Podcast: The Big Fall of a Big Bank
Earnings season is here! Ken and Jed Ellerbroek dive deep into the banking industry. They detail the fall of Silicon Valley Bank and speculate on future Fed regulations.
Ken Crawford: Welcome to Conversations with Ken, a podcast where we discuss relevant topics and investing. I’m Ken Crawford, Senior Portfolio Manager with Argent Capital Management.
Today with me, I have Jed Ellerbrook, Senior Analyst. Jed, welcome back!
We are recording this on the 13th of April, so Thursday. And one of the reasons why we wanted to do it was because tomorrow banks begin to report, and Jed, banks have been in the news of late, correct?
Jed Ellerbroek: Yeah, yeah! 2022 was an unusually good year for the banking industry. Interest rate increases caused net interest margin and revenue to increase for banks. Credit remains excellent or was excellent. And so, 2022 is probably the best year in a decade for the banking industry. And the story has flipped really quickly here in 2023, largely due to deposit flight that was the result of higher interest rates and consumers and businesses having options for the first time in a long time.
KC: So this is different than the great financial crisis where the issue was bad credit, right?
JE: Yes, yes, the 2008 recession caused massive credit problems for banks. A lot of it was fraud related, like in the single-family mortgage industry. Credits really since then, there’s been a significant tightening of regulation capital requirements, as you know, and credit has been really excellent for the industry over the preceding 12 years now, including up through the current day. So, credit not a problem at all. The issue is deposits flowed into the industry in 2020 with all the stimulus measures done after COVID hit. And we are now starting to see the unwind of that as interest rates have increased.
KC: So deposits going out of banks. Clients, consumers, whomever looking for higher interest rates. And then for Silicon Valley Bank, the 16th largest bank, that disappeared a month ago, they had a maturity mismatch I read. Can you kind of tell people what that means?
JE: As we all know what a bank does is it takes in short term deposits that can be pulled out at virtually any time, and they allocate those dollars into longer yielding assets, primarily loans and bonds and other treasury government securities. That mismatch is an inherent part of the banking industry, and banks have various ways of managing that. They have cushions and things like that. But when you have a significant outflow of deposits and you combine that with certain banks holding particularly long duration assets, that creates a major problem.
KC: And especially, as you mentioned, in a higher interest rate environment. So, I think all of the banks that I’ve seen have unrealized losses because their loans, their assets, their bonds, mortgage-backed securities are trading below where they bought them originally, but if they can hold them to maturity, their expectation is those are money good assets.
JE: Yeah, the banks most acutely caught in this little mini crisis are the banks that had significant deposit concentration issues, and we’ve seen that in the form of crypto deposits and also venture capital backed companies whose deposits were in banks. Those venture capital companies were able to direct a huge amount of businesses to pull their money, basically all at the same time. So deposit concentration #1.
And then the second thing, what you mentioned, interest rate causing bond prices to go down. Unrealized losses for the banks, if they don’t sell them, no problem. If they have to sell them, major problem.
KC: Right. Suddenly, unrealized losses become realized losses, especially as money is flying out the door because everyone’s worried. Then going back specifically to Silicon Valley Bank, I saw 90 plus percent of their deposits were over the $250,000 guarantee, so if you’re worried, you’re going to yank your money and then ask questions.
JE: Yeah. And so now banks are rushing to try to find ways to offer their depositors greater FDIC protection, so beyond that $250,000.
I saw an example of a bank in Chicago. Wind trust is a publicly traded company. Their business is they’ve acquired other banks around the Chicago area. And they’ve kept those banks separate with their unique names, like North County Bank, West Bank or whatever, so they have 15 charters. They were able to take that $250,000 of deposit insurance and take it times 15, basically spread the deposits for the customer out amongst their 15 subsidiary banks. So, there’s lots of creative solutions being formed today.
KC: So other than the headlines from the banks, there is fall out, above and beyond banks having problems. What are investors seeing or worried about and what could that portend for the future?
JE: Yeah, I think that commercial real estate is probably the biggest watch area for banks other than deposits today. And so, we’re talking about, you know, credit commercial real estate loans. You drive by most office park areas today not fully back. Retail is a bit challenged. And then interest rates rising pushes up cap rates on commercial real estate equity which can pressure the debt, obviously, if valuations get low enough. So commercial real estate is definitely a watch area for banks today. But generally, credit problems for commercial real estate develop slowly and with a significant lag.
KC: But what we’re seeing or hearing is with banks having a little bit more difficulty, their lending standards are becoming stricter, so money a little bit less available than it was just a little while ago.
JE: Yeah, good point. Banks are tightening up on credit availability and willingness to lend and that will have impacts on the broader economy. For example, it’s probably going to put downward pressure on inflation which has been a major issue facing most consumers and businesses for well over a year now, and was the root cause really, for the interest rate increases that were so dramatic in 2022.
KC: So, perhaps somewhat perversely, the Fed could be happy that we are in a banking crisis or bank turbulence so that banks are pulling back on lending, and one expects slowing the economy because of that.
JE: Yeah, the Federal Reserve Bank employs a team of researchers who have recently published a document that tries to quantify the impact of a tightening in bank lending, the likes of which has happened over the last month. And they estimate that it is having an equivalent impact of a 50 to 200 basis point increase in the Fed funds rate. So it’s doing a lot of work for them.
KC: Right. On that note, what is the expectation of the Fed going forward: raise rates, cut rates, stay flat?
JE: Yeah, the market is pricing in one more 25 basis point rate increase at next month’s Fed meeting. And then, like a roughly 6-month period stable, followed by a series of cuts extending throughout 2024 totaling about 100 to 150 basis points. So, change in direction coming soon is what the market is pricing into the bond market that has been very volatile over the last month and a half, far more volatile than the stock market.
KC: And going back to banks, expectations for changes coming out of this crisis: higher fees, more regulation? What are people saying?
JE: The banking industry is definitely going to have to face another round of regulatory pressure after this little mini crisis. I think most people expect the banking regulators, or the Congress to impose–there’s a lot of rules that were placed on the biggest banks after the oil recession – I think people expect them to extend those regulations down into more of the regional banks and even smaller perhaps. Those are things like additional liquidity requirements, perhaps higher capital ratios and perhaps a requirement that more banks issue long-term debt to provide a buffer against the types of deposit flight problems that just emerged.
KC: So, we will stay tuned and again tomorrow. Jamie Dimon speaks at JP Morgan, Citigroup, we’ve got PNC and then the rest of the banks report earnings next couple of weeks. So, investors will stay tuned. Jed, thank you very much for your comments. We will talk to you later.
JE: Thanks for having me! I have a question for you, actually, turning the tables.
KC: Go ahead.
JE: Am I your most frequent podcast guest?
KC: You may be. I think I’ve had Scott [Harrison] a couple of times, but you know, maybe like it’s SNL, you’re becoming the the go to guest host.
JE: I don’t know what the award is for the SNL people when they get up to five or whatever, but I would like for you to consider something like that for me down the road.
KC: We will put that on the notepad, and you listeners, if you have any comments or thoughts, please send it our way. In the meantime, we’ll gear up for first quarter earnings and see what the banks have to say and see how the market reacts from there. Thank you very much. This is Ken Crawford, portfolio manager at Argent Capital, saying goodbye for now.
Thank you for listening to Conversations with Ken. For now, stay safe, stay well and thank you for investing your time with us.
Opinions reflect the portfolio managers’ judgment on the date broadcast and are subject to change. A list of stocks recommended by Argent is available upon request. You should not assume that these recommendations are or will be profitable.