Who’s Swimming Naked?
Most of the talk this week was of the SVB failure, bank runs, and most important… who’s next? We think that’s the wrong question. Last week we called the SVB failure an old-fashioned bank run, which it was. Much like the movie ”It’s a Wonderful Life”, depositors were lining up at SVB’s internet doors to pull their deposits out of the bank. SVB was just like the movie, it just happened faster on the internet. But the poor (non-existent?) risk management at SVB is not typical. Yes, there are weaker banks that have not done a stellar job of risk management; there always are. But by and large, the banking sector does an admirable job. In this case, the risk is psychological. Not even super-bank JP Morgan can withstand a run when everyone wants their money NOW. The banking system only works because there is confidence in the banking system. While there may be a reason to lack confidence in a particular bank, there is no reason to lack confidence in the banking system.
Who’s to blame?
In our view, mostly regulators. Although politicians were quick to ask for more regulation, in reality, there is probably plenty of regulation, what we need are regulators. Some news reports this week claimed that SVB lacked a chief risk officer! Let’s assume for a moment that is accurate. In theory this bank is being visited by California regulators as well as Federal regulators at least once every 90 days. One would think that if those regulators really poked around, they might have discovered that there is no risk officer, and there was no interest rate hedging, at SVB. Lack of competent management is clearly to blame, but regulators making regular visits should have been well aware of that, if they were doing their job.
Is There a Banking Crisis?
Not yet, but it may be coming and it probably has little to so with depositors pulling cash and creating a run. Financial crises always involve banks, but they often start in the real estate market, in one way or another. In modern times, most financial crises have been credit crisis, not bank runs. A credit crisis is born of complacency and easy money, which lead to greater and greater levels of risk taking and eventually malinvestment, which always ends up in the banks’ lap.
It appears to be a similar story this time. The pandemic has dramatically altered the workplace and as more work from home or are in the office part time, less and less office space is needed. Interest rates were effectively zero during Covid, and there was plenty of money sloshing around to get us through a health crisis, and that kept the underlying problems hidden from view. Now that the stimulus is ended and interest rates are rising, the problem of refinancing commercial loans are beginning to float to the surface. Here is some evidence:
Quoted in a Bloomberg story, Nitin Chexal, chief executive officer of real estate investment firm Palladius Capital Management said “It’s just a group psychology, like, ‘Now that one of my peers has done it, everyone’s going to do it,’ so I wouldn’t be surprised over the next six months, if you just saw a wave of defaults and keys getting handed back, because the offices are not getting filled up. A lot of these assets will never recover.”
Delinquency rates remain low by historical standards, but are beginning to rise. If these real estate pros are willing to hand the bank the keys, as opposed to working with the bank to restructure loans, it’s very easy to conclude that delinquency rates will continue to head north and these buildings have little hope of recovery. If properties can be saved, owners will do whatever they can to keep the properties.
Situations like this can lead to sizable bank losses as the value of the collateral is severely compromised. Even if the banking industry as a whole is able to manage its way through these problems, there will be some banks that will succumb to the stress, but that is not really the point. The point is that credit crises involve a drastic reduction in the availability of capital and what is little capital is available, becomes very expensive. Our economy is driven by credit. Without it, the economy quickly sputters. There are plenty of reasons to expect a recession, but this might be the best one.
As Warren Buffett has said, it’s only when the tide goes out that you see who has been swimming naked.
A Pause that Refreshes?
On Wednesday the Federal Reserve will make their next interest rate decision. As of this writing, the bond market is as confused as everyone else. Markets are projecting a roughly 50-50 chance of a 25 basis point (0.25%) increase, or a pause in the rate hiking cycle (no increase). Here is what the Fed confronts as they make the decision.
The argument for no increase:
- The failure of SVB and Signature Bank pressures regional banks and will tighten lending conditions and make capital scarce. This is doing the Fed’s work for them, so rate increases might not be as necessary as believed.
- The SVB failure is the result of the rapid rate increases. Raising interest rates again only makes that situation worse.
The argument for hiking 25 basis points:
- Inflation is still high and still must be addressed
- An early pause calls the Fed’s inflation fighting credibility into question
- An early pause could give the impression that there is something worse going on that we don’t know about yet.
Our best guess is a hybrid scenario – a ‘pause without a pause’. In other words, there is no rate increase next week, but the Fed will provide guidance that says more increases are in the cards down the road and this pause is just to allow markets to settle down.
What We’re Reading
Cracks Emerging in U.S. Office Sector Lending, More Pain Ahead?
For 40 years, Silicon Valley Bank was a tech industry icon. It collapsed in just days
March Fed meeting preview: Will the Fed raise rates after Silicon Valley Bank blowup?
The Conference Board Economic Forecast for the US Economy
U.S. economy is headed for trouble, leading economic index signals
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