Stocks finished last week on a solid note as earnings reports lifted spirits. Treasury yields slid. The FOMC meets this week. The only thing that could have held back another 25-basis point increase in the Fed Funds rate on Wednesday was a chaotic resolution of the First Republic Bank crisis. That was avoided as JPMorgan Chase assumed all deposits immediately after the bank was put into receivership by the government. According to early reports, it will assume most loans as well, receive substantial FDIC funding, while the FDIC will take a loss of about $13 billion to be recovered through additional insurance premiums that banks will have to pay. The transaction likely wipes out First Republic stock and bond holders but avoids escalating a banking crisis. More on that in a moment.
For now, the odds of a rate increase on Wednesday have climbed to 90%. Friday’s economic reports indicating a solid economy and stubbornly high inflation sealed the deal. Core inflation remains at about 4.6% with wages growing at a similar rate. While those numbers are lower than they were several months ago, they are well above the Fed’s target of 2%. The odds of another increase in late June are rising, although markets still feel a pause after next week’s increase is the most likely outcome.
Real time survey data suggests noticeable economic weakness in March and April. That isn’t fully reflected in reported data, at least not yet. The weakness could relate to turmoil in the banking sector as three of the four largest banking failures in U.S. history have now occurred within the past two months. Or it simply could reflect a delayed response to all the increases in interest rates over the past 13 months. Why doesn’t really matter. There will be two more employment reports, two more CPI reports, and lots of other data between now and the next FOMC meeting after Wednesday’s. It’s simply too early to speculate what might happen that far out.
Let’s return to the banking turmoil. The weekend’s takeover of First Republic is the third in less than two months, and that excludes folding Credit Suisse into UBS, an event even larger than the three failures. There will always be another bank deemed most at risk of failure, but none at the moment seem imminent. In that sense, the near-term crisis seems to have been contained. But with that said, I turn to an article in The Wall Street Journal last week discussing an office building in the business district of San Francisco that was valued near $300 million just a couple of years ago, that is nearing sale at close to $60 million. I don’t know any details of the financial structure of that office building, but I feel safe saying there is much more than $60 million in debt attached. The owners of that debt will take a big loss if that sale is consummated. Vacancies in the San Francisco office marketplace are near 30%, much higher than in 2008. San Francisco is a unique market right now given its proximity to Silicon Valley. In the surge of demand post-pandemic, many leading companies like Google, Salesforce, and Facebook gobbled up San Francisco office space to meet anticipated future demand. That demand was vanquished by the pandemic and the change to working from home. Other cities don’t face 30% vacancies, but the oversupply of office space is enormous all over the country. Even 10% vacancies can be disastrous. While NYC rents still hover around $75 per square foot, subleased space can go for well under half that rate.
I don’t have to go further. The key points are as follows: In a bank run, deposits can exit literally overnight. We saw exactly that at SVB, Signature and First Republic. We also could see explicit changes in the values of bank investments tied to the rise in interest rates. For the most part, these were duration problems, not credit problems. Similarly, home mortgages are worth less but they too are, for the most part, not credit problems. However, commercial real estate, specifically office building loans, are different. Because leverage on office building loans is high, changes in value have a magnified impact on the values on the books of lenders. With that said, lenders are in no mood to take over ownership of troubled office buildings. What occurs instead is a long workout process. If a building owner can cover direct costs, lenders will make necessary adjustments or concessions. That doesn’t mean, however, that losses are avoided.
When reading a bank’s balance sheet, assets and liabilities like security holdings and deposits are clear and easily marked to market, either by statement footnotes or within the balance sheet. Loans are subject to posted reserves against future problems, but the calculation of those reserves is opaque, and the specifics, such as who owns the debt behind the San Francisco office building now valued at 20% of its former worth, are nowhere to be found.
Thus, when discussing banking turmoil, it can’t be assumed First Republic is the last shoe to drop. That doesn’t mean other banking failures will or won’t happen, but what one can say is that ever-higher interest rates increase debt service costs. They add to a system already stressed. Is it stressed to a point where other failures may occur? Right now, there are few signs that systemic stress will take down more banks. No one believes we are headed for a financial crisis of the scope of 2008-2009, but to presume that this past weekend’s takeover of First Republic is the end is foolish. At best, banks with heavy loan exposure to office building loans, particularly in markets like San Francisco and Manhattan, need to be closely monitored.
It is important to note that the impact of higher rates isn’t just an issue for banks. Look at the recent failure of Bed Bath & Beyond. Of course, mismanagement was at the root of its problems, but so was a dose of heavy borrowing, including loans to support stock buybacks at just the wrong time. Companies without debt rarely go out of business. If mismanaged, there is usually someone to buy the assets and bail out the company.
In response to free money, many businesses borrowed heavily to expand, acquire, and yes, buy back stock. That debt now has a cost that pinches profits, or even worse, wipes them out. Doing business a decade ago versus today is different. Quality companies understood that free money wasn’t going to last forever.
The process of rebalancing supply and demand by central banks puts most pressure on demand reduction. There is little that the Fed can do directly to alter supply, although reduced demand clearly lowers future capital spending. To reduce demand, its primary tools are interest rate increases and money supply reductions. It has used both to an extreme not seen in 40 years. To think the sum total of those consequences are the failure of three banks is foolish. There will be others. Where can they be found? Balance sheets hold most of the clues. Wherever debts are high and the quality of the loans is low is a perfect recipe for disaster. Right now, employment is still high and consumers are paying their bills. But if the Fed succeeds in slowing the economy enough to defeat inflation (and that’s its goal), then debt service problems will spread and we will be better able to judge the true extent of the collateral damage associated with higher rates.
Remember, raising rates is the first step. The impact of those rate increases follows. The Fed hasn’t finished raising rates. Hopefully, the May increase will be the last, but we don’t know yet. So far, economic resilience has been remarkable. That’s good news, but it also means the Fed might have to do even more to stifle the inflation that it created (with a lot of help from Congress and the White House). I continue to believe that stocks remain in a trading range. The good news on earnings is now history. The focus now will turn back to the economy and what Chairman Powell has to say on Wednesday. I doubt he will say the process of raising rates is over. Data so far doesn’t support that conclusion.
Today, Jamie Dornan is 41. Tim McGraw (Tug’s son for you Phillies fans) turns 56.
James M. Meyer, CFA 610-260-2220