2023-05-08 03:16:05 ET
Summary
- As anticipated, the financials-centric preferred equity ETF PFF has lost value this year due to increased bank instability.
- PFF carries some direct exposure to failing regional banks but is now more weighted toward large banks due to its market cap weighting.
- PFF's market-cap weighting should cause permanent losses as it disproportionately sells bank equities that have declined the most.
- Banks in PFF are failing without a recessionary increase in defaults, implying a recession could cause this crisis to grow dramatically.
- Should a recession occur, I believe the total amount of stimulus money needed to stop the crisis is far beyond the reasonable range for the Federal Reserve or US Treasury.
In December, I published " PFF: Preferred Stocks Could Suffer Worse Declines In 2023 As Banking Risks Mount ," which detailed my bearish outlook on the preferred equity sector through the popular iShares Preferred and Income Securities ETF ( PFF ). This bearish outlook began in 2021 when it appeared likely that PFF would face devaluation as inflation caused interest rates to rise. In December of 2022, I maintained a negative outlook not due to a rise in interest rates but an increase in risks within the banking sector due to PFF's immense exposure to banks. PFF has lost around 7% of its value since then as the increasing risks within the banking system have begun to come to light.
A significant cause for PFF's recent losses is directly associated with the recent bank collapses. At the end of last year, around 1.5% of PFF's holdings were concentrated in the now-defunct First Republic Bank, Signature Bank, and Silvergate. Today, the fund is still directly exposed to most of the larger regional banks that are at higher risk of bankruptcy , including PacWest ( PACW ), Zions Bancorp ( ZION ), First Horizon ( FHN ), Western Alliance ( WAL ), and others. That said, the fund's exposure to most of these equities is under 20-30 bps, so the overall impact of the potential collapse of more regional banks is lower today as PFF's market-cap weighting causes the most devalued banks to be pushed out of their holdings. Of course, this factor also means PFF has less upside if these banks recover since it dramatically reduces its exposure to banks with the most significant drawdowns.
PFF's overall exposure to financial institutions remains high at ~68% of the fund's total . In 2007, during the last banking crisis, PFF's exposure to the sector caused it to quickly lose around two-thirds of its value before the bank bailout. Today's situation is, in my view, very similar to that of 2007, albeit with different "bad asset" risks - focusing more on unrealized "low risk" securities losses and less on "high risk" loan losses. Although fewer total banks have failed, the total amount of assets in failed banks today is already more extensive than in 2008. Of course, PFF today is more concentrated in the largest banks, so its most significant risk is the failure of these banks or, more likely, a long-term rise in risk perception facing large banks.
Assessing PFF's Downside Exposure to Banks
Preferred equities are often viewed as "lower risk" than common stocks because they rank higher in bankruptcy priority. However, in most situations, it is improbable that preferred equity will be the "fulcrum security" since preferred usually only makes up around 1% of a bank's total assets or less. Indeed, in the US bank collapses, stock, preferred stock, and bond investors have generally lost all of their investments as the market value of assets has declined so much compared to liabilities that none have maintained value. This is common with banks due to their naturally higher leverage level and more complex capital structures. Thus, in most instances, we can assume that the credit risk in PFF's financial securities is equal to that of the common stock on the same banks.
Of course, the devaluation of banks' preferred equities has increased the yield on those securities. PFF's yield is now 6.4% after its expense ratio (note, its TTM yield is inaccurate due to the complete devaluation of numerous positions), higher than it was in December but still below that of high-yield bonds . Further, investors can receive a ~5.75% yield on one-month Treasury bonds and slightly higher on AAA corporate bonds of equivalent maturity. Thus, although PFF's yield is higher than it has been for around five years (excluding 2020), it is quite low compared to assets with tremendously lower risk profiles.
In my view, there remains a distinct possibility that larger US banks will fail, given the current situation. Large banks which I believe carry particularly high-risk profiles include Capital One ( COF ), U.S. Bancorp ( USB ), Ally Financial ( ALLY ), and Truist ( TFC ). Excluding Ally, PFF's exposure to these banks is much higher than its holdings in regional banks since they command much higher market capitalizations. I believe US Bancorp and Truist are at greater immediate risk due to their higher exposure to unrealized losses on securities positions - significantly reducing the "market value" of their net equity position. Should these banks suffer a decline in deposits, they'll be forced to sell assets at such a loss that their CET1 ratios will likely fall below-required levels.
Capital One, Ally, and many other large banks have lower (though still material) exposure to unrealized bond losses but more significant exposure to the possibility of an increase in loan losses. Further, virtually all US banks face threats from falling net interest margins as falling deposits force more to increase savings account interest rates to compete for deposits. On that note, we should remember that banks are facing their greatest crisis since 2008 without a recession. Indeed, most banks still see loan losses and defaults below normal levels and are failing with a liquidity shortage.
The most immediate risk to banks, and therefore PFF, is the ongoing decline in bank deposits and the total amount of "money" in the US economy. There is currently around 4X more "bank money" (M2) than there is actual money in the economy (M0), and most (~ two-thirds) of the "actual money" does not physically exist (i.e., hard currency) and was created through QE in 2008. Accordingly, should deposits decline sufficiently, there is almost no way for the FDIC, or any agency, to insure deposits since that amount of actual money simply does not exist. Further, the amount of " actual money " in the economy is falling due to the Federal Reserve's tapering program, creating negative pressure on bank deposits and the M2 money supply. See below:
Without a rapid end to the Fed's QT program, there is essentially no way for total US bank deposits to stop falling. However, total US bank assets generally do not decline with the falling money supply , inevitably meaning banks secure loans and securities with a falling supply of deposits. Should the deposit coverage levels continue to decline (due to depositor exit or asset devaluation), many, if not most, banks do not have sufficient excess capital to meet obligations.
It may be wise to be deceived by "strong" CET1 ratios (or similar), as these "headline" figures fail to account for unrealized losses on sovereign bond positions. By that popular dubious measure, Silicon Valley Bank was among the least risky. The uncomfortable reality is that most US banks are hardly solvent today if we account for the market value of bank assets. The significant media attention surrounding the situation may accelerate the crisis through a "bank run" decline in deposits; however, I believe these failures are inevitable due to excessive bank risk exposure toward securities positions.
Indeed, I, and some others, repeatedly warned of this specific risk factor in 2021 and 2022 .; to me, that indicates this crisis is not caused by "panic" (as many suggest) but mainly due to legal changes that encouraged banks to fund excessive government deficits since 2008 (Basel rules that discount government securities) and specifically in 2020 ( exclusion of Treasury securities from Fed leverage ratios ). The mass media attention, in my view, is merely accelerating the inevitable and can only be stopped through a massive decline in inflation that allows the Federal Reserve to increase the money supply.
Recession Risk Not Priced Into PFF
To assess PFF, we must paint a few potential scenarios the market may face over the coming year. In an ideal scenario, the US economic growth level will rebound, and inflation will decline - keeping defaults low, slowing the decline in total bank deposits, and stabilizing NIMs through a steeper yield curve. To me, this specific scenario is unlikely given the state of forward economic indicators; however, it is possible, and many investors maintain this viewpoint. In such a scenario, PFF could rise slightly as the current yields on its banks return to normal levels. That said, PFF is unlikely ever to recover its past price because it sells losing positions through market cap weighting. Further, even in that scenario, I believe PFF's yield is too low compared to lower-risk assets today.
A recession may occur in a more likely scenario, increasing credit spreads and default risks. Should a recession occur, as indicated by yield curve inversion, I believe this issue could grow much faster as loan default risks grow. Remember, it would only take a few percentage point increase in loan losses for most bank equities to become worthless, particularly considering their immense off-balance sheet loss issue today (which likely currently pushes the "market" CET1 ratio of most banks to around 4-6% , below required levels). Today, the US yield curve remains near multi-decade record inversion, and the PMI is signaling the largest contraction since 2008 (excluding 2020); however, bond credit spreads remain generally low. See below:
The PMI and yield curve are historically strong recession indicators and signal an economic contraction over the coming year. Importantly, recessions, and larger stock market declines, usually occur as the yield curve is "re-steepening," not when it is still inverting. The yield curve appears to have reached its minimum last month, implying it could steepen into a recession over the coming year, as is historically most common.
I believe credit spreads on BB-rated bonds (the high-end of non-investment grade bonds) are very low considering the economic outlook. Many banks are tightening lending standards today , implying companies will struggle to receive cheap financing. As banks look to reduce risk exposure to riskier loans, some borrowers (corporate and household) may default, implying credit spreads may widen much further. Once again, this risk factor can become "self-fulling" as banks look to sell risk assets without other banks looking to buy them, causing a potential devaluation spiral.
At this point, it is difficult to say where banks will fall should a recession occur over the next year. In reality, decisions from a smaller handful of individuals in the government and the Federal Reserve will likely have a considerable impact on bank solvency. Should there be a strong and clear pivot from the Fed, the pain could be mitigated, but more banks could fail or, at the least, be forced to sell business segments at significant discounts to restore solvency. However, the size of the potential strain may also become so large that there is very little the US government or the Federal Reserve can do to stop it.
The Bottom Line
In my view, the fact that PFF's holdings have lost this much value over the past year without a recession makes it likely that they will lose far more should one occur. A recession is not guaranteed, but it is exceptionally high using most quantitative models . If there is no increase in loan default risks, PFF could still lose some value due to its low spread to short-term Treasuries and impacts from the negative trend in total bank deposits. However, if loan losses do rise, as I expect, then I believe that most US banks could face insolvency by 2024 without immense government intervention. I do not state that as hyperbole but as a realistic outlook given the current state of bank capitalization after unrealized securities losses combined with relatively conservative historical recession impacts and the likelihood of a continued decline in deposit levels.
From this standpoint, I am very bearish on PFF today and believe its total declines could be similar to 2008, potentially bringing PFF's value under $20 per share as risk perception regarding banks continues to rise. Of course, in 2009, PFF's huge losses reversed quickly as the Federal government pursued massive bailouts and the Federal Reserve began its QE experiment. From that view, it may seem PFF's total long-term downside risk is greatly mitigated by the " Fed put ." However, from my standpoint, widespread beliefs in the "Fed put" have caused both banks and many investors to take on excessive risks in the view that they will always be bailed out should losses occur, thereby causing total market risk levels to rise so much that it is unlikely the US government (Treasury) or Federal Reserve could do so.
The Government (Probably) Can't Save You
In other words, these institutions can "fix" a $50-$200B issue relatively easily. A $1-$2T issue, such as that of 2020, maybe correctable via stimulus programs, but at the cost of creating record inflation. Banks today have around $1.7T in unrealized losses and could have much-realized losses should default rates rise. Thus, I believe the size of the current issue is outside of the range where the Federal Reserve or US Treasury could reasonably halt it, particularly considering they're still fighting inflation from its 2020-2021 stimulus programs.
The rising possibility of a US government default in a few weeks is a significant potential negative catalyst for PFF and virtually all banks due to their immense direct and derivative exposure to Treasury markets. Until recently, this risk factor seemed extremely unlikely, but the unending congressional deadlock makes it more reasonable. At the least, a "debt deal" would cause the US Treasury to greatly increase its bond sales over the coming months, demanding more liquidity from the seemingly illiquid financial system. At worst, a prolonged default would likely create significant temporary financial market illiquidity and, most likely, permanently mar international perception of US market stability (hampering the US dollar's position as a dominant reserve currency).
Overall, I believe the takeaway is that PFF carries great downside exposure today, limited upside potential, and a low probability of benefiting from a "Fed pivot." In my view, the US economy is currently seeing a confluence of multiple negative catalysts simultaneously (potential default, falling market liquidity, and recession risks), creating a "perfect storm" that, I believe, could erase the equity value of most highly leveraged companies. While some may see that as a "doom and gloom" view (as many readers will contend), I believe it is reasonable given the data. As an investor and analyst, I do not think the failure of inefficient or broken systems (such as zombie banks ) is necessarily "bad" for the economy or society as it opens the door for superior systems in the long run.
For further details see:
PFF: More Banks May Fail And Bring Preferred Equities Along With Them