Saturday, March 11, 2023

Thoughts on Banks with Negative Equity

Banks that invested deposits in long term bonds have lost a lot of money as interest rates have risen. (Not just banks, but also other leveraged institutions like insurers.) This is a topic we have been following closely over at the Oddball Stocks Newsletter. For example, in Issue 43 we said:

We cannot help observing that most bankers have completely fumbled the incredible opportunity that they were given, by the government and by the fickle markets, in the wake of the pandemic.

Banks are nothing more than ultra-leveraged vehicles for investing in fixed income assets. At the same time that their own shares were trading at big discounts to liquidation value and private market or takeover value, their assets (loans and securities) were worth all-time, world-historically high valuations. (That is captured in the record low U.S. ten year bond yield of around 50 basis points in 2020.) A discrepancy where pessimism existed simultaneously with record optimism regarding the same assets.

Yet how many (or how few) bankers took serious advantage of that discrepancy? Remember, last Issue in our “Cheap Cyclicals” commentary, we talked about the importance of looking for “markets that aren't talking to each other” to find opportunity. Banks, as we said, are leveraged fixed income investors. And on one hand, the market was very depressed about banks, while at the same time very enthusiastic, even manic, about the fixed income investments that banks own: the loans and securities.

But what banker, anywhere, took action by selling off his expensive assets, deleveraging, and buying back his own cheap shares? Sure, many small banks (ones that we wrote about) bought back perhaps ten percent of their outstanding shares. But none of them treated this as the career-making, potentially transformative opportunity that it was. (Except, arguably, the banks that did their shareholders a favor and sold out, since the market price for takeovers was far higher than that for fractional interests in banks.) [...]

The last time we had very high inflation in the United States there were not many alternatives for idle cash. One could invest in Treasury bonds, but it was not just a few clicks, it was an involved process and required one to be able to buy in size. One could also purchase gold, but again, it was something physical that needed to be stored. There were no money market funds. You could not buy high-yielding Certificates of Deposit in a Fidelity account with one click. With these high barriers people just sucked it up and kept their cash in the bank.

Fast forward to now: frustrated customers have many alternatives. From TreasuryDirect, to purchasing Treasury bonds directly via online platforms, to easy and convenient money market funds with checkwriting ability. Why keep cash at a bank earning 0% when one can keep cash in a money market fund earning 3.5% and functionally have the exact same experience as the bank account?

That’s exactly what is starting to happen, that is the wildcard of this banking equation. If our example bank experiences a small amount of deposit flight they will be able to handle that with cash on hand. But let’s presume that 20% of their deposits leave for greener pastures. The bank doesn’t have enough cash on hand to handle this. They would need to some of sell their securities, locking in a permanent loss and tangible hit to their regulatory capital.

In our example above the bank could sell securities, handle the deposit outflow, and survive. But not all banks would be able to do this. As you will see in one of this Issue's guest pieces, there are now 30 banks reporting negative equity. There are also 246 banks with equity equal to less than 5% of their assets. For any of these, any deposit outflows are going to result in a situation where they’re either raising capital at a dilutive price, or potentially going out of business or being “taken under” by a competitor.

Where things can also get really bad is if rates continue to increase, further depressing security values. Every positive tick in rates means a further gap between what depositors are getting paid and where market rates are, as well as a further downtick in the value of securities purchased at the top of the market. This is actually such a threat to the banking system and economy that it implies that the Federal Reserve might not be able to tighten much further.

In Issues 41 and 43 of the Newsletter, we published lists of banks that had negative equity (taking into account securities losses) or were getting close. Silicon Valley Bank was actually one that was flagged as having negative equity in Issue 43.

Note that we first raised this as a concern on Credit Bubble Stocks almost eight years ago in our review of the book Panic. Sometimes things take a very long time to happen!

If you synthesize the best parts of Falkenstein and Redleaf, you predict that the next crisis is going to come in the investment that is currently perceived as riskless enough for highly leveraged institutions like banks to buy. In the 2000s that was mortgages, at other times it has been other investments like railroads.

Right now, government bonds are accorded zero risk in calculating bank capital ratios. The idea that government bonds are riskless when governments are planning to flood the market and when the expenditures are consumed (building no collateral) may prove to be the latest delusion.


It seems like there are three possibilities for how this will play out, starting Sunday night.

First would be if the Fed keeps tightening and nothing is done for the SIVB depositors. In that case, everyone is going to build mark-to-market balance sheet models for all banks in the country to see who has the worst combinations of negative equity and uninsured deposits that are at risk of running. These models could mark not only the banks' securities investments to markets but also the loans that were originated when rates were much lower. Quite a few banks would have negative equity if they were forced to liquidate all of their securities and loans. (A mortgage originated at 3% has lost a lot of value with mortgage rates now at 7%.)

These lists will circulate on Twitter and these banks will have runs - people will move their deposits to "too big to fail" banks or to brokerage accounts where they can buy Treasuries directly. Not only is that safer, but they also go from earning nearly zero to 5%. (And deposit flight gets all the more likely if the Fed keeps raising rates further, since the gap between low interest bank deposits and money market yields widens.) No one is going to tolerate keeping money on deposit for free and at risk of impairment. These runs would result in further failures. Things get very messy indeed if banks' $50-$100 billion loan portfolios are being put up for fire sale every week. Social media (like finance Twitter) means that these runs can happen in a day. This is already starting to happen as of Saturday, with lines outside of First Republic Bank branches in California, and people on Twitter crowdsourcing research into weak banks.

Second possibility would be various measures aimed at calming bank depositors' concerns. On Saturday night, there has been talk of an FDIC fund to backstop deposits at failed banks. Also, from 2009-2010, the FDIC insurance on transactional accounts was temporarily uncapped: the Temporary Liquidity Guarantee Program. Something like that could be done again.

Ultimately, though, it seems unlikely that this will stop until the Fed stops tightening. Continued interest rate increases have been widening the gap between what bank deposits pay and what customers could earn by buying Treasuries directly. At some point, the dam would just burst and deposits would get converted to direct Treasury investments, never to return. Also, higher interest rates have already basically wiped out the equity in commercial real estate (just look at a stock chart of an office REIT like BXP or VNO), and if the rates increase further, these properties will start getting handed back to the banks.

But once the Fed pauses, then no one will think that their bank deposits are at risk because of the interest-rate related decreases in value of assets which are still performing. Banks can then continue to earn their way out of their liquidation value hole, as they had been doing and as has normally happened at various points in past economic cycles.

However, the caveat here is that inflation will come back. They have to give up on trying to get it back down using monetary policy. Maybe they raise taxes, maybe they put a sumptuary goods tax on Ferarris and private jet flights. Maybe they stop printing money to send to Ukraine. There are all kinds of fiscal and regulatory things that could be attempted. Inflation would have been better over the past two years if we had more sawmills and oil refineries and fewer cryptocurrency startups.

But they will have to eat some big CPI prints without being able to jawbone about tightening unless they want a banking crisis.

9 comments:

CP said...

Financial regulators are discussing two different facilities to manage the fallout from the closure of Silicon Valley Bank if no buyer materializes, according to a source close to the situation.

One way that the regulators would step in would be to create a backstop for uninsured deposits at Silicon Valley Bank, using an authority from the Federal Deposit Insurance Act, according to the source. The move would also touch the systemic risk exception that allows the Fed to take extraordinary action to stem contagion fears.

https://www.cnbc.com/2023/03/12/fed-fdic-discussing-backstop-to-make-svb-depositors-whole-and-stem-contagion-fears-source.html

viennacapitalist said...

I am surprised a duration mismatch of that magnitude is even possible.

In Europe, banks have to report the impact of 200bps shifts in the yield curve on the equity on a quarterly basis. This is tracked and outliers, i.e. those banks that would loose > 10 percent of BV, are monitored more closely…

I would have thought something similar is in place in the US...

So why did they do it? It is not that long-term yields were that attractive (and the US never had negative rates, unlike Europe and Japan)??
This was puzzling to me, such that I initially thought there must be more to the story, this cannot be all there is.

Hence, I looked at one of SVBs presentations and they plainly state that they hold upwards of 100 billion in Bonds (on a 200 billion BS!) with a duration of 5.6 unhedged. A 200 bps point shift (as has happened over the last 18months) therefore results in losses of more than 10 billion...

How much would they have earned on this? Eyeballing the 3 month-10 year spread as a proxy, I concluded they would have earned around 1 percent on average (not really attractive, if you ask me)
https://fred.stlouisfed.org/series/T10Y3M

To sum up: they decided to bet the house on rates to earn around 1.5 billion in additional net income (I assume agency spreads are somewhat higher)...

This compares to a total net income in 2021 of USD 1.8 billion!!!

2021 was as boomy as they come, no one defaulted on its debt, provisions from securities sales were sky-high, the loan book was growing - and they can't make a profit?!?

I repeat: they can't make a profit serving Silicon Valley in 2021?

Hance, the real story is this:
This bank serving the clientele riding the biggest boom in stock market history, could not make a profit from its business model and therefore had to speculate on rates!

Like a Japanese regional lender!

How this even possible, I still do not understand - something is fishy here...

And the next question:

Why was nobody talking about this obvious short?


CP said...

After the bailout of Continental Illinois, Volcker told the Fed Open Markets Committee: “My bottom line is that we’ve run out of room for the time being for any tightening, given this situation.” Within six months, the Fed cut rates by 0.50 percentage points. Since monetary policy has a “long and variable lag”, the Fed is likely to become cautious this time but they may choose to pause rate rises or revert to 0.25 percentage point rate increases.

https://www.ft.com/content/907c50c1-74e7-4547-8489-89e738c3c828

CP said...

People thought that the higher rates on long-term securities represented free money, since rates would stay low forever.

They really did.

We could not get small financial companies (like banks and insurers) to sell their overvalued government bonds (e.g. ten year bonds at a 1% yield) and buy back their own stock at big discounts to book value.

We wrote about it at Oddball, as you can see in the post above.

Banks are nothing more than ultra-leveraged vehicles for investing in fixed income assets. At the same time that their own shares were trading at big discounts to liquidation value and private market or takeover value, their assets (loans and securities) were worth all-time, world-historically high valuations. (That is captured in the record low U.S. ten year bond yield of around 50 basis points in 2020.) A discrepancy where pessimism existed simultaneously with record optimism regarding the same assets.

Yet how many (or how few) bankers took serious advantage of that discrepancy? Remember, last Issue in our “Cheap Cyclicals” commentary, we talked about the importance of looking for “markets that aren't talking to each other” to find opportunity. Banks, as we said, are leveraged fixed income investors. And on one hand, the market was very depressed about banks, while at the same time very enthusiastic, even manic, about the fixed income investments that banks own: the loans and securities.

But what banker, anywhere, took action by selling off his expensive assets, deleveraging, and buying back his own cheap shares? Sure, many small banks (ones that we wrote about) bought back perhaps ten percent of their outstanding shares. But none of them treated this as the career-making, potentially transformative opportunity that it was. (Except, arguably, the banks that did their shareholders a favor and sold out, since the market price for takeovers was far higher than that for fractional interests in banks.)

CP said...

The accounting treatment of the bonds (and loans, for that matter) also encouraged the bankers to ignore the effect of the rising interest rates.

If you're allowed to pretend that something is worth what you paid for it, it gives rise to a heads-we-win, tails-we-don't-lose (don't have to acknowledge losing) mindset.

Of course, this ignores the opportunity cost of holding an asset that declines precipitously in value instead of selling it and redeploying the capital somewhere else. (Like buying back stock below liquidation value.)

One big obstacle, though, was that these banks are inefficient. They needed the interest income to pay their salaries and inefficient operating expenses.

Viennacapitalist said...

In europe the mark to mark losses are deducted from regulatory capital regardless of the accounting treatment- no free lunch....
Us rules leave me speechless tbh..

Still i fail to understand how they could not turn a profit on their operating business...

CP said...

One thing maybe forgetting - it was HARD to make money with the really low interest rates.

Net interest margin kept declining: https://fred.stlouisfed.org/series/USNIM

Short term interest rates were zero. If you wanted to earn income and couldn't make enough loans, you had to go out on the curve.

CP said...

In support of my comments:

In late 2020, the firm’s asset-liability committee received an internal recommendation to buy shorter-term bonds as more deposits flowed in, according to documents viewed by Bloomberg. That shift would reduce the risk of sizable losses if interest rates quickly rose. But it would have a cost: an estimated $18 million reduction in earnings, with a $36 million hit going forward from there.

Executives balked. Instead, the company continued to plow cash into higher-yielding assets. That helped profit jump 52% to a record in 2021 and helped the firm’s valuation soar past $40 billion. But as rates soared in 2022, the firm racked up more than $16 billion of unrealized losses on its bond holdings.

Throughout last year, some employees pleaded to reposition the company’s balance sheet into shorter duration bonds. The asks were repeatedly rejected, according to a person familiar with the conversations. The firm did start to put on some hedges and sell assets late last year, but the moves proved too late.

https://www.bloomberg.com/news/articles/2023-03-13/svb-failure-sparks-blame-game-over-trump-era-regulatory-rollback

viennacapitalist said...

It is always hard to make money, ask European banks who had to pay a tax on reserves (negative interest)...
In the US rates have always been higher, fees for everything are higher (wiring money across the US costs a fortune)...
do not forget that they were lending against capital calls, future IPOs, etc. - these are high margin products.
Their wealth managment department AuM must have grown in line with the Nasdaq...

I still do not understand how they could not make money in their core business - I smell a rat here. This cannot be the full story...