Stocks continued to slide on Friday as a possible collapse of Credit Suisse came into focus. Unlike other banks, Credit Suisse is primarily an investment bank, with a major securities trading arm that raises significant counterparty risk. Over the weekend UBS stepped in to buy the bank at a sharply discounted price. Another imminent crisis averted. Now the focus moves to First Republic, another California bank with a heavy concentration of deposits and lending in the Silicon Valley region. Despite new deposit inflows of $30 billion from a consortium of major banks, the outflows continue. Its survival is questionable.
All of our memories have etched into them the saga of 2008 and the accompanying financial crisis. Banks overextended in a time of easy money. They were over-leveraged, exaggerated by a heavy dose of derivatives like tiered mortgage pools and increased loans to high-risk borrowers. As the Fed tightened, the pyramids collapsed leading to massive foreclosures, defaults, and bankruptcies. After the crisis ended, the inevitable finger pointing began. There were lots of places to point. Banks got sued. They even got sued for problems created by banks they rescued. Dodd-Frank passed, requiring banks to hold more capital and take less credit risk.
In essence, the Great Recession was a combination of flawed central bank policies of allowing easy credit for too long, and too much credit risk across the financial sector of the economy. While Dodd-Frank reduced future exposure to credit risk, as we later found out, it didn’t reduce all risks.
In the bond world, there are two kinds of risk, credit risk and duration risk. Credit risk is easy to define and understand. It can relate to the ability of the borrower to repay, and it can relate to the amount of leverage used within the debt structure, such as the collateralized tiered mortgage pools or credit default swaps used so prominently prior to the Great Recession.
Then there is duration risk. As rates rise the value of older bonds with smaller coupons decline. The longer the time to maturity, the greater the decline in price. Today, a Treasury with a 1.5% coupon that matures is 2030 sells for less than $0.60 on the dollar. If you hold it until 2050, you will undoubtedly get $1.00 back, but the current value reflects current market rates and sells at a 40%+ discount. Banks don’t hold many 30-year bonds, but they do own a lot of Treasuries and related securities that are safe from credit risk and are now worth less than par value. A typical regional bank might have a balance sheet with 25% cash and investments and 75% loans. On the liability side, about 25% would be stock holders’ equity and debt, with the balance being customer deposits. As we have seen over the past two weeks, those deposits can leave very quickly if customers fear they are not safe. It took hours literally for Silicon Valley Bank to run out of money. Thus, the duration of 75% of a bank’s liabilities is variable. In normal times, deposits are sticky. In a crisis, however, the duration is close to zero. No bank can withstand a run such as the one experienced by Silicon Valley.
The U.S. government stepped in to guarantee bank deposits for Silicon Valley and Signature Bank labeling both strategically important to the entire banking system. While that appears to imply a guarantee for all deposits of all banks, anyone with rudimentary knowledge of finance and economics knows that the U.S. government cannot guarantee the safety of everyone’s money. The Fed has a balance sheet of $8 trillion. M2 money supply is over $21 trillion. Anyone can do the math. Over the last week, the money supply increased by nearly $300 trillion, despite the fact that the Fed sold close to $25 billion as part of its QT program. The rest were borrowings by banks (or a reduction of deposits) from the Fed, changes in reverse repo activity and over $140 billion funding to support SVB and Signature.
With all that said, we aren’t collectively going to take all our money out of banks and put it under mattresses. Rather, money will flow from the weakest banks with at-risk balance sheets to the strongest banks. When a consortium of 11 banks last week deposited $30 billion at First Republic, all they were doing was recirculating part of the $90 billion that fled the bank. While details aren’t public, you can rest assured that the Fed gave them implied guarantees that such action was safe. Should First Republic fail, its deposits are likely to be protected as well, but clearly, this can’t continue forever.
When a financial crisis erupts, the first to fall are always flawed participants. SVB’s investments had way too much duration risk. Signature had too much lending to crypto players. Credit Suisse has had management problems for years. In January 2007, a handful of sub-prime mortgage lenders failed. We learned more than a year later that the mortgage crisis wasn’t contained to sub-prime lenders and borrowers. Bear Stearns failed in March 2008 and was folded into JP Morgan. That was not a one-off problem as we all learned 6 months later.
This doesn’t mean that the problems related to the rapid rise of interest rates need to explode into something akin to 2008, but history tells us that what lies below the surface can be larger that what first appears above the waterline. All banks invest what they can’t or choose not to loan in safe assets. All these assets carry some duration risk. Banks don’t buy these assets with the intent to trade or sell them. Accounting rules allow the banks to carry these investments at cost. When you buy a 1-year Treasury, the likelihood is that you plan to hold it until it matures a year from now. You keep cash to meet immediate needs separate. If the Treasury’s value changes by a few pennies every day, you don’t care as long as you get the full par value back in a year. But if circumstances change, it is possible you will be forced to sell at a loss. That is what happened at SVB.
Banks are not standing still. Much of the banks’ borrowing or pulling money back from the Fed last week was to improve near-term liquidity, not because they expect a run against them, but to ensure that sufficient liquidity existed if any above-average outflow happened. And, indeed, some money did flow out of banks last week, most likely into Treasury investments. That is why yields fell. Fortunately, the decline in yields actually helps reduce the unrealized losses on bank balance sheets. Lower yields result in higher prices for securities held by the banks.
The concerns don’t stop with the banks. Corporations seeing a contraction of liquidity must react. Some pull down lines of credit making sure they have ample near-term liquidity. Some postpone investments. Most manage working capital, concentrating on inventory and receivables management. When money flows decline, so does economic activity. Consumer confidence falls. Demand for goods and services decline in tandem. Gasoline and oil prices drop sharply as a result. Inflationary pressures ease.
All this brings us back to the Federal Reserve whose Open Market Committee meets tomorrow and Wednesday to decide what to do about interest rates. The Fed has a dual mandate to maintain price stability while maximizing employment. Obviously, its focus over the past year has been to stop inflation and restore price stability. Employment continues to grow despite higher rates.
This week the Fed faces a unique challenge. Virtually all data it will look at will be backward looking. With the exception of money flows in and out of banks, which it can see in real time, any other data it will see could be weeks old or even longer. Real time surveys will show a slowing over the past week or so. How much is tied to the banking crisis and how much relates to prior interest rate increases won’t be ascertained.
Every time the Fed has responded to economic challenges by raising interest rates, some sort of financial crisis or event emerged. It could be the failure of certain banks, or investment banks, or a hedge fund. It could be global such as the European crisis in 2011. It’s all quite logical. Higher interest rates pinch. Eventually, they pinch too hard and something bursts. There is little question we are in a pinch today. Credit Suisse is not going to be the last shoe to drop.
A few weeks ago, after some disappointing inflation data for January appeared and a strong February jobs report, consensus suggested that the Fed would raise interest rates another 50-basis points this week. Now, with an exploding bank crisis, the odds of a 25-basis point increase are only slightly above 50%. The chances for a pause are approaching 50%.
No crisis has ended without a change in Fed policy, i.e., a pause or a cut in short-term rates. The Fed could say on Wednesday that it must continue to fight inflation, justifying a 25-basis point increase, but in my opinion that would be the wrong policy. Policy works with a lag. The impact of all the increases to date have not been fully reflected. Indeed, the failures of banks this past week are directly attributable, at least in part, to the impact of rising rates. You don’t solve an exploding liquidity crisis by reducing liquidity. That is exactly what the Fed would be doing by raising rates and selling more assets off its balance sheet.
Markets shouldn’t define Fed action, but the reality is that if the Fed stays on course and raises rates 25-basis points Wednesday, while still selling assets off its balance sheet, markets will tumble immediately. Pausing will create a rally. How long should it pause? How long can a market rally ensue? That will depend on what happens over the next 5-6 weeks before the next Fed meeting. How many more banks might fail? First Republic seems the next threatened bank in line, but may not be the last. Investors would like a pause in rate increases, but earnings growth will be hurt by slower activity and tighter lending conditions. To date, I have said that I couldn’t predict whether a recession is inevitable or not. The odds of recession today are much higher.
For equity investors, Wednesday is the important day. No rate increase would suggest the Fed is at or near the end of the interest rate cycle. There is nothing to preclude the Fed from resuming rate increases in May, but that would depend on the data between now and then. It also would presume that the emerging bank crisis can be contained in some fashion. What is typical after a financial crisis would be a rally in the banking sector, followed by some sort of retest of the lows as worries don’t disappear overnight. If, however, the Fed raises rates, fears will rise. The Fed was very late to start raising rates and was, therefore, forced to raise them at a pace that hadn’t been seen in many decades. Will it go too far now, and exacerbate a developing crisis?
Fed officials are in a silent period today in front of Wednesday’s meeting. None will speak to the Credit Suisse takeover except in emergency conditions. The Fed is unlikely to get much help from the largest U.S. banks, still burned by all the lawsuits that followed the last crisis, without guarantees that the government won’t give. The safe strategy on Wednesday is to stand back and pause, while acknowledging the need for future increases is possible if inflationary pressures persist. But if recession is near, no further action will be needed. Over the next six months, liquidity will dictate less monetary tightening. What isn’t needed, however, is a rapid return to a world where money is free and widely available. The problems of the past have been centered on the fact that in each of the last three decades the Fed has stayed with excessively accommodative monetary policy for far too long. Whether that mistake is repeated again is a story to be told several years from now.
If the Fed stands pat on Wednesday, stocks can remain within their recent trading range. If the Fed increases rates again, look for quick challenge of last Fall’s October lows amid accentuated volatility.
Today, Holly Hunter is 65. Spike Lee is 66. Bobby Orr turns 75.
James M. Meyer, CFA 610-260-2220