2023-04-26 10:26:25 ET
Summary
- Regional bank stocks have taken another dive over the past week as banks begin to report large deposit outflows and losses in their earnings report.
- The overall decline in bank liquidity has returned as banks begin to repay "Discount Window" borrowings to the Federal Reserve.
- Regional banks are at significantly elevated leverage today and are not trading at a significant discount, particularly considering their net asset values are likely tremendously below their book values.
- The overall degree of debt and debt-related issues in the financial system is more significant today than in 2008.
- With inflation persistence and a slowing economy, the US government cannot provide necessary stimulus without fundamentally jeopardizing the US dollar.
Last month's "regional bank crisis" sent jitters across global financial markets. The value of most regional banks collapsed, with the SPDR S&P Regional Banking ETF ( KRE ) falling by roughly 30% in a matter of days. Although media attention surrounding the situation has subsided, the storm may not be over, as KRE has continued to slide to lower lows over the past week. Initially, many of these banks maintained liquidity by borrowing significant sums from the Federal Reserve Discount Window; however, that provided a short-term fix to a long-term solution. As the weeks pass, banks must repay the Federal Reserve, meaning, in the absence of deposit growth, most must sell assets to raise cash.
Total US bank deposits have begun to trend lower over recent months due to quantitative tightening. Banks usually assume deposits will never decline since they never would in most circumstances, particularly before the introduction of "QE," as minted currency essentially exists forever. Small banks have taken a significant hit to deposits, creating more outstanding issues due to their elevated leverage today. In fact, the total liabilities-to-asset ratio for small US commercial banks is significantly higher today than it was before the 2008 crash. See below:
When leverage is significant, and deposits fall, banks must recoup cash-outflows with new liabilities, usually in debt financing or short-term Fed "discount window" borrowing. However, doing so becomes very difficult when most banks are looking to sell assets simultaneously, and QT continues to create negative pressure on deposits. If this trend continues, then I believe regional banks may face more significant declines and will fall to the mercy of a politically dead-locked congress (as the Fed cannot unilaterally act to bail out these banks).
To add more pressure, the US Treasury should run out of money around July without increasing the debt ceiling. Default could create a more significant liquidity crisis, creating volatility in the ~$204T US interest rate derivatives market. In my view, it remains far more likely that a debt deal will be made; however, this will mean hundreds of billions in rapid Treasury auctions as the Treasury replenishes its depressed account, pulling significant liquidity out of financial markets during an already tumultuous time.
Some investors may view KRE and its constituents favorably as a "value opportunity." Without a doubt, KRE is much cheaper today than it was two months ago, and, in the short term, the "bank crisis" risk factor seems to be on the back burner. However, taking a closer look at the state of the US banking system today, I believe investors may want to brace for more significant losses over the coming months.
Why US Banks Are Worse Today Than in 2008
Problematically, there are many more "bank assets" than cash in today's economy. There are around 5.5X in bank deposits to bank cash and over 7X total bank assets to bank cash. Further, the M2-to-M0 ratio is around 4X today, meaning there is around 4X more "cash and near cash" (such as time deposits and money market) compared to "actual cash." Of course, most "M0 cash" is made of non-physical Federal Reserve assets not backed by physical currency. There is ~$2.3T in US currency in circulation, just over 10% of the total bank deposits and money market funds. Accordingly, people could only receive 10-20 cents on the dollar if everyone sought to withdraw deposits.
The existence of the FDIC limits this risk; however, even the FDIC is limited by its assets, which at $128B (and likely less following the recent bank collapses), is highly inadequate in the event of a more considerable decline in deposits. While I am not concerned about a more extensive "bank run," investors should pay attention to falling deposits and the impact that could have on banks as they're forced to sell assets at a discount. Problematically, this situation is forcing nearly all banks to be net sellers of assets, creating growing negative pressure on asset prices that reinforces the problem.
On the surface, bank solvency and liquidity measures may seem ok; however, we should remember that Silicon Valley Bank had a Tier 1 capital ratio of 16% last year, well above that of most large and small banks today . However, like many, it also had immense off-balance-sheet asset losses due to rising interest rates and significant fixed-rate bond security assets (many lost 15-30% of their value last year). If banks were to sell these assets today, most would have capitalization 4-6% below their "Tier 1" official level, making most large banks near-or-below the minimum solvency level of 6%.
How Basel Reforms Obfuscate Bank Risk
Many analysts and investors focus on the strong "official" Basel ratio for banks and other traditional solvency metrics such as "loans-to-deposits." Based on these measures, banks are healthier today; of course, SIVB would have been in "stellar health" as its Tier 1 capital was substantial while its loan-to-deposit ratio was extremely low at ~41% . However, these metrics fail to consider the impact of Treasury and agency securities, a massive portion of bank assets today.
Before 2008, banks were less interested in these securities due to their low returns. However, after that crisis, the introduction of the Basel Accords , which reduced financial risks, allowed Treasury and agency securities to receive a 0% risk weighting, meaning they're traded as "riskless" and are unaccounted for in ratio calculations. Accordingly, banks aggressively increased Treasury security positions, rising by almost 4X since then before the recent peak. Of course, most governments loved this change as it provided immense government debt financing via the commercial banking system. This issue grew in 2020 as Treasury securities and Fed deposits were explicitly excluded from leverage ratio calculations, a change deliberately encouraging banks to finance the immense government deficit in 2020.
In my view, the problem here is that "low credit risk" has been equated to "low risk" when "duration risk" in Treasury securities can be immense, as I warned many times from 2020 to 2022. In 2021, I also specifically warned of the impact excessive Treasury assets could have on banks and warned of a coming liquidity crisis last year as yield curve inversion and QT forces banks to become net asset sellers. Most readers disagreed with my views, focusing on outdated bank solvency metrics, "stress tests," and other measures that fail to account for immense off-balance-sheet asset value changes (realized when banks inevitably look to sell such assets).
To me, this points to the fact that many analysts and investors do not understand the evolution of the banking system since 2008 and the fact that nothing was genuinely fixed after 2008. Total US public and private debt-to-GDP is much higher today than then due to COVID borrowing, implying that the financial risks are slightly more significant today than they were ~2007. See below:
Since 2008, measures of "who owes what to whom" has changed dramatically, with banks dramatically altering balance sheets to comply with Basel Accord rules. However, the total amount owed credit, the true economic and financial burden, has continued to rise slightly faster than the GDP. After all, this implies nothing was solved in 2008, and "the can has been kicked down the road" continually since. Some investors may wish to deny this fact to justify riskier investments; however, recent (and impending) events appear to be forcing this reality to the surface.
KRE Is Not Trading At A Discount
The trouble with bank stocks is that they have very vague fundamental value, mainly as liquidity issues arise. This issue is further exacerbated by the fact that many popular bank risks metrics, such as Tier 1 capital ratios or loan-to-deposit ratios (used in stress tests), fail to account for the significant changes in most banks' asset books. Additionally, due to their high leverage (and off-balance sheet assets and liabilities), bank stocks often "rise like an escalator but fall like an elevator." In other words, they offer high consistent returns in "good" periods and immense losses in challenging ones.
One particularly crucial issue for regional banks is the sharp rise in total leverage that most firms use. This is illustrated in KRE's top holdings below:
Today, most of these banks have similar total liabilities-to-assets that they did around 2006-2007 (of those which have existed since). In 2020, these banks dramatically increased leverage as the sharp increase in QE liquidity and reduced leverage and stress test requirements encouraged bank lending (or securities purchases, more specifically). Cash levels may be higher today, but some cash is tied up in off-balance sheet derivatives. Further, their actual "market" asset values are likely significantly lower than stated on their balance sheets due to significant valuation declines for Treasury and agency securities last year.
Despite substantial price declines, most banks are not trading at a significant discount today. The median price-to-book ratio for the top ten stocks in KRE is currently 86%. That figure is on the low end of the normal range over the past ten years. See below:
If these banks could liquidate their assets at book value, KRE would likely be trading at a 10-20% discount today. Most recent losses merely erased the premiums in many regional bank stocks from 2021-2022. Considering that most banks have significant unrealized portfolio losses, I do not believe KRE is trading at a considerable discount on its holdings' actual net asset values.
Of course, that figure is difficult to measure. The market value of total bank assets is believed to be ~9%, or $2.2T lower than suggested by their book values. Total US bank equity capital is only $2.2T, meaning the actual "NAV" of many, if not most, banks are currently near zero. Theoretically, many banks have some longer-term debt at low rates that can be discounted due to rising interest rates, offsetting this to an extent. However, banks generally borrow short-term and lend long-term, so I believe bank NAVs are likely at least 50-70% below book values today, illustrating how leverage can dramatically increase the effect of asset losses on bank equity.
Looking Forward
The situation facing banks, notably smaller regional banks, is quite tremendous and could easily wipe out the equity value of most of them if these banks sell their assets. I believe it is unlikely that rates on 3-year Treasuries and longer will fall significantly anytime soon (due to curve inversion), meaning banks will unlikely recoup these losses unless they hold to maturity. In reality, most banks should, and usually expect , to hold securities to maturity. However, that relies on bank deposits rising in perpetuity; if deposits decline, they must sell securities at a significant loss before maturity.
The negative trend on deposits will likely continue until both QT ends (keeping the M2 from falling) and the velocity of money decreases. This should not occur until we see a sharp decline in inflation that allows the Federal Reserve to make a dovish pivot. Although inflation is cooling today due to the slowing economy, that does not aid banks because it causes loan losses to rise. Thus, without immense and seemingly unlikely support from Congress, I do not believe most regional banks can sustain their equity value indefinitely.
The growing strains in commercial mortgage lending and rising CMBS market spread imply that more "off-balance sheet losses" may occur today. M&T Bank ( MTB ), the second-largest holding in KRE, recently disclosed that a staggering 20% of its office CMBS loans are in danger of default today due to the numerous issues in office properties. I suspect that figure will grow as more companies do not renew office leases in order to save money by using hybrid work. I also believe strain will spread to most other commercial properties and their lenders as low transaction volumes cause all commercial property valuations to fall (pushing loan LTVs higher). Looking forward, I suspect the commercial property market may trigger another negative catalyst for US banks by year-end.
Over the next year, many events can occur that could alter the course of the banking system. KRE is a "binary option" to an extent because its constituents will either recover as risk fades or lose most of their value as new catalysts cause another wave in asset sales losses, likely causing some of KRE's constituents to collapse. Thus far, the Federal Reserve and the US government have made efforts to provide some minor liquidity that slows the crisis. Still, considering it is a multi-trillion-dollar issue, I do not believe they can stop it altogether without fundamentally jeopardizing the US dollar. Further, since the Treasury relies on bank financing, and banks are racing out of Treasury assets, the Treasury likely cannot provide money to banks as it did in 2008.
With this in mind, I am very bearish on KRE and believe its troubles have only begun. Indeed, I think this issue is larger today than in 2008 because the US government has much less power to continue supporting the many " zombie banks " today. I do not say this to promote fear or as hyperbole, as I firmly believe this is the most rational view based on the hard data available. Further, while this view may promote anxiety or fear, a realistic look at difficult truths is far wiser than denial in the long run. That said, I am apprehensive to short KRE or its constituents because government stimulus, or rumors of such, will likely create excessive volatility in the event of another wave of regional bank strains.
For further details see:
KRE: The Banking Crisis Has Slowed, But It Cannot Be Stopped