SECOND QUARTER UPDATE – 2023
“Only when the tide goes out do you discover whose been swimming naked.”
– Warren Buffet
The past quarter has been nothing less than active. We saw markets run up in January only to give some back into February and early March, while finally finding their footing again in late March. There are two big news items for the first quarter of 2023. First, inflation continues its downward trend while the Fed continues to talk tough and hikes interest rates albeit at a slower pace than in 2022. Second and heavily talked about was the failure of Silicon Valley Bank and the aftershocks it created in the system. I’ve maintained all along the Fed would push interest rates up until something broke. Well, something broke. I’ll get into that in more detail momentarily, but for those who may want to skip ahead to the conclusion, I think we may see one more interest rate hike next month and then the Fed can maybe conclude its year long battle with inflation. After that, I think we’re done with rising rates for a while as the economy fully absorbs the poison the Fed has been feeding it the past 12 months.
Now, for the something that broke.
This isn’t going to be another history of the meltdown of Silicon Valley Bank. Dozens of accounts have appeared over the past month or so…Thus, rather than merely recount the developments, I’m going to discuss their significance. My sense is that the significance of the failure of SVB (and Signature Bank) is less that it portends additional bank failures and more that it may amplify preexisting wariness among investors and lenders, leading to further credit tightening and additional pain across a range of industries and sectors.
One-off or a Harbinger of Things to Come?
A number of things about SVB made it somewhat of a special case – which means it probably won’t turn out to be the first of many:
- The bank’s business was heavily concentrated in a single sector – venture capital-backed startups in tech and healthcare – and a single region – Northern California. Many regional banks’ businesses are similarly concentrated, but not usually in sectors and regions that are both highly volatile.
- The boom in its sector and region caused SVB’s business to grow very rapidly.
- In recent years, startups were a major destination for investors’ cash, a good deal of which they deposited at SVB. This caused SVB’s deposits to triple, from $62 billion at the end of 2019 to $189 billion at the end of 2021.
- For the same reason, many of SVB’s clients had so much capital that they had little need to borrow. As deposits piled up at SVB, there wasn’t enough offsetting demand for loans. Few other banks have customers with similar cash inflows and consequently so little need to borrow money.
- Because SVB had few traditional banking uses for the cash that piled up, it instead invested $91 billion in Treasury bonds and U.S. government agency mortgage-backed securities between 2020 and 2021. This brought SVB’s investments to roughly half its total assets. (At the average bank, that figure is about one-quarter.)
- Presumably, to maximize yield – and thus the bank’s earnings – in what was a low-return environment, SVB bought securities with long-dated maturities. SVB designated these securities as “hold to maturity” (HTM) assets, meaning they wouldn’t be marked to market on the bank’s balance sheet since it had no intention of selling them.
- When the Federal Reserve embarked on its program of interest rate increases last year, bond prices fell rapidly, and, of course, the longer the term of the bonds, the greater the decline in value. In short order, the market value of SVB’s bond holdings was down $21 billion.
- Word of the bank’s losses caused depositors to start withdrawing their money. To meet the withdrawals, SVB had to sell bonds. Consequently, the bonds could no longer be considered HTM. Instead, they had to be categorized as “available for sale” (AFS), meaning (a) the bonds were marked down on SVB’s financial statements and (b) actual sales caused the losses to be realized.
- The recognized losses helped hasten the spread of negative rumors throughout the tight-knit venture capital community, which led to further withdrawals. An unusually large percentage of SVB’s deposits – 94% – exceeded $250,000 and thus weren’t fully insured by the FDIC. This meant they were more “institutional” than “retail.” Additionally, SVB’s customers were highly interconnected: They had many backers in common, lived and worked near each other, and could exchange information almost instantaneously through social media.
The sum of the above rendered SVB particularly vulnerable to a bank run if adverse circumstances developed – and they did. However, many of the above factors were peculiar to SVB. Thus, I don’t think SVB’s failure suggests problems are widespread in the U.S. banking system.
What Did SVB Have in Common with Other Banks?
Above, I talked about some things that distinguished SVB from other banks. But it is just as important to consider the elements they shared:
- Asset/liability mismatch – Financial mismatches are dangerous, and banks are built on them. Deposits are banks’ primary source of funds, and while some have longer terms, most can be withdrawn on any day, without prior notice. On the other hand, making loans represents banks’ main use of funds, and most loans have lives ranging from one year (commercial loans) up to 10-30 years (mortgages). So, while most depositors can demand their money back at any time, (a) no banks keep enough cash on hand to pay back all their depositors, (b) their main assets don’t pay down in a short timeframe, and (c) if they need cash, it can take them a long time to sell loans – especially if they want a price close to par. Maintaining solvency requires bank managements to be aware of the riskiness of the assets they acquire, among other things. But liquidity is a more transient quality. By definition, no bank can have enough liquidity to meet its needs if enough depositors ask for their money all at once. Managing these issues is a serious task, since it’s a bank’s job to borrow short (from its depositors) and lend long.
This mismatch, like most other mismatches, is encouraged by the upward slope of the typical yield curve. If you want to borrow, you’ll find the lowest interest rates at the “short end” of the curve. Thus, you minimize your costs by borrowing for a day or a month…but you expose yourself to the risk of rising interest expense, since you haven’t fixed your rate for long. Similarly, if you want to lend (or invest in bonds), you maximize your interest income by lending long…but that subjects you to the risk of capital losses if interest rates rise. If you follow the yield curve’s dictates, you’ll always borrow short and lend long, exposing you to the possibility of an SVB-type mismatch.
- High leverage – Banks operate with skinny returns on assets. They pay depositors (or the Fed) a low rate of interest to borrow the funds they need to operate, and they lend or invest those funds at slightly higher rates, earning a modest spread. But they literally make it up on volume. They employ heavy leverage, meaning they can do a lot of business based on little equity capital, thereby translating a low return on assets into a high return on equity. However, having a high ratio of total assets to equity capital means a modest decline in asset prices can wipe out a bank’s equity, rendering it insolvent. There’s no source of meltdown – in any sector – as potentially toxic as the combination of high leverage and an asset/liability mismatch. Banks have them both.
- Reliance on trust – Since depositors put money in banks in pursuit of safety and liquidity and, in exchange, accept a low return, faith in banks’ ability to meet withdrawals is obviously paramount. Depositors ostensibly can get liquidity, safekeeping, and low interest from any bank – that is, one bank’s offering is essentially undifferentiated from those of others. Thus, most depositors are perfectly willing to change banks if given the slightest reason, and there’s no offsetting reason for them to leave their money on deposit if a bank’s safety is questioned.
The bottom line is that banks are, essentially, highly levered fixed income investors. Any long-term, fixed-rate loans or bonds they own (which for most banks aren't a large percentage of total assets) are subject to declines in economic value in a rising-interest-rate environment. Banks don’t have to recognize price declines on assets they intend to hold to maturity, but any bank that is forced to sell those assets to meet withdrawals would have to show the declines on its financial statements.
Looked at this way, retaining depositors’ trust is an absolutely essential ingredient in a bank’s activities, and that means assets, liabilities, liquidity, and capital have to be skillfully managed. In SVB’s case, its equity went up in smoke when rising interest rates reduced the value of a good part of its assets.
While I wouldn’t expect widespread contagion – either psychological or financial – arising from the SVB failure alone, I must address the elephant in the room U.S. banks will be facing: the possibility of problems stemming from loans against commercial real estate (“CRE”), especially office buildings.
The following factors are influencing the CRE sector today:
- Interest rates are up substantially. While some borrowers benefit from having fixed interest rates, roughly 40% of all CRE mortgages will need to be refinanced by the end of 2025, and in the case of fixed-rate loans, presumably at higher rates.
- Higher interest rates call for higher demanded capitalization rates (the ratio of a property’s net operating income to its price), which will cause most real estate prices to fall.
- The possibility of a recession bodes ill for rental rates and occupancy, and thus for landlords’ income.
- Credit is likely to be generally less available in the coming year or so.
- The concept of people occupying desks in office buildings five days a week is in question, threatening landlords’ underlying business model. While workers may spend more time in the office in the future, no one knows what occupancy levels lenders will assume in their refinancing calculations.
Total U.S. bank assets exceed $23 trillion. Banks collectively are the biggest real estate lenders, and while we only have rough ranges for the data, they’re estimated to hold about 40% of the $4.5 trillion of CRE mortgages outstanding, or around $1.8 trillion at face value. Based on these estimates, CRE loans represent approximately 8-9% of the average bank’s assets, a percentage that is significant but not overwhelming. (Total exposure to CRE may be higher, however, as any investments in commercial mortgage-backed securities have to be considered in addition to banks’ holdings of direct CRE loans.)
However, CRE loans aren’t spread evenly among banks: Some banks concentrate on parts of the country where real estate markets were “hotter” and thus could see bigger percentage declines; some loaned against lower-quality properties, which is where the biggest problems are likely to show up; some provided mortgages at higher loan-to-value ratios; and some have a higher percentage of their assets in CRE loans. To this latter point, a recent report from Bank of America indicates that average CRE loan exposure is just 4.5% of total assets at banks with more than $250 billion of assets, while it’s 11.4% at banks with less than $250 billion of assets. Since banks are so highly levered, with collective equity capital of just $2.2 trillion (roughly 9% of total assets), the estimated amount the average bank has in CRE loans is equal to approximately 100% of its capital. Thus, losses on CRE mortgages in the average loan book could wipe out an equivalent percentage of the average bank’s capital, leaving the bank undercapitalized. As the BofA report notes, the average large bank has 50% of its risk-based capital in CRE loans, while for smaller banks that figure is 167%.
Notable defaults on office building mortgages and other CRE loans are highly likely to occur. Some already have. But that doesn’t necessarily mean the banks involved will suffer losses. If loans were made at reasonable LTV ratios, there could be enough owners’ equity beneath each mortgage to absorb losses before the banks’ loans are jeopardized. Further, mortgage defaults generally don’t signal the end of the story, but rather the beginning of negotiations between lenders and landlords. In many cases, the result is likely to be extension of the loan on restructured terms.
No one knows whether banks will suffer losses on their commercial real estate loans, or what the magnitude will be. But we’re very likely to see mortgage defaults in the headlines, and at a minimum, this may spook lenders, throw sand into the gears of the financing and refinancing processes, and further contribute to a sense of heightened risk. Developments along these lines certainly have the potential to add to whatever additional distress materializes in the months ahead.
Inflation is falling and will most likely continue to fall. The Fed’s medicine (keep in mind any medicine becomes poison when it is over dosed) is working. The complications in the banking industry from the “medicine” of rising interest rates will put some strain on lending which in turn will act as a drag on the economy. So, for now, the Fed will get what it wants in the form of lower inflation through a slower economy and higher unemployment.
The next hurdle for the markets is corporate earnings. At the time of this writing corporate earnings are just starting to come out for the latest quarter and the news is they aren’t as bad as expected. Typically the market bottoms 2-3 quarters before corporate earnings hit their nadir. If the current trend remains the second quarter could shape up to see stocks grind their way higher. With short term treasury bonds and CDs yielding almost 5% these days, the fixed income markets are much more attractive as well. The futures markets are pricing in rate cuts early next year but forecasting more than 6 months out is difficult for anyone. So, for long term investors, the best course of action is to maintain the course. When the markets finally make the turn, you’re going to want to be there. Obviously, if your situation has changed let us know. Otherwise, being patient still makes sense.
If you have any questions or would like to discuss anything in this update or any other matter, please feel free to give me a call. As always, I’m honored and humbled you have given me the opportunity to serve you.
Nick Toadvine, CFP®
Guardian Wealth Management | 464 West Pipkin Road, Lakeland, FL 33813 | www.guardwealth.net
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