anywhere from $400 billion to $2 trillion of liquidity provided by the Fed to the system to defend against a banking panic.
Bank failures occur more often than you might suppose, though admittedly not $200 billion failures. The Fed and other Central Banks exist specifically to stop bank runs. That is their founding rationale, and they are stepping up quickly to stop these issues from becoming system issues. The Fed can lend an infinite amount of money against “good collateral” to stop bank runs. In 2008, the collateral was not (at all) good, creating a monstrous systemic problem. That is not the case currently.
Re-examining deposit insurance
From the dawn of the modern financial system, banks have always been vulnerable to a confidence blow to their depositors. It is not practical, nor feasible, for depositors to ask for all their money back and then put it back into their bank accounts when they feel better about things. Banks… don’t operate with the reserves in place to do this en masse. And yet it is axiomatic that bank depositors will, from time to time, question the solvency of banks, leading to destabilizing bank runs. This kind of thing happened frequently in the late 19th and early 20th centuries, culminating in the Panic of 1907, which led to the inception of the Federal Reserve. The Fed, ECB, Bank of England, etc. were explicitly set up as uniquely powerful financial institutions with an unlimited capacity to lend money to combat bank runs. The inflation fighting and economic steering features of Central Banks came later. This is their primary job! The FDIC deposit guarantee and Fed capacity to create an infinite supply of dollars to quash bank runs meant they almost never happened in the second half of the 20th Century. More recently, the growth of the economy in nominal terms has left the $250,000 deposit insurance cap as rather undersized versus a variety of individual and corporate deposits, which has stealthily re-opened the possibility of bank-run risk.
The $250,000 deposit insurance coverage level surely needs to be increased, as it is very impractical for small businesses or small charities to house their checking accounts across dozens of banks, or to closely follow the financial position of banks where they hold more concentrated deposits. This is an obvious gap in regulations and policy that should be addressed promptly. There are basic political and industrial questions about how to do this. Should the cap be $1, $5, $10 million? Unlimited? If 100% of banking system deposits are guaranteed, there is a huge moral hazard issue along with another basic question of what, exactly, banks are if their primary source of funding comes with blanket government guarantees? On the other hand, just as the banking system was vulnerable back in 1907 to bank runs via word of mouth, just how vulnerable is it in the age of Twitter? It’s fair to say that nobody really thought-out depositor risks in an age where most people have smartphone banking apps and check social media daily.
Are Fed discount window loans versus collateral a form of Quantitative Easing (Q.E.)?
No, they are not. These loans have a term of 90 days, and the Fed is swapping bonds to offset outflows of depositor cash. This cash will either come back to the afflicted bank or show up in a different bank (big banks are receiving substantial inflows). These deposits and any assets they buy to generate interest income will require capital reserves to hold. In Q.E., the Fed is a buyer, not a swapper, and their purchases create reserve capital in the system. Net, Q.E. increases system lending capacity, while bank runs (even if stabilized by the Fed) reduce lending capacity. There is potentially a down-the-road read that the Fed’s target balance sheet post Quantitative Tightening (Q.T.) of $6-6.5 trillion may need to be sized-up.
Do big banks (J.P. Morgan – JPM, Bank of America – BAC, Goldman Sachs – GS, etc.) benefit?
Yes, but the deposit growth they might experience is quite small relative to their size, and there is a capital requirement for onboarding the deposits of SVB and others. But net they should gain a tiny bit of share. We have heard anecdotally of months-long waits to onboard corporate accounts and payroll etc. at JPM from companies that were at SVB. JPM does not want/need more deposits. Overall, there are literally thousands of banks in the U.S. If we lose four or five and have slower growth in smaller banks because they have capital requirements raised, this won’t change the world all that much.
Would you buy shares in small to mid-cap banks now?
We cannot come up with a good story for smaller regional banks right now other than the “contagion contained” angle. They should face considerably more restrictive regulations; frankly these are necessary. Recent events are a very bad look for anyone favoring looser banking regulations in general – digital age banking runs spurred on by Twitter are a new and even scarier angle on how quickly a banking run can come about, as is interest rate volatility.
At the moment, there are two very different sets of bank regulations for Systemically Important Financial Institutions (“SIFIs” – >$250 billion in assets) and non-SIFIs (<$250B ). SIFIs hold more capital per dollar of assets, have tighter capital “rules”, and more of their balance sheet is liquid (and hedged against interest rate risk). Yet the systemic threat is coming from non-SIFIs, suggesting that they, too, are systemically important. The argument to impose SIFI capital and liquidity management rules on banks is clear and seems likely come to pass in the current Congress. This would force greater capital retention by regionals and fewer degrees of freedom, leading to low earnings growth and lower L.T. ROEs. There are other large asset-platform businesses, such as multi-trillion dollar asset managers and wealth platforms, where client assets are segregated from a two-sided bank balance sheet, that reside below SIFI capital rules. We are doubtful this exemption from SIFI-status and related capital rules can be sustained.
Net, although financials are down the most this month by far, we are not adding to banks given the pending regulatory issues (as well as down the road asset quality considerations). There is potentially a decent trade-off the lows, but we believe it’s more likely the group will go sideways for some time and may submarine into a lower multiple range. Outside the U.S., should the Credit Suisse contagion issues be contained successfully (we think it will), Eurobanks are already as or more tightly regulated than U.S. SIFIs. Unlike the U.S., a lot more of their loan books are floating rate, so these asset/liability mismatch issues are not so relevant for them.
Fed and ECB Terminal Rates – Are we there yet?
Entering the year, where exactly the Fed, ECB, and other Central Banks would stop represented a critical “known unknown” component of any market assessment. The Fed made a material policy error by continuing with hyper-stimulative monetary policy past early 2021. It does not need to make a second material policy error in a row by seeking to quash current inflation faster than is realistically possible.
There is a pretty good chance the peak Fed Funds rate is not much higher than where we are right now (4.75% Fed Funds floor). There was loose/crazy talk of 6% terminal rates which now seems laughable (this would indeed damage the whole system). As you have probably heard the expression, the Fed will keep going until it “breaks something”; the SVB failure and near failure of FRC do meet that criteria.
It is realistic to expect a meaningful tightening of lending standards (and capital retention) in the banking system. This is not a 2008 credit freeze, but however tight banks were in February, they are getting tighter. This would have the same effect as further increases in the Fed Funds rate in terms of contracting credit conditions. Smaller and regional banks represent 35% of the system by assets/loans. There is still plenty of banking system capacity, but for now one has to suspect very low/near zero loan growth from regionals, as they will need to hoard capital and liquidity.
The ECB did raise by 50 bps last week which was a pre-announced rate hike a couple weeks prior. Europe always lags the U.S. – inflation there is still accelerating but should start rolling over later this year. The ECB had multiple dissents on the raise, suggesting they too may be done after this move. The U.S. banking system is rather unique in having a high percentage of fixed-rate loans through the system. Most loans ex-U.S. are floating rate, which means there is an immediate transmission of higher rates into higher monthly payments. It’s reasonable to assume a lower terminal rate for the ECB, Bank of England, Swiss National Bank, etc.
Neutral vs. Restrictive Interest Rates, Interest Rates as a System Price
Let’s remember that before, mid-2022, nobody took the notion of a 4.5% Fed Funds rate very seriously. That was viewed as highly restrictive, with 3.5% already in restrictive territory. Given the sheer quantity of debt in the U.S. and the global financial system, it may not be possible for the whole system to run at 4.5% sustainably or even at 3.5% for very long. That’s another read from recent events. The steepest yield curve inversion since the peak rates of the Volcker era suggests that the market believes current Fed Funds rates are far above a longer-term neutral interest rate.
Determining the “correct” interest rate on sovereign debt, and especially the world’s dominant reserve currency, is not a straightforward analysis. For most goods and services, as well as corporate stocks and bonds, today’s price represents a balance between buyers and sellers. It is tempting to think of U.S. Treasury bond yields as accomplishing the same, but as the reference yield in a nearly $300 trillion world of bonds and loans, that is a gross oversimplification and rather misleading. In a non-traditional analysis of monetary economics, the U.S. risk-free interest rates represent a price (for debt) that allows the system to run correctly over time. The system was not running correctly at 0% Fed Funds as of early 2022, we really did have a bad inflation problem, so that was an incorrect system price. The Fed are on a mission to stop inflation (that they helped to launch). But they are not out to destroy the system.
It is entirely possible that the financial system “runs” better at, 3% 10-yr yield, a 2% Fed Funds rate, and 3% inflation going forward, versus the Fed’s stated 2% goal. For the moment, that is just a hypothesis, and not provable. But we think it has a good chance of being correct. This would entail that interest rates become less onerous than they are now by 2025 but that we do not go back to ZIRP, Q.E.-forever, and other (asset price distorting) features of the lowflation era that we believe has ended.
Malinvestment: Understand the nature of the problem
Cambiar is agnostic to where the opportunities reside, sector-wise, provided stocks meet our valuation and business quality features. We are not so agnostic, however, as to where we are in financial history. We do believe that 2022 was an important year as it marked the end of a long period of anomalously low capital costs (in both nominal and real terms) and other asset value-distorting factors that have on balance served to inflate certain asset prices, return streams on those assets, and price signals emanating from those assets. The sheer length of this period has contributed to a malinvestment bubble that we are still working through. Malinvestment is a by-product of incorrect/distorted price signals, especially if they endure for extended time periods. The travails of SVB and FRB (they bought way too many bonds at super low yields, which led to their balance sheets becoming untenable, and terrible risk management, a function of complacency with respect to the low yield era), were a form of or an offshoot of the lowflation malinvestment bubble.
Malinvestment is an extremely old (late 19th – early 20th century) concept in the field of economics. Most modern era macro economists lean toward either the Keynesian side or the Monetarist side when evaluating economic imbalances and the appropriate mechanism to correct them (or what might have caused them in the first place). Keynesians famously believe that insufficient demand relative to supply can best be remedied by elevated government spending, which pumps up demand and multiplies its impacts through the economy longer term. Monetarists dispute the Keynesian multiplier and the capacity of governments to achieve the above without creating other unproductive distortions and prefer to focus on stable and consistent monetary conditions and money supply growth as a superior channel for achieving economic stability. Deficient or inflated money supply growth, or monetary shocks such as the 2008 GFC, lead to poorer outcomes from a Monetarist perspective.
Prior to WWII, the Austrian economics school was followed more closely than today. They had a very different take on the cause of recessions: malinvestment. In the Austrian School, malinvestment is caused by an incorrect price signal that leads to investments that can only be productive based on this incorrect price signal continuing. This can be an inflated price for a commodity or industrial product, leading to excess capacity and boom/bust cycles, or deficient interest rates, leading to loans that cannot be serviced in the longer run, or other speculative investments. Recessions occur once the incorrect prices adjust, leading to collapses in economic activity as the malinvestment reveals itself, impairing the value of businesses’ assets, loans, stocks, etc. The mid-2000s housing bubble and late 1990s dot.com bubble would be familiar examples. In the Austrian School, the single most dangerous economic policy is an extended unreasonably low cost of capital, as this is the most likely incorrect price to cause malinvestment given that it scales across the entire economy and financial system. To some extent, the Austrian School’s aversion to the conditions that lead to malinvestment explain the old Bundesbank’s affection to high real interest rates and “hard” money – it is the best broad-based protection against malinvestment.
Does any systemic malinvestment sound possible based on the environment of the last ~15 years?
Our view is an unqualified yes. To date, we know that growth stocks and “disruptor” stocks became serially over-valued in 2020-21, and possibly well before then too, on the back of the low yields/no inflation forever mindset that prevailed for much of the 2010s. There may be more pain here yet, but much of the deflation in blue-chip growth stock multiples has occurred.
The Cambiar investment team believes there are three to five major “avoid” areas based on likely prior malinvestment and a higher real cost of capital prospectively:
Ground zero are bonds issued in the lowflation era of sub 2% yields. If the world has a more durable propensity for inflation as the eras of globalization and digitalization slow, higher yields may be the norm. Other likely candidates for malinvestment include:
- Commercial real estate-driven businesses
- Private capital-driven businesses (huge purveyors of leverage and inflated asset prices on the back of said-leverage)
- Disruptor business models (mostly in tech, not self-funding, need high multiples)
- Anything in close proximity to the above 3 (Silicon Valley Bank close to 2 & 3)
- Businesses that are not self-funding
Rather than guessing whether the stock market will rise or fall from here, we suspect the financial world post malinvestment bubble will feature rolling pockets of asset deflation (in some cases severe) when the froth reveals itself or creates untenable situations such as SVB.
Our goal is not to get caught in these. It is also important to recognize that it is just going to require more time for the scope of asset price distortion to reveal itself. It is still early in the context of 15+ years of distortive financial concepts seeming more than likely to take more than 15 months to find equilibrium.
Certain information contained in this communication constitutes “forward-looking statements”, which are based on Cambiar’s beliefs, as well as certain assumptions concerning future events, using information currently available to Cambiar. Due to market risk and uncertainties, actual events, results or performance may differ materially from that reflected or contemplated in such forward-looking statements. The information provided is not intended to be, and should not be construed as, investment, legal or tax advice. Nothing contained herein should be construed as a recommendation or endorsement to buy or sell any security, investment or portfolio allocation. Securities highlighted or discussed have been selected to illustrate Cambiar’s investment approach and/or market outlook and are not intended to represent the performance or be an indicator for how the accounts have performed or may perform in the future. The portfolios are actively managed and securities discussed may or may not be held in client portfolios at any given time.
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