Stocks rose again in anticipation of a favorable reading on inflation when the consumer price index numbers are released before the market opens this morning. While those numbers are likely to be market moving, the question is whether they can alter what appears to be an intent by Federal Reserve leadership to increase the Fed Funds rate to a minimum of 5% at the next FOMC meeting that concludes on May 3.
Inflation is coming down. That has been apparent. Furthermore, everyone knows the shelter costs within the index have been rising faster than current reality suggests. At some point, those numbers will reflect a lower inflation rate, But moving lower and getting to the 2% target are two different things. At the same time, while we haven’t witnessed any significant bank failures in a month, there is little doubt that higher rates and a reduction in both bank deposits and money supply have added stress to our financial system. Whether that stress is severe enough to create significant further havoc is an unanswerable question. Those who fear the worst would opt to stop raising rates for now and monitor the pace at which inflation declines. Others, who believe the worst impact of higher rates has already happened, will opt to keep going, at least for one more meeting. There will be no more employment or CPI reports between now and the May 3 day of decision. There will be two more before the June meeting. While I would personally opt to stop and let both the inflation and banking stress unwind a bit, the odds currently favor another and perhaps final rate increase. In reality, a quarter point one way or the other is not likely to make a big difference longer term.
While we are on the subject of financial stress, I want to turn to bank balance sheets as they will be front and center over the next two weeks as banks report first quarter earnings. Simplistically, bank assets are mostly loans and investments. The right side of the ledger is comprised of bank deposits, long term debt, and shareholders’ equity. There has been a lot of discussion lately about these balance sheets with most of the focus being on the asset side. Under accounting rules, securities that banks intend to hold to maturity don’t have to be marked down but those intended for sale must be marked to market. Note that any bank borrowings remain on the balance sheet at par value. If a bank issued bonds at 2% and they now sell on the open market at a discount, the bank is still obligated to pay them off at par when they mature. Obviously, it benefits from lower debt service costs over the duration of the bond’s life. It can also go into the open market and retire bonds at a discount which would create a transactional profit should it do so.
Let me return to the asset side. The argument not to discount the value of securities deemed to be held to maturity is consistent with keeping the value of debt on the books at par and not current market value. The problem arises as to separating what is to be held to maturity and what is for sale. Obviously, as was the case with Silicon Valley Bank, when there is a run, all securities are for sale, but banks don’t operate expecting depositors to exit all at once. SVB was the exception, not the rule. The way to overcome this issue is to state in the financial statement footnotes the value of securities to be held to maturity and let the investor make his own decision.
Loans are subject to the same issues. Banks can’t adjust loans to daily changes in interest rates but they do have to reserve against losses and defaults. They set up reserves. New rules are well defined how to establish, increase or decrease those reserves. They are designed to be proactive, i.e., one increases reserves in anticipation of a more difficult environment ahead rather than waiting for a loan to actually default before adding to reserves. Indeed, the accounting for defaults is to create a charge against the reserve. It is the creation or addition to the reserve that affects earnings, not the actual charge off.
As we all know, there are many kinds of loans, but let me just look at two; a corporate letter of credit, and a home mortgage. Generally, the letter of credit either carries a variable rate or some other mechanism to reduce duration risk to the lender. The risk here is on the credit side. As noted, banks set up appropriate reserves, but to the outsider/investor the picture is a bit opaque. We have few ways to know the composite credit rating of its borrowers, industry concentration, or geographic focus. Some footnote data helps, but overall, our views are quite foggy.
Now to the mortgage. Many banks sell mortgages to third parties right away. A 30-year loan that can be prepaid by the borrower at any time at his or her discretion is not an appealing paper for most banks to own, but some do, particularly mortgages that can’t easily be packaged for sale. In theory, the values fluctuate with changes in interest rates. That means today the mortgage portfolios of most banks are under water. They are worth less in the open market than the day they were issued.
What does that mean? The bank can’t call in your 3% mortgage and make you refinance at a higher rate. The only way that loan dissolves is if you, the borrower default in some way. We saw massive foreclosures in 2008 and beyond, but today is different. Almost all homes today are worth as much or more than the day they were bought. If you can’t make payment on your mortgage, you can more than likely sell the home, repay the mortgage, and still have money left over. Indeed, most mortgages are prepaid because few homeowners stay in their homes for the duration of their mortgage. The current reality is that virtually all mortgages today are adequately capitalized and will be repaid at their full value.
Marking down the asset side of a bank’s balance sheet and not touching the liability side can create some faulty conclusions. If a bank has equity of $100 million and the mark-to-market value of assets (loans and securities) is $110 million, one could argue that the bank is broke. Say it loudly enough and another run could be created.
But wait a minute! Companies don’t go broke because they have a negative net worth. They go broke because they run out of cash. Look at AutoZone. Its book value per share is ($185) as in negative $185. Why? Because for years it has used its free cashflow to buy back stock. If their stock is bought back for more than it was issued decades ago, the repurchase works to reduce shareholders equity, but AutoZone isn’t broke. Far from it. It is thriving earning enough money to keep growing and still have excess funds to buy more shares. Its share count today is half of what it was 10 years ago meaning each remaining share owns twice the percentage of AutoZone as it did a decade ago.
Bringing this all together, what matters to a bank investor is the bank’s ability to make money for its shareholders. If a bank gives you a mortgage, how future rates fluctuate won’t change the income it derives from that loan. Is the loan itself worth less? On a mark-to-market basis, yes. The real answer to bank profitability is to look at the spread between its cost of capital and the income it derives on its loan portfolio. At the moment, for many banks that is contracting and is reflected in the price of bank stocks. The whole purpose of this morning’s discussion is to make the point that however one wants to look at a bank’s balance sheet, virtually all U.S. banks are sound.
Obviously, there are mismanaged banks that can fail. Silicon Valley had too much duration on its asset side. Signature had too much crypto concentration. Under the stress of higher rates, other examples of mismanagement might surface. But this notion that all assets be marked to market in some form of analysis creating a notion that any particular bank is at sudden risk of failure is a folly. Failure will come when costs exceed income. That means what one pays for deposits and debt plus real losses on portfolio investments and loans exceed earned interest. That rarely happens.
Let me end with a final example. Take yourself back to 2005 when you could have bought your dream house for 10% down at a price of $500,000. Move forward five years and the home might have only been worth $400,000. Your $50,000 original equity is now underwater, but you still have a job and are making monthly payments on time. In this scenario, most stayed. Today, that home might be worth $750,000. The mortgage balance might be $400,000. Equity for the homeowner rose from $50,000 initially to $350,000. As long as the homeowner was current on the mortgage, it proved to be a happy ending for all.
Every bank failure you can remember was a result of mismanagement. High interest rates increase the risks associated with mismanagement. This applies to all businesses including many high-tech startups funded in 2021-2022 that now are out of cash without any obvious capital sources to keep them afloat. Leverage is your friend when money is cheap and the enemy when the cost is dear. As an investor, it is important to use the right tools to make the right judgment. As the banks report over the next two weeks, it will be important to read the tea leaves correctly.
Today, Claire Danes is 44. Vince Gill is 66. David Letterman turns 76. Finally, Herbie Hancock is 83.
James M. Meyer, CFA 610-260-2220
April 2023 Economic Update – The Banks, The Economy and Valuation