ACTV - Life After Silicon Valley Bank: Tighter Credit Conditions

2023-04-20 07:59:59 ET

Summary

• Since Silicon Valley Bank's collapse, banks have pulled back on extending credit.
• Banks are now charging more to provide all sorts of loans including financing corporate bond holdings (provide margin loans).
• This carry spread, the difference between what banks charge to buy corporate bonds and the yield from those bonds, is at points last seen in 2007 and 2001.
• There are other negative developments.
• My new Investment Group launch, Catalyst Hedge Investing, coming April 27th!

Credit Availability Declines Since Silicon Valley Bank Implosion

Many people have asked me what I think are the potential fallouts from the Silicon Valley Bank ( SIVBQ ) failure. The answer is multipronged and will likely play out at different points, but I think the most direct and immediate result is banks' decreased certainty of their deposit base. A direct consequence of shakier deposit bases is less lending and more expensive lending rates. Said simply, if banks fear deposit losses and/or higher costs to keep those deposits (in the form of higher rates paid to depositors), then they will extend fewer loans and charge more for any loans they make.

Most ordinary people will see these "tighter lending standards" when they apply for a mortgage or a car loan. Banks will likely require higher credit score borrowers, lend against a lower percentage of assets, and charge higher interest rates. So expect to put down higher deposits and pay more for anything you buy with lank loan assistance. If you have a low credit score, prepare to pay through the nose and have fewer banks offering credit.

This dynamic will also play out for anyone who borrows to buy stocks or bonds (buying on margin). This means individual investors with an account in Fidelity or Schwab ( SCHW ), which I wrote favorably about in March "Silicon Valley Fallout: Opportunity in Schwab?" and for institutional investors.

Institutional investors, such as hedge funds, mutual funds, closed-end funds, and even some pension funds, will often use borrowed money (leverage) to invest in corporate bonds, particularly investment grade corporate bonds where the yields might be too low by themselves. The money for this borrowing comes largely from banks.

Banks charge the Federal Funds rate plus some premium to lend out money. Just the difference between Fed Funds and the yield on Investment Grade bonds is called the "carry spread". According to a recent report by TD Securities published in Bloomberg, this spread is at 23, a level last seen in 2007 and the third lowest level since 1996.

This dynamic usually does not persist for long at all. Either Fed Funds and the premium that banks add to lend money for investment grade bonds has to come down, which I think is unlikely, or the yields on investment grade bonds have to go up. For those who don't trade bonds, yields going up means prices come down.

New York Federal Reserve President John Williams is clearly watching this restrictive lending environment carefully. He recently said, “These developments will likely lead to some tightening in credit conditions for households and businesses, which in turn will weigh on spending.”

Tighter credit conditions and lower spending usually means lower economic activity, which can lead to a recession. If you look at the right-hand side chart above, the last time the carry trade got this low was right before the 01-02 recession and Great Financial Crisis.

What Does All of This Mean for the Stock Market?

History doesn't repeat itself, but it does rhyme. Despite the failure of Silicon Valley and other banks, I think the banking sector is in much better shape than in 2008, particularly the large, money-center banks. That said, regional banks are enormous transmitters of credit and liquidity to the economy. Regional banks supply about 80% of the loans that banks extend to commercial real estate, an industry with enormous impact to the broader economy and whose growth via new construction creates a lot of jobs. A pullback and/or higher cost on these types of loans would be consistent with the tighter carry spread, which ultimately could/should lead to higher yields on bonds.

Higher bond yields should impact the equity markets. If you can earn a high enough yield for investment grade bond risk, that yield competes with the total return one should demand from stocks. More money flowing into bonds versus stocks could translate to lower prices.

Lower prices and higher yields for bonds means that companies will have to pay higher interest rates too, which can impact earnings. Combine lower earnings with more competition for investor dollars and it is not a good dynamic for the stock market.

Conclusion

I have mentioned in the past that it pays to follow the bond market when investing in stocks. It was less important when the Fed kept interest rates at insanely low levels for years. But now that interest rates are closer to more normalized levels (although still pretty low by historical standards), action in the bond market can matter to the stock market quite a bit. I think higher bond yields and potentially significantly lower corporate earnings this year and next are something every stock investor should pay attention to.

Catalyst Hedge Investing Launches in One Week!

My new investment group, Catalyst Hedge Investing , launches on April 27. That's just a week away. Most of my best ideas will remain private for my subscribers as will live portfolio of longs and shorts, an active chat board and direct access to me. There will be generous introductory prices for early subscribers that will continue for the life of your subscription. I hope to see you as a subscriber and thank you for following my work.

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