Steve Peacher: Hi this is Steve Peacher at SLC Management. This is our next episode of “Three in Five.” Thanks for tuning in, today I’m with two of our most senior portfolio managers within SLC Management on the fixed income side, and we want to talk about the topic of the day, which is the stress in the banking sector. And it started I guess, with Silicon Valley Bank, and there's been a lot in the press on it. Probably some people haven't been as following it as closely as you guys have. So, maybe for those who haven't been following it blow by blow, you could explain what happened and why is the situation with Silicon Valley Bank, and also kind of the broader situation we're facing today with financials, different from 2008?
Richard Familetti: Thanks, Steve. So I’ll start so SVB, it's interesting. They essentially experienced a classic run on the bank, and unlike past runs the depositors who, which are other funds, were actually people from the mostly people from the technology field or companies in the technology field, so high net worth individuals or companies that that decided to pull their all their money out. And it's interesting because it's very different from how the crisis began in 2008, in the sense that period revolved around asset quality, obviously subprime mortgages being the number one culprit, but other assets as well where lending came under pressure. So asset deterioration was really the issue in ‘08 for banks in the banking sector. Today it's more a matter of liquidity, and then maybe a little bit of sprinkle in some asset liability management for SVB. So you know, all banks borrow short and lend long. SVB is, was a little different only in in a couple of ways. One they had a huge influx of deposits over the last couple of years, so their balance sheet ballooned by almost three times as much as it had been back in 2018, and so they bought a lot of long maturity bonds. With interest rates higher the value those bonds fell. And then there is a social media phenomenon, interestingly enough, that got the panic rolling and caused the liquidity crisis at SVB.
Peter Cramer: Yeah. And I think the only thing I’m gonna add, and Rich already touched on this, this is very much a liquidity issue, and not a solvency the issue. In the bank crisis of ‘08 there were concerns that there are losses on the assets of the bank held, I think most concerning was, it was unknown what those losses might be. So the market value went from par to ‘I don't know’ and if you don't know then you immediately just assume the bank's gonna have to have massive and unknown write downs. In this case, at Silicon Valley Bank and the other banks, the losses are very known. They're very transparent. We know with a high degree of certainly what the mark to market losses are in the securities, but there's no concerns about the ultimate value of the security. For the most part it's mortgages and treasury. It's a liquidity concern, and that to Rich’s point, I think fed on itself and became more of a crisis of I think, confidence in the banks, particularly in the case of Silicon Valley Bank, when that borrower type or that client that's highly concentrated in one sector that is also in itself having its own challenges with venture capital I think starting to struggle to raise capital. That's where you think it's you see the confidence in and the entire herd started to shift away from a bank in terms of the deposit base, but very different than what we saw in ‘08 because the asset quality side of things.
Steve Peacher: The chain of events that was set off by the collapse of SVB, or Silicon Valley Bank, has led to a lot of volatility in the markets, led to a lot of questions, lot of movement, you know spreads have changed, Treasury rates have moved a lot and there's questions about knock on effects in the financial sector, and across the economy, what the Fed will do. As you face all those questions what have you been doing in client portfolios in response to kind of all this market activity in the wake of SVB?
Richard Familetti: Right so for us there's short-term impact and there's a longer-term impact. So in the short run what we have tended to do is focus on the sector where, that is most under pressure, and in this case the banking sector, and that in fact is the riskiest in terms of short term volatility and the potential for surprises, as we've seen with a number of other banks, both in the U.S. and Europe since SVB’s collapse. And so we what we've done so far, and what we, what we tend to do in these periods is, you're gonna see a lot of volatility from day to day, some days are euphoric, and others terrible. And those euphoric days we we've tended to trim positions within the sector, right? So in the banking sector just get positions down a little bit just in case our research on any particular name it isn't correct and the bank comes under pressure. So far, so good that that hasn't happened to us. But trimming risk in in the sectors is it's probably the number one sort of short-term strategy. And in the longer run we, we can be patient, lean back on our fundamental analysis. Have our analysts grind away and find the opportunities. And then when fundamentals look good versus the current price of debt we can make a move and start to buy bonds that look interesting.
Peter Cramer: So for our clients the other thing that we started to do a little bit of is to the extent that we had a cash in the portfolios in excess of a $250,000 FDIC insured limit, we'd look to put a lot of cash in T-bill ladders, a lot of our clients want us to hold cash as protection against potential claims payments that they might have to make, whereas before I say we're more comfortable on holding that just in cash or in custodial sweep accounts, we've now looked to ladder some of that cash out as a way of protecting from some of the bank run issues.
Steve Peacher: All of the things equal, and during a financial crisis you would expect the Fed to be cutting rates. But all of the things, I suppose aren’t able today because the Fed's been aggressively trying to attack inflation which has been running at high levels now for well over a year. What does that mean? This is a real curve ball to the Fed. What does it mean for what they do from here?
Peter Cramer: Yeah, I think that's a great question, Steve and one that that the market is really grappling with. I think the Fed, I think Chairman Powell has been pretty clear about this is really trying to distance its job as providing liquidity to the market versus achieving on a dual mandate which is achieving price stability and full employment. And so I’d say from a liquidity standpoint, they're very quick to come out with the borrowing facility that allows banks to pledge collateral at par not market value, which is a huge difference in this particular environment to access virtually unlimited amounts of liquidity. So I think they really want to provide support that they might normally provide through cutting rates via that liquidity facility, and what that is setting themselves up for is therefore to be able to continue along their path from hiking rates. Because, again, if you were to just look at macro data, they very much justify continuing to hike rate, and then we still have inflation well above their 2% target. We still have a labor market that that's running very hot with the unemployment rate well below their long-term target. So I think this allows the Fed to continue to hike rates. I think one of the interesting knock-on effect if you will is that the likely impact on the banking sector is going to be one of much tighter financial conditions. By that I just mean if you're running a bank of any size, really I’d say your propensity to loan out to a marginal bar or is significantly reduced today versus where it was say 2 weeks ago at this time. That impact the entire financial condition has been estimated to be equivalent to anywhere from 25 to 50 basis points of incremental Fed tightening activity[1]. So whereas we've seen the expected terminal rate for Fed fund fall by about 75 basis point just on Fed Fund futures market basis1, this impact of tighter financial condition puts you almost all the way back there. So I think the Fed will still feel that they have an obligation to continue to hike rates just possibly not as much at this point because they're achieving tighter financial conditions through this, this challenging environment for the banks.
Richard Familetti: I mean, I'd add that that you could make the case that in the Fed has so far has been only, you know, mildly successful it at reducing inflation, which is obviously their ultimate goal. And this strangely, this, this crisis could be the, finally, the thing that that may that may have makes their policy start to work, obviously quite a cost. And you know this is sort of riffing off what Peter said, where once lending standards tighten and credit creation starts to wither, you know that's when the economy can slow down. And the Fed might finally achieve its goals.
Steve Peacher: You know, in a market like this, investors sitting in seats like yours have to absorb two things: one they have to absorb a lot of new information and a lot of new changing information. And so my question is, do you think that so far the markets are reacting appropriately? And are you seeing any opportunities that are developing in the markets because of the events of the last week?
Peter Cramer: I think the market initially did a pretty good job in terms of sniffing out where the weak points are. So I think they are very quick to identify what some of the issues were with Silicon Valley Bank, and then take some of the equity valuations of some of those other small banks that had similar issues, that being high percentage of their deposit base that was uninsured and then high percentage of the portfolio with how the maturity mark to market losses and really rapidly took those equity values down quite a bit. I think there was also some overreaction that that led to some evaluations of the general banking sector being taken down, even though I think a lot of those business models still remain very much intact and very protected from this this issue. And then I’d say more broadly I think the market is gonna move to a space where they're gonna start to look at the impact that the withdrawal of the small banking space has onto the broader economy. What I mean by that is, if you look at the lending that small banks do versus large banks, in a lot of spaces it's about 50/50, and by small banks I mean banks with less than $250 billion in assets. You look at like consumer loans or C&I loans it's about 50/50 in terms of their split versus larger banks. In the commercial real estate space they're about 80% of the loans that are done in the U.S. compared to 20% for larger banks.1 That's an area where I think the market will start to shift to looking at what impact this will have longer term the extent that you have 80% of the market pulling back from the commercial real estate space. And I don't think the market has quite done that yet, but I think that's probably where they're headed.
Richard Familetti: I’d add two things: one on the topic of credit market dynamics, and what we've seen so far is a relatively, relatively orderly sell off and credit spreads a day to day investors can still buy and sell bonds pretty readily. But often in periods like this you'll see a spike in in liquidity, with a point where liquidity is essentially disappears, and then coinciding with that will be a significant widening in credit spreads, like over the course of a few days or week followed by it by a spike back down. And so far we haven't seen that, and maybe we won't, we'd say if there's more to come in in the banking sector that you wouldn't be the least bit surprising to see one of those moments where you know we're credit spread spike pretty aggressively, but so the other thing is just mentioning it in passing. This Credit Suisse event and the impact on their capital securities called AT1’s or interestingly, coco's. I mean the fact that the equity holders of Credit Suisse got some money. But these coco's or capital securities got were valued at zero and the transaction with UBS is interesting, and it's had that's had a really negative impact on the entire market for or for perpetuals or coco securities in Europe.
Steve Peacher: Let me end by putting you guys on the on the spot on something. We're recording this on Monday, March 20th. So you refer to Credit Suisse. We got the news over the weekend about a deal with UBS and Credit Suisse. Today markets are reacting positively to that. Do you think, do you think all these moves over last week, with SVB with Credit Suisse for Signature Bank, the liquidity line from the Fed from Swiss National Bank. Do you think that in the financial sector this is now going to be successful in calming things down? Or do you think we're in the early innings of this? And I’m thinking just about the financial sector. Peter, I’ll put you on the spot first.
Peter Cramer: I think that as of today I don't think there's gonna be a lot to hear of it. I will say that I think it seems like the banking sector is kind of coalesced around support for First Republic. First Republic Bank is, I think, the next weakest link in the chain that's really been taken to the woodshed from an equity evaluation standpoint. You know we saw last week that a consortium of banks got together to agree to deposit at $30 billion with them[2], which didn't really help as much. Today there's news that Jamie Dimon is leading an effort to possibly convert that into capital for First Republic. So, I think there's a large, concerted effort by some very powerful players with deep pockets to firewall this issue, and really have First Republic be the line in the sand. So I think that we're gonna be able to see them hold that line, and then it won't continue to spread from here. But I think that process still needs a couple of headlines before it really starts the impact the valuation for First Republic. But I think that's really the canary in the coal mine that I’m watching. If they're able to be successful I don't think it spreads from here.
Richard Familetti: Yeah, I mean, I would say in the U.S. that we might very well have it pretty contained. There might be some other stories out there, but we would think that they're smaller capitalist station, financial institutions, not as not as huge as SVB or Credit Suisse or some of these others. But in Europe given what's going on with the with the aforementioned coco’s and such, and there's been a lot more weakness in banking there that there might be might be other shoes to drop. But I think here in the U.S. for the most part the certainly, the money center banks are well capitalized, and the regionals and super regionals here have a ton of liquidity, and so a fair amount of protection against this is the type of thing we saw with SVB.
Steve Peacher: Well, it's definitely bought brought back memories of the weekends during the financial crisis where you're waiting all day Sunday to hear about the news on the latest financial institution. Let's hope it doesn't come close to the magnitude of that period. Rich Familetti, Peter Cramer, thank you very much for taking the time today to talk about this, and thanks to everyone for listening to this episode of “Three in Five.”
1 Goldman Sachs Economic Research, 2023
2 Dow Jones 2023
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