Winter is Coming in Bank Credit

September 1, 2023 | Premium Service | As Labor Day 2023 arrives, investors, risk managers and just plain folks are confronted by hungry monopolies on one side and predatory politicians on the other. The Fed has engineered what may become the mother of all credit cycles, this even as prudential regulators prepare to radically increase bank capital requirements (and decrease leverage and profitability). Really can't make this stuff up.

Meanwhile, the largest Buy Side ”passive” fund sponsors now control as much as half of the daily flow in US equities, according to several researchers, and essentially act as a permanent source of stock price inflation, at least for indexed stocks. The ability of the passive fund sponsors to push equity valuations is hardly a new revelation, yet in the conflicted world of American equities the fact hides in plain sight. On Wall Street, nobody has any clothes.

Republican presidential candidate and tech entrepreneur Vivek Ramaswamy claimed financial investment giants BlackRock, State Street and Vanguard "represent arguably the most powerful cartel in human history." So true. Former South Carolina Governor Nikki Haley compares Ramaswamy to AOC, a frightening possibility, yet he is clearly in step with the times. But we digress.

Even with the active connivance and conspiracy found so easily on Wall Street, the largest banks have been giving up ground all month. Bank of America (BAC) is down double digits, as are PNC Financial (PNC) and NY Community Bank (NYCB), but the last is still up 25% for the year. Citigroup (C) is likewise down mid-teens and is approaching 0.4x book value? Our bank surveillance group is shown below.

Source: Bloomberg (08/31/23)

Last week we had the latest in a series of conversations with analysts and fund managers who asked: What happened to Citi during COVID? The opinions are varied. Yet even with the powerful gravitational pull of the great Black Rock (BLK)/Vanguard long only conspiracy posited by Michael Green and others, the unsleeping goddess piloted by CEO Jane Fraser staggers from one restructuring effort after another with no resolution in sight.

If you compare Citi with JPMorgan (JPM), for example, it is pretty clear that the former stock took a torpedo during COVID and never recovered. Vanguard, BLK and State Street (STT) are naturally the largest holders of Citi, but that has not helped the stock even as positions in these passive sponsors have increased and institutional ownership grows. Passive investing means buying the good with the crapola apparently, but as Green notes, are any funds truly "passive?"

Notice in the chart below that Citi still follows the large cap bank herd, but the movements are truncated and muted, especially on the upside. Notice also that the beta on Citi is just 1.1x the market average volatility, which means nobody cares either way. And even as the institutional holdings in the stock have actually grown over the past year, Citi continues to wallow like a fully loaded oil tanker.

Source: Google

Prince Alweed bin Talal is still a shareholder of Citi, at least according to Bloomberg, but apparently the amount is so small that it does not require disclosure. Several decades back, the Saudi Kingdom reportedly saved Citigroup by moving funds from a deposit account to equity, but those days are long gone. Indeed, the only SEC ownership disclosure document for Kingdom Holding for the past five years seems to be a 6% stake in BDC Hercules Capital (HTGC).

Why are banks under pressure? First and foremost, higher interest rates for longer means that credit is likely to become a significant factor in earnings after more than five years of free ride ℅ the FOMC. As we noted in our last comment, QE had the effect of pushing down loss given default across most asset sectors. Sadly the delightful joy juice is wearing off now and credit costs are likely to figure in bank earnings going forward.

The second, related reason for the weakness of bank stocks over the last month is the prospect of new regulations via the latest Basel capital proposal. The new rule will raise capital requirements for large banks some 20% and increase the risk weighting for 1-4 family loans to prohibitive levels. The proposal is so radical that it has caused a diverse coalition of groups to come together to defeat the new Basel proposal.

“This unnecessary proposal will increase borrowing costs and reduce credit availability for the very consumers and borrowers this administration ostensibly seeks to assist,” said Mortgage Bankers Association President and CEO Bob Broeksmit. “Experience with such significant capital changes tells us that equity markets will react immediately, and banks will respond to that pressure in real time, long before the final rule is issued.”

More, the latest rule proposed by federal regulators will impose GSIB-like regulatory requirements on banks down to $100 billion in assets. These institutions will be forced to issue debt at the bank level to offset the potential cost of resolution to the FDIC, further weakening the claim of equity and debt holders at the parent bank holding company (BHC). If a bank has 6% debt to assets, what is the equity of the parent BHC worth?

Given this latest rule proposal, should all large US banks simply shed their BHC and adopt a unitary bank model? GSIBs already issue debt at the bank level, subordinating the equity and debt holders of the parent BHC to the depositors and the FDIC. Given the Basel proposal from the Biden Administration, why would any investor want to hold BHC debt vs the debt of the subsidiary bank?

The latest proposals from US regulators will have the effect of throttling access to credit at precisely the time when banks are already stepping back from many markets and credit exposures. Less credit availability means more defaults and more losses for banks. In past decades, federal regulators understood the connection between credit availability, default and market contagion. No longer.

Today US regulators seem more concerned about their own personal and bureaucratic convenience than in serving the needs of consumers and the nation. Consider the political message of the Biden Administration to US consumers, especially low-income families. You can deposit your savings in a large US bank like JPMorgan, but that same bank cannot give you a mortgage to buy a house. Basel runs the risk of appearing to be explicitly racist in progressive Washington. Just ask the folks at FICO.

"When consumer/civil rights advocates & industry stakeholders align on an issue, you should listen very, very closely to what they’re saying & why they’re saying it—and don’t disregard the nuances," notes mortgage industry leader Eric Kaplan. But we fear that federal bank regulators are in a panic over the bank failures in Q1 2023, thus their natural tendency is to make things worse.

Whether you are an investor in a bank with FDIC insurance or an independent mortgage bank facing Ginnie Mae as guarantor, your property rights are qualified by the legal power of the sovereign. As federal regulators try to protect themselves from the public embarrassment of further bank failures, they are alienating equity and debt investors and making more bank failures increasingly likely. Happy holiday.

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