May 23, 2023 | Readers ask if the banking crisis of 2023 ended last month. The short answer is no. There are banks that are insolvent and need to be closed, but the FDIC has run out of cash and, more important, ready buyers of failed banks. The market volatility that the Fed has injected into the banking system, first with QE and now by ending this irresponsible policy, makes it virtually impossible to value bank equity today.
Matt Levine of Bloomberg, in a brilliant analysis of First Republic's acquisition by JPMorgan (JPM) from the FDIC Receivership, describes why ready buyers are essential to federal deposit insurance:
"The goal is to have banks with ample capital, whose assets are worth much more than their liabilities; the acute problem with a failed bank is that it has negative capital; the solution is for someone to put in more money so that the system as a whole is well capitalized again. Sometimes the FDIC puts in the money."
The federalized system of federal deposit insurance only works if there are good banks and bad banks. The former buy the assets of the latter, and the FDIC provides a small subsidy in terms of a discount to create new capital to support the assets of the dead bank. But when the FDIC and the US banks that stand behind it are forced to take over dead banks without a buyer to carry most the the load, the system fails.
Meanwhile, the narrative coming from within the Federal Open Market Committee continues unaffected by market turmoil. Fed officials assign blame for bank failures everywhere but where it belongs. Federal Reserve Bank of Minneapolis President Neel Kashkari, for example, says bank capital requirements should be lifted significantly to help “backstop financial institutions against distress.” Really?
The distress to which Kashkari refers was caused by the FOMC. And the childlike naivete displayed by Kashkari accurately reflects the consensus within the committee. The truth is that dead banks like Silicon Valley, Signature Bank of New York and First Republic all had plenty of book capital. More capital would not have changed the outcomes for any of these banks in a market where risk-free assets are trading at 10 or 15 point cash discounts to levels of two years ago. Sadly, the liquidity provided by the Fed during QE is now causing outsized losses to banks and investors as interest rates rise.
The Federal Reserve Bank of St Louis reminds us that the “Three Cs” of credit are “capacity, character, and collateral,” not the mantra of static book equity capital that passes for deep thinking in Washington. Since Kashkari and most other FOMC members have little actual experience in the world of finance, the discussion defaults to “capital.” This simple financial measure is about as complex a concept as most political appointees and members of Congress can understand.
The relevant discussion when it comes to banks is not capital, but “capacity and collateral.” Capacity speaks to cash; the ability to fund obligations and meet financial demands for holding long-term assets. If you are Bank of America (BAC) or JPMorgan (JPM) and you own a bunch of 2.5% conventional mortgages, do you have the capacity to hold these assets to maturity? When your cost of funds gets to 5% by year end, BAC and JPM will be losing several points a year on these loans.
Collateral is the other side of the equation. Even though the 2.5% mortgage loans owned by JPM or BAC or many other banks are government guaranteed, risk-free assets with “AAA” ratings, these assets are impaired because of the rate hikes by the Fed. If the entire $13 trillion residential mortgage complex has an average coupon of 3%, when you move the fed funds rate 5.5%, everyone is insolvent. As we old our friends at Nomura last week, the agency and government MBS is the most dangerous security on the planet and should have 100% risk weight for Basel III.
Take the case of PacWest Bancorp (PACW), the parent of $44 billion asset Pacific West Bank. At the end of Q1 2023, PACW had 10% simple capital leverage and 14% Tier One Capital, so by any measure the bank met regulatory capital guidelines. But the tangible capital of the bank, after allowing for the unrealized losses on securities caused by rising interest rates, was in low single digits. The fact that 20% of the balance sheet was funded with non-core funding opened the door to the short-sellers.
Unlike many larger banks, PACW has a gross yield on its loan book that is well-above peer. The weighted average coupon on the bank’s new production was over 8% in Q1 2023. Funding costs are also above peer, which we view as a positive because the bank is accurately pricing its liabilities. To borrow from progressive newspeak, PACW’s balance sheet is a lot more “sustainable” than most regional banks, yet it was still singled out by the shorts because of the non-deposit funding supporting 20% of total assets.
At Q1 2023, PACW’s cost of deposits was about 2% and the yield on total assets was over 6% or well-above its larger peers. The bank’s $12 billion in non-deposit funding had a cost of 5.3% All of these measures for funding costs will move higher in coming months as will the asset returns. As long-term interest rates rise, however, the mark-to-market losses on securities and loans in the banking industry will grow.
Just as there was nothing hideously wrong with Silicon Valley Bank or the other victims of the FOMC’s intemperate interest rate policies, there is nothing really wrong with PACW. The bank is relatively small and easily attacked by short-sellers, but the bank is well-managed. As we described last week (“Fed Asymmetry Threatens Credit Crisis”), the short selling trade against smaller regional banks has required vast amounts of derivatives.
The crescendo of selling pressure on PACW was May 4th, when the stock traded down to $2.48 at 10:00AM. By May 8th the stock was back up in the high $7s, but fell back to below $7 until yesterday. Management has announced plans to sell assets and are considering other strategic alternatives. All of these moves are laudable, but do not change the fact that all US banks have a basic problem with solvency that arises from the large increase in interest rates by the Fed.
PACW closed yesterday at 0.35x book value on huge volume. The stock has a beta of 3.8x the 6-month average market volatility, a measure of the speculative attention on the stock and other banks. Just above PACW in terms of book value multiple is Citigroup (C) wallowing dead in the water with a beta of 1. Next is Truist Financial (TRU) at 0.7x book and a market beta of 1.4x. Then comes Western Alliance (WAL), now back up to 0.75x book but with an eye-watering beta of 2.8x. To survive long-term, both WAL and PACW need to get that beta back down below 2 and closer to 1, but the hawks on the FOMC may not cooperate.
The moral of the story is that capital is only worth the fair value today of the assets invested, that is, cash. Since 2021, the FOMC has decreased the cash value of bank capital by roughly 10-20% because the value of bank assets has declined. When PACW announced the fire sale of a portfolio of commercial loans, the bank is shrinking back down to a size funded entirely by deposits. But can PACW raise its deposit rates fast enough to buy the time needed to reprice its entire business?
Since it is presently impossible to value bank and nonbank assets from 2020-2021 with any precision, the usual pool of banks ready to buy failed institutions has dried up. This is why the FDIC has stopped resolving struggling banks, preferring to buy time until additional funding is available. Zombie banks are being kept alive by liquidity provided by the Fed, but with no exit strategy to recapitalize the banks.
With the 10-year Treasury yield rising toward 4% and the TBAs rolling from 5.5% to 6% for new MBS production, we expect the mark-to-market disclosure for banks in Q2 2023 to be ugly. Only the fact of bank securities sales will hold down the dollar value of the asset impairment. The number of banks on various forms of life support from the Fed will grow, creating a backlog of bank resolutions for the FDIC. And as we never tire of reminding our readers, the banking industry cleans up the mess.
As we’ve written previously, the repricing of bank assets and liabilities during the rest of 2023 will be an existential event for many lenders, but there may not be any bids for the banks in the event of failure. We see a growing risk that regulators will simply keep zombie banks on cash life support rather than incur the cost of a closure and sale. Bankers can take some comfort, however, that their clients in the world of commercial finance are suffering the same ill-effects from rising interest rates as the banks.
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