Well, it’s been an interesting week and a bit. First Silicon Valley Bank and Signature Bank were closed by their respective State banking authorities with the FDIC stepping in as receiver and then the extraordinary action by the Fed and Treasury to address liquidity concerns and a bunch of rather disingenuous assurances from the great and good that all is well. What actually happened? We’ll undoubtedly learn more over the next couple of days and weeks, but in the meantime, we need a plan.
No one is talking about the risk of SIFIs (Systemically Important Financial Institution) or Global SIFIs failing in this environment. The fortress balance sheets of these institutions are large and considerably larger than they were during the Great Recession. This is not the Great Financial Collapse of ‘08, but does this not have more than a whiff of the 1980s’ Savings and Loan mess about it? Sure does. Remember the late 1980’s interest rates? I remember, and not fondly, my 13% home mortgage loan. Any parallels here? Hmmmm?
For what it’s worth, here’s my recipe for bank failure or bank bailout, because we’re going to see it again. Start with a material negative difference between the book or par value of a bank assets and the fair value of those assets. This delta has just about been baked into the cake in the Fed’s actions by rapidly increasing the Fed funds rate. If you originated or acquired assets prior to the end of the first quarter of 2022, you own this pain. In the SVB case, the problem was long-dated treasuries, but it could have easily been loans. This valuation gap, which is tracked as the Economic Value of Equity (EVE) under the Basel rules, has heretofore not elicited much attention, but clearly it should have. In 2021, SVB reported that a 200-bps increase in interest rates would result in a 27% decline in the value of its assets or a 35% reduction in Tier 1 Capital! No one apparently noticed. Of course, interest rates have escalated about twice as much as SVB modeled in 2021. The result was inevitable.
For many small banks, their capital is heavily invested in loans. Fixed rate loans have the same problem as treasuries. Even if performing, value crashes as market yields go up. Floating rate loans are sheltered from this basic price/yield effect but as coupons skyrocket, credit issues ensue. In both cases, the value of these loans rapidly goes down.
The other fact to consider in understanding risk here, is how these assets are held by a bank. If held in a held-to-maturity (HTM) book, these assets are held at book value and are not subject to a fair value mark. Other assets of the bank may be held in an available for sale (AFS) book and these are subject to quarterly marks. When loans are sold from either book, losses will be recognized. When HTM loans must be sold (and most banks will run through their AFS book pretty quick), losses will be recognized, and further, it’s likely that the bank auditors will recharacterize the preponderance of its HTM assets as ASF assets. Consequently, the entire book will be subject to mark to market, further depleting the institution’s capital (Note that the new CECL rules in effect this year will exacerbate this for floaters, but CECL only addresses credit losses, not fair value). Rinse and repeat. Cue the FDIC and we have a bank failure or a bailout candidate.
Any bank which is heavily invested in mortgage loans, whether resi or commercial, will carry on its balance sheet that risk, and know with an absolute certainty, these assets are worth far less than par in a rate increasing environment. To manage these risks, banks are of course supposed to hedge, but my guess is not enough risk will be hedged away.
So, the critical predicates to the danse macabre will be present in many institutions. Only question is who will light the match. Virtually all banks have material non-insured balances. Plenty of matches out there.
Look, I don’t want to cry wolf here and maybe all this settles down. The Fed and Treasury stepped in and utilized (dubious) systemic risk powers to guarantee all of SVB’s and Signature’s deposits and everyone took a deep breath and climbed down off the ledge. Moreover, Treasury officials muttered something about everyone’s deposits are safe. That caught the eyes of many observers. One wonders if that means the government is saying that all deposits are fully insured now? I don’t see the authority for that to happen, and clearly such a move would be a big step toward recasting our entire banking system as a utility. That would be fixing one problem in exchange for a cascading set of other more consequential problems. Seems that what those soft assurances presaged was this nifty new Fed credit facility. The Fed has now announced a new credit facility for banks. The facility, called the Bank Term Funding Program (BTFP) will provide liquidity by providing 100% financing for a year at extraordinarily low interest rates against treasuries, mortgage-backed securities and certain other traded assets (mortgage loans will not qualify). For these purposes, those assets will be valued at par. How wonderful! Thank you, taxpayers! This bailout (did I say bailout? Oops!) is backstopped by a $25 billion line from the Treasury.
My operating assumption at the beginning of the week was that bank failures would cascade. Now, in the short run, we may not see bank failures (what happens a year from now is an interesting question). But surely we will continue to see bank distress. Many have already bellied up to the existing Fed window and the new BTFP window, and borrowed something close to $160 billion as of last week.
So don’t put your broken bank playbook away. For now and into the intermediate short term, all banking institutions, both large and small, are likely to be put under significantly enhanced regulatory pressure to shore up balance sheets and to manage assets and liabilities to reduce the chance of failure. New fun and frustrating regulations are likely to be enacted (stand by for this… see our advice below). Bank boards will turtle and loan growth will dramatically slow. I have already heard lenders saying, at least for the moment, that the window is shut. Will this change banks posture on loan defaults, waiver requests, replacement of rate caps and other accommodations requested by stress borrowers? It very well might. All that will result in is a material reduction of liquidity to CRE markets for the foreseeable future and possibly a less flexible approach to workouts and restructurings than we had been anticipating.
Well, we’ll all get to watch this slow-motion train wreck and the question is what to do about it.
In no particular order, here’s what we think right now:
- Non-banks, start your engines! The competitive pressure from the regulated banks is about to abate. Pricing power will return to you. Go ahead and get a new warehouse. Consider refreshing capital, now there is something to do with it, through securitization or loan sales of the legacy book, even if not accretive. Take the hit, make good, new loans and move on. You will need it.
- Also, for the non-bank set, turbocharge efforts to assemble money and leverage to acquire both distressed debt and other debt from distressed institutions. It seems to us that there will clearly be a drive inside the regulatory establishment and in fact with the Boards of many institutions, both large and small, to be increasingly “disciplined” about the content and construction of the balance sheet. Maybe management will recall the hard-earned wisdom of the GFC that the first loss is the best loss. Some with overwrought balance sheets will embrace that now. Nothing that was originated before the interest rate runup last year is going to trade at par, and indeed nothing should. Coupons are up 400-500 bps for floaters and cap rates have widened by a couple hundred bps. Refinancing will be inaccessible without a great deal of new equity. Many institutions will be ill-prepared to deal with burgeoning distressed debt. Private credit should take advantage of this. There will be motivated sellers in the marketplace. Months ago, CrunchedCredit projected that we would see distressed debt and distressed sellers at some point in the future. Taking a lesson from economists, we only said it would happen, not when. Maybe, when is now.
- Adopt a DACA. If you’re a bank and things are good, look at this as a huge competitive advantage. Hang that big “open for business” sign where everyone can see it. Institutions with fortress balance sheets could offer to the marketplace willingness to accept the transfer of DACAs and other reserve accounts without the laborious multi-week-long process it now takes to negotiate fresh documents. Agree to execute the form of the pre-negotiated DACA that the other institution had, with the understanding that the DACA will either be renegotiated or terminated within some finite period of time; perhaps 60 or 90 days. Let’s face it, while it’s been increasingly difficult to get a DACA negotiated because of the high level of negotiation around these damned things, they are all fundamentally alike. It would not be unreasonable to take a view that if another institution negotiated a DACA, it’s probably okay. Oh, we will need to run KYC, but that can be fast-tracked. A bank could do this and hoover up a significant amount of money and banking relationships in this crisis. Win, win. Please feel free to embrace this notion.
- If you are a depositor, carefully review all your banking relationships (DUH!). Even if all your accounts are below the $250,000 level or if you happen to be a fabulist with a sunny disposition and think all deposits are in fact now secured (I don’t), think carefully about the frictional cost of having money tied up in an institution that’s in significant financial difficulty. Bake in early triggers to respond to evidence that a bank might commence the danse macabre at some time in the near future. We need a rapid mechanic to allow the transfer of deposits or DACA funds to another institution, ideally before the institution becomes page one news.
- If you’re lender, clean up your loan documents. Make it clear that a lender is not liable if a DACA or cash management bank fails. Confirm and clean up ownership of accounts. Figure out what your servicers are doing. Make sure that if accounts may be commingled, there’s now mechanics in place to avoid major uninsured deposit positions. (Please see Part I and Part II of the Dechert OnPoints by Laura Ciabarra and Kate Mylod). Are we good here?
- Consider other lending opportunities. Can a credit vehicle lend against the FDIC receivership certificates with respect to the uninsured portions of deposits? Sort of like any other distressed debt lending, isn’t it? The calculation is when will money be forthcoming and how much? That could be modeled. Consider doing a liquidating trust full of those sorts of financings. Could be a thing.
- Look into Credit Risk Transfer deals. Many banks will be badly in need of risk-based capital relief. Have a mechanic to transform CRE exposure into securitization exposure with much lower risk-based capital charges. This could also be a thing.
- Buy a bank (why not?).
- Contribute to your PAC…or at least get involved. Onto the battlements! If you don’t think these events will trigger a significant effort to regulate banks more comprehensively (both large and small), you’re in for a very bad surprise. Some of that enhanced regulation may be understandable and, indeed, a rational response to a new set of perceived risks, but the negative externalities of new comprehensive regulation will be myriad and far-reaching. The government will overshoot. We need to be ready.
There’s probably more to do, and as we think about it, we will share it with our readers. But make no mistake, the collapse of SVB is consequential. It is likely to usher in a period of enhanced insecurity with respect to the health of the banking system and create complexity and uncertainty across the finance landscape.
As is always the case in periods of rapid change and stress, there will be opportunities to harvest significant profits for those with capital, strong analytics and conviction.