Summary

• Arguably, policy choices/regulations have been largely made in a backward-looking fashion fighting the last crisis. There have been improvements to safety and soundness in the financial system as well. The regulations also promote fiscal deficits via High-Quality Liquid Asset treatment of sovereign debt, which provides an inflationary impulse.  

• The size of the COVID-19 response and debt-to-income ratios of most countries are elevated. Slowness in tightening monetary policy is likely a result of financial repression to bring debt-to-income ratios down via higher inflation relative to the level of interest rates. Coming out of wars, governments have used similar tactics to reduce debt-to-income ratios.

• The funding profiles of banks have become much more susceptible to interest rate/liquidity sensitivity given the reliance on non-maturity deposits (NMD) as a significant funding source (85% of total deposits). Reliance on NMD is more a symptom of falling interest rates since the 1980s as inflation uncertainty and volatility have declined over time.  Bank’s Net Interest Income has become reliant on NMD as a major source of income.

• The speed of interest rate hikes in 2022, has exposed the interest rate sensitivity of banks and the lack of capital held for interest rate risk, given that rates of inflation remained largely within the 2% target for the last 20 years.

• Large drawdowns in bank deposits by moving money to money market funds and U.S. Treasuries destabilize the funding profiles of banks, which reduces lending growth. With less credit available to households and businesses less purchasing power and jobless claims rise (cyclical deflationary impulse).

• Global Central Banks are faced with continuing to fight inflation or maintain Financial Stability. We believe Financial Stability will be prioritized, with many leading indicators of cyclical inflation continuing to decline. Total system-wide debt was below trend (7%) in Q4/22 (3.5%), and continue debt growth continues to fall as banks continue to tighten standards and funding profiles are destabilized. The pricing power of businesses and profit margins also appear to be declining.
• Wrapped up in all of this story is human behavior that continues to repeat which is why cycles continue to repeat over and over again. Some certain behaviors/biases and incentives exist that cause people to maximize benefits in the short-term for a select few for financial gain or greed that inflicts pain on many others in society in the process and create distress in markets. It is very difficult to predict in advance the source of stress, though there are always common red flags/indicators that are in place ahead of time.

• Walter Bagehot, a 19th-century British journalist and editor of The Economist, used to say “John Bull cannot stand 2%”. Earning such a low return was unacceptable and would need to take on more risk which helped generate some now-infamous investment crazes: the Tulip Bubble, the South Sea Bubble, and others. With years of low rates (often well below that 2% level John Bull couldn’t stand) pushing investors to take excessive risk in search of more and higher returns (maximizing short-term benefits).

• Long-term capital allocators that become liquidity providers in periods of distressed markets and tend to take advantage of these situations. 
• We reviewed Berkshire Hathaway’s rescue of Home Capital Group in 2017 as a template for a private market solution to the U.S. regional banking crisis in terms of expected returns and deal terms given the fact pattern seems somewhat similar.  

Background

We need to understand the roadmap in terms of how we got here:

• COVID-19 and the shutdown of the economy resulted in a GDP decline of 30-40% on an annualized basis. Stimulus offset the original estimate of decline, and working from home caused many to save as well. Technology advancement and changes in behavior, allowed the economy to be extremely resilient and which allowed significant savings to be accumulated.  

• Bank regulation has been drafted based on fighting the last war (credit risk and liquidity rather than interest rate risk). Also, banks are major buyers in sovereign bond markets, along with governments buying their debt to manage the yield curve and debt service ratios, given high debt-to-income levels:
  • Sovereign debt is low risk from a credit perspective and considered a High-Quality Liquid Asset. Had exception to carve out Sovereign Bonds on Leverage Ratio temporarily, to allow for banks to finance large fiscal deficits during COVID-19, along with Central banks with Quantitative Easing. No capital holding for sovereign bonds for Interest Rate Risk in Banking Book (IRRBB), just captured as part of stress testing and Internal Capital Adequacy Assessment Process (ICAAP). 
  • Favorable treatment of sovereign debt may perpetuate higher fiscal deficits/debt growth which tends to drive inflation higher.  

• COVID-19 stimulus bypassing banking system straight to deposit account (40% of GDP/Fiscal Deficits) are inflationary

• Transitory Inflation narrative and Flexible Average Inflation Targeting in 2021, rather than a smoother rate hiking cycle. We believe that financial repression (level of inflation above overnight interest) is required to bring debt-to-income levels to manageable levels after COVID-19 and attempt to maintain social stability in the process without major disruptions. Central Banks/government authorities will look to plug the gaps with temporary operations to maintain Financial Stability as the primary objective.

• 450 bps increase in overnight interest rates in 12 months to offset rates in consumer price inflation we have yet to see in the past 40 years.  

• Long lags of monetary policy given inherent mismatch maturity profiles credit on bank balance sheets are greater than short-term deposits which fund credit outstanding. Rundown of excess savings and increase in credit as economy re-opened/higher inflation over the past 1.5 years.

• Non-maturity deposits represent 85% of total deposits (vs 1984 – 60%) and have increased as interest rates have fallen over time since the 1980s.

• Insured deposits as % of total deposits have declined over time. Likely due to policies favoring capital vs labor, and therefore corporate deposits/institutional deposits which are largely uninsured grown over time.

• The economy is built by creating credit to drive productive capacity forward by renewing/rolling existing credit, as well as, new credit (i.e. new population growth/labor, business, etc).
• Over time, this has led to continued expansion/inflation of credit and deposits and bank balance sheets. Given the size of overall debt to income, if credit creation slows, this is quite a deflationary impulse and the main tail risk of the existing financial/economic system. Debt deflationary situations can be quite non-linear and difficult to predict in advance. This is what the central planners are concerned with and why maintaining financial stability is critical.    

The Focus of Bank Regulation and Stress Testing

Now that we have understood where we came from, let’s understand the recent history of bank regulation:

• Regulation and Stress Testing is largely based on lessons learned from the prior crisis. Weak collateral and poor underwriting created credit risk in the 2008/2009 Global Financial Crisis (GFC). Therefore the focus of current regulation has been largely on capital and credit risk. Liquidity and Funding mismatches were also addressed.
• Interest Rate in Banking Book (IRRBB) – has not been a focus, given the low-interest rate environment and disinflationary environment have largely kept inflation close to the 2% target range over the past 30 years. 
• The pace of the rate hikes (400 bps in 12 month) is potentially higher than the stress test contemplated, given the lack of inflation in recent past 40 years, as most of the regulation and stress testing have looked back in the recent past (10-20 years) and as humans, we tend to fight the last crisis.   

Banks’ Behavior Before SVB and Signature Bank Failures

Even before recent bank failures, the banking system was tightening lending as a result of reduced deposit levels:

• The economy has been resilient to date as banking credit growth has continued to be positive (see Table 1).
• To provide perspective on the amount of credit creation in U.S. regional banks vs Large Banks and the importance of U.S. regional banks to the overall U.S. Financial System, small banks have provided 45% vs 55% from large banks of all lending into the economy. So the financial stability and trust within the regional system around the safety and stability of the deposit base are critical to continue to provide lending to the economy.  U.S. regional banks have actually been lending more to individuals and small business in the past year relative to large U.S. banks.
• Quantitative Tightening reduced liquidity in the banking system which in turn, Banks were tightening Credit standards (Table 2) and credit availability to reduce balance sheet size, as deposits were being reduced.
• Deposits were leaving Bank Balance sheets and moving into Money Market Funds due to higher interest rates relative to bank deposits, specifically non-maturity deposits (see Table 3).  
• Given the low-interest rate environment and the balance sheet profile of many banks, their Net Interest Margin relied on earning margins on both Loans and Deposits. Non-maturity deposits have increased over time and compromise a significant portion of U.S. Bank Net Interest Income.
• The interest rate shock before recent bank failures based on deposit betas was orderly and banks could alter lending or de-lever the balance sheet in response.

Table 1: Aggregate U.S. Bank Lending

Table 2: Tightening Credit Standards to Slow Lending

Table 3: Total Deposits: Aggregate US Banking System

Hypothetical Interest Rate Risk in the Banking Book (IRRBB) for Aggregate US Banking System:

Economic Value of Equity at Risk and Earnings at Risk

The pace of interest rate hikes and balance sheet position of banks coming out of a long period of low-interest rates and low inflation volatility created the capital shortfall on a mark-to-market basis (when looking at loans and all securities) on an aggregate basis and at beginning of 2023 running an EVE based on a parallel shift of 400 bps (a YoY change in Fed Funds Rate) would have revealed the capital shortfall, based on the static balance sheet and interest rates at a point in time (see Table 4).

Table 4: Aggregate U.S. Banking System: Economic Value of Equity at Risk

We believe that we are past the largest rate of change or acceleration in interest rates during this rate cycle. The acceleration of rates impacts the Economic Value of Equity at Risk and we are probably seeing the largest impacts right now given that rates are up 425 bps from the prior year.  

• The speed of the rate of change in interest rates is extremely important given the maturity mismatch on the Aggregate U.S. Banking System Balance Sheet as deposits tend to reprice much quicker than assets, so banks tend to see NIM compression in rising rates relative to declining rate scenarios. The inversion of the yield curve has compounded this impact as well.

• Repositioning a Bank’s balance sheet takes time, especially moving very quickly from a low-interest regime from 2009-2021 to the highest rates in the last 40 years.

• Demand for U.S. Treasuries due to higher yield relative to bank deposits, which is creating instability in the funding profile of banks. Based on the outlook for the Fed Funds rate, aggregate deposit costs are expected to move up in 2023 to offset fleeing deposits into Treasuries (see Table 5). This has pretty big implications for the economy going forward via the further tightening of lending growth.

Table 5 – Aggregate U.S. Banking System:  YoY Change, Deposit Costs vs Fed Funds Rate (1-year moving avg)

• These “losses” or “capital shortfall” due to IRRBB stress testing are usually thought to be manageable given the implicit assumption that not all depositors en masse would move out deposits and create a run/panic and the securities book would need to be liquefied. Also, there is probably a failure in understanding from a macro-prudential and regulatory perspective the severity/connectivity of the issue of the pace of interest rate hikes vs stability of the overall commercial banking system on asset/liability management. See below for further thoughts on private equity/capital coming in to help plug capital shortfall and reap the rewards of buying regionals at distressed/liquidation values.    

• One of the reasons the U.S. consumer has been so resilient through 2022 into 2023 in the face of high inflation is that lending has continued to support the growth via credit cards/consumer loans/mortgages.  Also, the full impact of the previous Fed Funds Rate hikes has not been fully reflected in the loan spread given the longer average maturities of 3.5 years (Table 6). Again the long lag of monetary policy still looms large. 

Table 6 – Aggregate U.S. Banking System:  YoY Change, Loan Interest Yields vs Fed Funds Rate (3.5-year moving avg)

• We note that the business cycle is roughly 3-4 years in length, consistent with the repricing of the loans, which makes sense given the hyper-financialization of the economy and the importance of maintaining a debt service ratio within a certain range to provide consistent economic growth over time.

• The next phase of the business cycle moves from liquidity and funding/interest rate risk concerns of banks to liquidity and funding concerns of consumers, which results in higher credit risk in the economy/credit losses to lenders in both the banking and non-banking system.  

• Outlier banks from a duration perspective such as SVB are impacted, as they had to sell the assets at fair value to redeem the deposits, effectively a margin call at the worst possible time (height of interest rate acceleration/rate peak which reduces the value of long-term assets such as loans).

• However, we note that we need to take this IRRBB test with a grain of salt as most banks will survive, continue to be a going concern, and collect the interest on the loans that they will hold to maturity, rather than valuing the balance sheet at current liquidation value.  Net Interest Margin/Net Interest Income compression is expected in 2023 (see Table 7) largely due to bank deposit repricing.

Table 7 – Aggregate U.S. Banking System:  Earnings at Risk

Another Way to Look at Net Interest Margin – Bifurcating Deposit Spreads vs Loans Spreads and Sensitivity to Interest Rates over time 

Given the past 40 years of low-interest rates and additional regulation to reduce credit risk in the banking sector, the spread on deposits has increased relative to the spread on lending as banks have relied more on non-maturity deposits (NMD) over time moving from 60% in 1984 to 85% at end of 2022.

The crisis could have been avoided if deposit costs would have been more in line with the Fed Funds rate – however, we need a roadmap to show how we got here.

Over time as interest rates fell from the 1980s, banks started to rely more on deposit margins as part of Net Interest Income (NII) rather than lending. Also to repair capital/credit (reducing credit risk) coming out of GFC by reducing private debt service ratios and as result, banks have relied more on deposits versus lending since then to drive NII (Table  8).

Table 8 – Proportion of Net Interest Income – Lending vs Deposits

The outsized COVID-19 stimulus and rapid rate rise, de-stabilized bank funding profiles (largely NMD). Given that assets on bank balance sheets have a longer maturity, they will not reprice as quickly as deposits. The difference between deposit costs and FFR at 2.44% (largest ever) (Table 9). Over time, deposit sensitivity to change in interest rate changes from the Federal Reserve, also known as, deposit beta, has declined as well (Table 10). 

Table 9 – Deposit Cost vs Fed Funds Rate

Table 10 – Deposit Betas across Rate Regimes

Table 11 – Deposit Flight and Fed Funds Rate

Without a stable deposit/funding base, banks will pull back on lending into the real economy (including tightening of credit standards to give money only to the most creditworthy business and consumers) slowing credit creation within the economy, especially to middle market clients that the U.S. regionals serve. The resulting credit crunch forces companies to cut prices and labor costs by cutting wages and payroll, which tends to slow the activity in the economy, eventually causing a recession.

We note that with large deposit flights in the past (1995, 1998, 2001, 2008), the Fed Funds rate has come down/taken a less aggressive stance as they have chosen Financial Stability in the Banking Industry over reducing inflation (Table 11). Based on the most recent data on March/23, deposits have declined 3% from the peak, which has caused banks to slow lending/start to de-lever. This appears to point to the Fed slowing the rate of interest rate increase/pausing to assess the damage inflicted on the real economy. We believe the Fed may be cutting interest rates if deflationary impulses via lower lending become more evident.  

The point of the Bank Term Funding Program (BTFP) was to address (as the Central Bank acts as a lender of last resort, temporarily creating more liquidity in the system based on collateralize lending) this point-in time issue and buy time to relieve the liquidity stress event and not have banks sell down their securities and loans portfolios in the heat of the moment if there is a bank run on deposits and realize these losses, further creating issues with their solvency. It also values sovereign debt as a high liquid or cash equivalent by removing the mark-to-market losses on U.S. Treasury bonds and MBS.

This is important as commercial banks have been major buyers of government bonds since GFC and have allowed fiscal deficits to be financed.  

By their very nature through their main function of maturity transformation, banks would typically have more illiquid assets than liquid assets by managing both duration and liquidity mismatches, which enables customers to bring their purchasing power in the future forward and reduce the need for customers holding liquid assets.   

Bank Term Funding Program (BTFP), Discount Window, and Federal Reserve Balance Sheets

• As a result of bank failures and market stress, this past week banks facing deposit outflows or expecting outflows, likely reacted by enacting their contingent funding plans to ensure that they were able to transform their illiquid assets (loans, securities with unrealized MTM losses) into readily available liquid assets, should customers their deposits.

• The Federal Reserve is acting as lender of last resort by lending against collateral BTFP (U.S. Treasuries and MBS) and charging wholesale funding rates of 4.69% over 1 year, to allow banks to manage their asset/liability mismatches (i.e. reprice loans and deposits higher). This is favorable to banks as liquidity is provided at par, ignoring unrealized MTM losses. It strengthens demand for Treasuries and MBS from banks as well, allowing for the US government managing their interest rate cost, as well. It is essentially a term repurchase agreement (repo) or collateralized borrowing arrangement over a 1-year, at more favorable terms than Discount Window lending. Ultimately, this is a delay tactic to see if monetary tightening will allow inflationary impulses to subside.   

• At the Discount Window, banks can pledge collateral (securities and loans) at haircuts of 20-30% of underlying collateral at the Fed Funds rate of 4.75%. This would equate to a much higher rate when adjusting for collateral haircuts at 5.4% or higher on an overnight basis. This is quite punitive and potentially higher than current lending yields due to the inversion of the yield curve.   

• Despite adding liquidity to the overall system, similar to Quantitative Easing (QE), is not looking to incent the same behaviors as QE. QE is an asset swap, with no added cost to the provider of the bonds, and pushes investors to take on more risk by adding duration – more on this below.

• These ideas can be traced to Walter Bagehot, a 19th-century British journalist, and editor of The Economist, observing the Bank of England develop into what we now know as modern central banking. He believed central banks were necessary as lenders of last resort but should lend only to solvent institutions against sound collateral and at high-interest rates. That advice is known today as “Bagehot’s Dictum”.

Impact of Bank Failures on Bank Behaviour – Why BTFP and DW are not inflationary?

• Like most things in life, it comes down to incentives. Given that deposit costs were 0.60% on an aggregate basis at end of 2022 versus BTFP and DW of 4.69% and 4.75%, do not have the incentive to retain this funding and lend it out unless loan or securities yields are far greater than the cost of funds.

• In aggregate, yes, there is more aggregate liquidity (measured by Federal Reserve’s balance sheet) in the system but you must ask yourself, how likely will banks in aggregate replace low-cost deposits, with this much higher-cost funding in the long-term?  Let’s compare this to Quantitative Easing which is an asset swap as the central bank will buy bonds in exchange for bank reserves/cash. There is no cost of funds against this transaction.

• As long as the liquidity drawn from these banks stays on their balance sheets and does not find its way into the real economy through a higher pace of lending, then these programs should not be inflationary.

• Banks are generally risk-averse organizations, like certainty/fear volatility, and tend to understand the risks that they take on their balance sheet to earn profit. The fact that overall deposits in the system have been declining and banks are starting to tap the liquidity programs, destabilizes their funding profile and makes them less likely to expand credit and make credit available only to their best customer or strongest credits.

• Credit standards were tightened before the bank failures and likely will continue to tighten as monetary policy looks to reduce inflation. Historically when deposits are destabilized (i.e. stop continuing to grow, declining from a local peak), this has led to lower credit creation as the credit standards tighten and try to recover the higher costs of deposits via higher lending spreads. This has historically reduced the availability of credit.

• Given the opacity of most banks given the complexity of the organization, uncertainty and volatility tend to reduce trust between banks and other sophisticated institutional lenders as well, which slows the flow of liquidity across different spectrums/channels in the market.

• Given that most consumer credit (mortgage, credit cards, and automotive loans) rely on securitization markets, given the complexity/structuring required for each deal, these markets tend to freeze up and/or are very expensive to raise funding when there is general uncertainty/market stress. This also reduces credit creation from banks.

• Even though new liquidity has been created by these programs, understanding the change in behavior and outlook is the important point here and has historically provided a disinflationary impulse. This is why when looking at the bond market this week we saw a fall in yields and inflation expectations, as well as lower commodity prices.

• Generally, when deposits leave the banking system, credit availability tightens as the funding stability of banks is less certain (lower appetite for risk) and they hold additional liquidity or de-lever rather than lending out liquidity to the real economy (Table 12).

• Before March 10/23 deposits were leaving the banking system into Money Market Mutual Funds (off-balance balance sheets, do not support bank lending) given higher rates offered and more left this past week. With less funding from deposits, there is less credit available, and see initial job claims increase, which is deflationary

Table 12 – Total Deposits vs Total Lending: Aggregate US Banking System

• When we have seen similar events in the past, expected credit availability has slowed based on survey data from small businesses (NFIB). Small businesses in the aggregate, are the largest employers, and when they are unable to expand via additional credit or credit is too expensive, they will rationalize their cost structure (first by reducing hours, then by reducing payrolls). There has been a historical relationship between expected credit availability and initial jobless claims. Fewer people working is a deflationary impulse as well (See Table 13).

• Resolving this banking crisis in the short-term by adding more permanent/long-term capital in the system may increase confidence and trust in the banking system once again so that bank equity prices do not trade well below their tangible book value at liquidation-like valuations, but we believe that most will act very cautiously given that there is too a stigma around managing your bank into failure, which damages the legacy of senior management.

• The equity markets’ reaction to BTFP appears to see through the temporary nature and questions if any uninsured deposit is safe in non-SIB banks and remains focused on the unrealized losses that have created a hole in bank capital. The bond market is telling us all that transpired is deflationary and has largely reversed a lot of the unrealized losses.  

Table 13 – Credit Availability vs Initial Jobless Claims

So who could add $1.5 trillion in permanent capital to enhance confidence in the U.S. Banking System and reduce liquidity stress and deposit outflow?

• As it stands, as interest rates have increased, this has reduced capital (unrealized losses) by $1.5 trillion (See Table 4). Though it is likely as interest rates move down closer to neutral over time, much of the unrealized losses will be reversed and the balance sheet size reducing due to lower deposit levels, requiring much less than $1.5 trillion to be added to the banking system. Also as we have noted, banks will likely hold assets to maturity, so it’s unlikely these losses will be realized as assets (i.e. loans) will be held to maturity.  Other G-SIB Banks may have an interest in acquiring the U.S. regionals, to help increase confidence in the sector. Buffett has been rumored to be discussing the banking crisis with U.S. officials as well.   

• The investor will need patience and a long-term view of the US economy and understands the banking model is not based on next quarter’s earnings and it’s far more important to have good risk management and governance that can look through business cycles (short-term vs long-term perspective).

• However, this is a decision with a lot of moving pieces and high uncertainty. Several questions they are probably asking (though not exhaustive)…

• Do a number of these regional banks merge, after re-capitalization? What type of regulation do we see going forward and does this reduce profitability?
  • Will the Fed Funds rate by at 5% over the long-term or are we close to the top end of the rate hiking cycle?
  • Looking back at the prior cycle, how did we have so much trouble with the Fed Funds rates slightly above 2%, even though now we have more debt than before? Is this just temporary as the debt maturity profile was pushed out by many corporates when bonds were at generational lows?  
  • What about geopolitics and long-term inflation – does this support higher secular inflation and rates?
  • Domestic politics/Central Control of Financial System – Do you need 4000 banks or what about a “safer system” that relies on large oligopoly/heavily regulated ones that are 80% of the overall market? Do we need to increase the level of insured deposits from $250,000 to a higher level?

Potential Strong Non-banks that could be Liquidity Providers via Private Equity investment…

• Berkshire Hathaway
• Blackrock
• Pension Plans

Below we review a hypothetical template of a private market solution for a deal that was used in Canada to help regain market confidence, and stave off a deposit run at a non-SIB bank. The central bank/government did not intervene given the size of the bank. The size of the deposit run in non-maturity deposits appears to be roughly the same (20-25% of total deposits) as experienced in U.S. regionals and consistent with ~3-month survival horizon. This is an illustrative study to demonstrate how market confidence may be regained via a private market solution, without government intervention.

Berkshire Hathaway’s Rescue of Home Capital Group (HCG) in 2017 – A Potential Template for Increasing Confidence in U.S. Regionals through Private Placement

• This deal could be used as a template for the potential rescue of First Republic, as Home Capital Group (an alternative mortgage bank) was facing a similar deposit run on non-maturity deposits (high-interest savings accounts) that it relied on to fund high-margin less than prime mortgages and eroding market confidence after it was found that company disclosed misleading information to investors in its disclosures surrounding a scandal involving falsified loan applications.
• HCG lost about 90% of non-maturity deposits over a 6-week period, which represented roughly 20% of total deposits. At the depths of the crisis, HCG traded at Price-to-Tangible Book of 0.20x (May 2017).

• The falling balances from Home Trust’s high-interest savings accounts forced the company to seek a $2-billion emergency credit line in April 2017 as a backstop, the onerous terms.
• To reduce the crisis of confidence and replace the deposits outflows, Berkshire Hathaway, came to the rescue through common equity investment and replacement credit facility at cheaper terms than the original credit facility provided by a Canadian pension plan (Healthcare of Ontario Pension Plan (HOPP). It helped investors and depositors regain confidence in the lender.   

Terms of the Deal (Home Capital Group)

• Terms were extremely favorable to Buffett/Berkshire as a liquidity provider in short-term liquidity stress.

• The investments (private placements) represented an almost 39% equity stake, at ~30% discount to market price. The credit facility of $2.0B was 9.5% (1.0% lower than HOPP) on outstanding balances. After Berkshire completed its initial investment, it dropped further to 9%. Other differences include a lower standby fee of 1.75%, reduced from the current 2.5%, and dropped further to 1% after Berkshire’s initial investment.

• Total HCG Deposit outflows were ~$2.9 billion (~20% of Total Deposits). Equity raised was $400M + Credit Facility of $2.0 billion.
• A few days before the deal, HCG de-levered its balance sheet by selling $1.2B in mortgages to KingSett Capital, a private equity firm focused on real estate.

 Outcome

• Upon announcement of the deal with Berkshire Hathaway, HCG common shares moved up ~30%
• About ~1.5 years later, Berkshire Hathaway sold down its stake in HCG for ~70% gain and additional fees earned on the credit facility.
• HCG remained a going concern and has agreed to be taken private by Smith Financial Corp in mid-2023 for $44/share.
• If an investor bought into HCG right before Berkshire in June 2017 and held until taken private for 6 years, you would have earned 21% on an annualized basis. 

Applying Deal Terms to U.S. Regional Situation (First Republic as an Example)

• Net Interest Margin appears lower at First Republic than Home Capital given differences in credit quality (prime mortgages vs non-prime in HCG), so upfront terms on credit facility may not be as favorable to Berkshire. 

• It is difficult to tell the full amount of deposit outflows from FRC at this point, though a combination of term deposit of syndicate of banks $30 billion (assuming this was the amount that was moved from FRC to SIBs) and higher FHLB advances of $10 billion, but appears outflows are at about ~25% of deposits. Also, FRC’s funding from term deposits is much less than HCG’s at the time of the liquidity event.

• Taking a similar 40% equity interest in FRC (at a similar discount to the market price at a 30% discount to the market price) could help bring back confidence to the sector and add comfort to depositors/reduce further outflows that a patient long-term capital allocator is supportive of the industry and a source of permanent capital (See Table 14), that replaced the non-maturity deposits.  

• The source of the Expected Returns for Berkshire Hathaway or any other investor for that matter would be 1) the discount to market prices + 2) narrowing of market price to tangible book value, which in the FRC case if it were to remain a going concern, would be 66% to 88% depending on the permanence of the unrealized losses. For the HCG case, it was 78% or 52% on an annualized basis – not bad for a 0.1% portfolio allocation as a liquidity provider in the time of need. 

• Extending this analysis to the impacted U.S. Regional players (FRC, PACW, and WAL) which represent ~$10 billion in total market cap and at 40% interest in each, would be ~$4.0 billion in equity investment and a Term Credit Facility on market terms (standby fee, draw fee, etc.) to support estimated deposit outflows of $80 billion.

• A syndicate of non-banks and banks could take equity positions (at significant discounts to the market price to provide a margin of safety) to provide confidence. Banks would likely want to take a control position given the punitive regulatory capital treatment of non-controlling positions. 

Table 14 – Hypothetical Example Using Home Capital Group/Berkshire Hathaway Deal

Pick your Poison – “Elevated Inflation” vs. Financial Instability?

We believe the Fed will choose Financial Stability over inflation and will allow the US dollar to fall further by loosening monetary policy through pausing Quantitative Tightening.

One of the reasons for this is that the U.S. needs a ready buyer of “Treasuries/MBS” to help finance the fiscal deficit to continue the status quo and strategic competition with China. Next to governments buying up their bonds, banks have been a large marginal buyer since the GFC, and are large holders of sovereign debt, potentially replacing China and others as investors in a multipolar world.

The collateral (U.S. Treasuries & MBS) needs to be trusted within the U.S. as well as allies, under the Basel III regime as a High-Quality Liquid Asset (HQLA). The Bank Term Funding program allows more time for inflation to fall further, keeps demand for sovereign debt high, and attempts to address liquidity/funding concerns in the short term. 

Today’s announcement of the coordination of USD Liquidity Swap Lines between the Bank of Canada, Bank of England, Bank of Japan, European Central Bank, Federal Reserve, and Swiss National Bank, given the backdrop of the Credit Suisse/UBS deal, may give us “a tell” that Financial Stability and a lower U.S. dollar is important to maintain, and the inflation fight via higher Fed Funds rate, may be abandoned with further evidence of disinflation (i.e. evolution of the banking crisis causing further deflation).

Let’s take a look at inflation in more detail and try to separate 1) Cyclical Inflation vs 2) Secular Inflation Trends

Differentiating between Cyclical vs Secular Inflation Trends:

1. Cyclical Inflation Pressure is Easing based on Leading Indicators of Inflation (See Table 15)

• Though inflation is still elevated, we see many of the leading indicators of inflation (which make up the BT Inflation Gauge – Tables 15 & 16) continuing to move down in the 2^nd half of this year.  Our estimates of core inflation based on our models are about 3.5% by the middle of 2023. Beyond this period, it will depend upon the trend of the drivers below:
  • Even before the U.S. regional banking crisis, total debt growth in the economy is slowing to about 4% YoY (Q4/22), which is much lower than the average growth of 7%, due to higher rates. Banking crises tend not to be inflationary but rather deflationary. Inflation pressure lags debt growth by ~24 months.
  • Small business pricing power is continuing to decline, as well as manufacturing pricing.
  • Debt growth and pricing power by small businesses have the highest weighting in the model.
  • Import prices went negative in February 2023
  • Industrial commodity prices have continued to decline on a YoY basis, despite U.S. dollar strength relative to other currencies weakening
  • Pressures in supply chains have eased significantly
  • Base effects when comparing year-over-year prices start to kick in March/April 2023
  • Wage growth/employment has held up well in 2023.
  • We will watch credit availability in the NFIB survey, as this tends to lead to initial jobless claims. 
  • Near-term inflation expectations have continued to fall     

Table 15 – Leading Indicators of Inflation – Inflation Gauge

Table 16 – Inflation Gauge Components

2. Secular Inflation trends

• Secular forces point to higher trend inflation and more trend Inflation uncertainty (See Table 17) going forward
• In a multi-polar world (U.S. and allies vs China/Russia), trend inflation is expected to increase due to strategic competition/war to build separate supply chains (return of industrial base to the U.S. and its allies via reshoring), as well as build energy sources/climate change. Our recent estimates are that trend inflation should be ~2.5% to 3.5%, which is higher than the 2% target.
• Historically, Monetary and Fiscal policy has been expansionary in war times. To reduce debt-to-income levels in the past coming out of WW2, financial repression (interest rates set below the level of inflation) was used to manage debt-to-income levels down over time. Given that it appears we are in a multi-polar world and at “war” we believe secular inflation should be higher going forward, but in the near term cyclical forces may dominate.    

Table 17 – Secular Drivers of Inflation

Overview

Though U.S. Regional Banks do not measure their liquidity position under Basel III Liquidity requirements, we have tried to estimate a proxy for a Liquidity Survival Horizon based on deposit withdrawals that have been used by banks/regulators in the Liquidity Coverage Ratio (30-day liquidity stress test) and look at other historical examples of bank runs that have been on a more sustained basis (> 5 days) to get a sense of how long First Republic (FRC), Western Alliance (WAL) and Pac West (PACW) may be able to survive a sustained bank run on deposits.

Despite what you hear in the media, the issue is largely a liquidity issue (regaining depositor confidence to reduce deposit flight out of U.S. regionals) rather than a capital/solvency crisis related to unrealized Held-to-Maturity (HTM) securities portfolios.  

These bank’s stocks have been quite volatile over the past week (currently trading below Tangible Book Value even after adjusting for losses on securities and potential losses on venture capital lending), even after the U.S. government authorities have provided de-facto support to uninsured depositors in Silicon Valley Bank and Signature Bank bail failures.

The situation at each of these banks is very different than what occurred at Silicon Valley Bank (SVB) (i.e. have not taken on as much duration risk as SVB through securities book, do not have the same management/governance issues, and have been historically well-run banks with long customer relationships).

We believe this is a crisis of confidence, along with a re-rating of the potential economic outlook as a result of near-term further tightening of credit conditions and potentially paying elevated costs for deposits and wholesale funding. It remains to be seen over the long term if there are changes to the fundamental characteristics of the underlying businesses. We believe some enhanced prudential regulation may be warranted at the U.S. regional banks to ensure a consistent level of testing for capital/credit, liquidity/funding and interest rate risk.

To provide perspective on the amount of credit creation in U.S. regional banks vs Large Banks and the importance of U.S. regional banks to the overall U.S. Financial System, small banks have provided 45% vs 55% from large banks of all lending growth into the economy since 2010. So the financial stability and trust within the regional system around the safety and stability of the deposit base are critical to continue to provide lending to the economy.    

Table 1 – Lending Growth – Large vs Small Chartered Banks

By March 24, we will get a sense of the aggregate deposit outflows from Small Chartered Banks (U.S. Regional Banks) vs. Large Chartered Banks as we get an update on the aggregate deposit balances from the week of March 15^th. It is hard to assess the amount of deposit outflow, though rating agencies (Moody’s/S&P/Fitch) have downgraded/put on negative watch the U.S. regionals (including cutting First Republic to non-investment grade). However, these actions are more of a lagging indicator and more akin to the action of closing the barn doors after the horses have escaped.

Looking at the Fed Balance Sheet released today, there was an increase of $300 billion week-over-week in response to the ‘Liquidity stress’ by adding additional liquidity to the banking system to increase liquidity on banks’ balance sheets as many banks enacted their contingent funding plans to deal with potential deposit outflows:

1. $148 billion of Fed overnight discount window lending

2. $11.9 billion from the new Bank Term Funding Program

3. $142.8 billion of lending to depository institutions backed by collateral & FDIC guarantees.

Table 2 – U.S. Federal Reserve Balance Sheet  

We do not have any further information on which banks would have tapped the discount window, BFTP, and other guarantees.

The real risk in the short term for each of the U.S. regional banks is how long they may be able to sustain the liquidity risk (deposit outflows). We have attempted to calculate the exposure and how long each bank may survive based on stress testing via regulations.

Also, the reduction in interest rates over the past week has likely reduced the unrealized losses in securities portfolios, and as a result the reduced the negative impact on the capital ratio, should these portfolios be sold to meet deposit withdrawals.

The regional banks have a similar business model, borrow short via largely non-maturity deposits and lend long and earn a spread called net interest margin for managing maturity mismatches and underlying credit risk.

Loan books for most U.S. regionals have weighted average maturity between 7-10 years and are largely funded by non-maturity demand (NMD) of both retail and commercial clients. These NMD deposits’ weighted average maturity is determined largely through statistical analysis of related “stickiness” of the deposit base based on “deposit betas” based on cohorts and underlying characteristics (under market stress like we are seeing the past week, which make deposit withdrawal or runoff more likely). This information is not available publicly and internal Treasury teams would be reviewing the “stickiness” and “beta” on an ongoing basis.

Without a stable deposit/funding base, banks will pull back on lending into the real economy (including tightening of credit standards to give money only to the most creditworthy business and consumers) slowing credit creation within the economy, especially to middle market clients that the U.S. regionals serve. The resulting credit crunch forces companies to cut prices and labor costs by cutting wages and payroll, which tends to slow the activity in the economy, eventually causing a recession.

In an inverted yield curve environment, lending usually slows, as net interest margins may be compressed as deposit costs rise faster than lending, given that for most banks the effective maturity on the asset side of their balance sheet (say 30-year mortgage) is greater than effective maturity the on liability side of the balance sheet (say non-maturity operational deposit 3-5 years) – this is maturity transformation and along with credit risk, is the reason that banks earn net interest margin.

With the inverted yield curve and credit contraction resulting in a recession or economic slowdown, the Federal Reserve is likely to cut interest rates and reduce margin compression due to higher deposit costs and will start credit expansion again. Over the past week, we have seen a deflationary impulse due to the potential for credit contraction due to funding instability, and the Federal Reserve may need to prioritize Financial Stability relative to inflation concerns, and the speed of the rate hiking cycle.     

Liquidity Stress Tests: Covering the Basics: A Background on Deposit Runoffs and Other Cash Outflows  

In Basel III banking regulations, there is a framework that helps banks determine their liquidity risk profile by setting minimum standards and measures which include the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR).

As we have noted in our earlier reports on Silicon Valley Bank (SVB), given the $250 billion threshold (asset size), U.S. regional banks have not had to adopt capital and liquidity stress testing on an ongoing basis, similar to the Global Significant Banks (G-SIBs) (JP Morgan, Citigroup, etc.). So this means, that they do not have to report their Liquidity Coverage Ratio or Net Stable Funding Ratio.

Since adopting Basel III rules, G-SIBs have repriced low-quality deposits (i.e. institutional fast money deposits) and many of these deposits may have found their way into the unregulated space U.S. regional banking space such as SVB, FRC, WAL, and PACW. Given the potential for impact on G-SIBs’ Liquidity and Funding ratios, it may be a difficult decision for G-SIBs to acquire the deposit base given the regulatory overhang.

We will attempt our best to apply this regulatory framework to the U.S. regional banks, though given there is limited information publicly available, we would say these estimates are very high level. Banks that have adopted these regulations would rely on a lot of underlying consumer data to help determine the proper classification of a particular deposit or loan product. But on to the basics of bank stress testing before the application.   

The LCR is meant to measure emergency funding capacity over a short period (30 days) to see if a bank can withstand liquidity stress over 30 days, with limited capacity to obtain additional funding (i.e. no additional deposit or wholesale funding inflows to refinance existing maturities) to continue ongoing operations.  

It is the ratio of the amount of ‘High-Quality Liquid Assets’ or HQLA you have available, compared to a rough-and-ready estimate of the cash outflows you might experience over 30 days if your wholesale funding dried up and some (but not all) of your retail and corporate deposit was withdrawn.

The ratio is meant to be above 100% and represents a 30-day “survival horizon” based on available liquidity that is on the bank’s balance sheet. 

• The bank’s deposit liabilities are risk-weighted based on the likelihood that depositors withdraw their money in the 30-day stress period. Retail consumers are less likely than more sophisticated clients such as Commercial customers or Financial Institutions to withdraw their deposits based on prior studies of bank runs. These larger institutional clients will have larger deposits that are uninsured under deposit insurance programs.  

• If a bank holds an LCR ratio above, 100%, they will have the “Liquidity Survival Horizon” based on existing liquidity resources will be greater than 1 month.
• Typically, based on historical episodes of liquidity stress/deposit runoff do not last for months at a time, as regulators/Treasury will try to regain Financial Stability and quell fears of an ongoing run on confidence. 
• Banking is built on trust, as in that, clients’ deposits are safe and can be used when the customer wants to use them. Headlines or market volatility cause unwarranted panic and erode customer trust and confidence in the safety of the financial system.

The NSFR — is also meant to be above 100%, which measures structural funding liquidity to ensure that maturity mismatches are manageable over a period of > 1 year. It is a ratio of the two sides of the bank’s balance sheet after each side is adjusted for structural liquidity risk (greater than 1 year).  Assets are assigned weightings according to how easy they are to turn into cash or how illiquid they are to enable deposit withdrawals from the bank.  

• Short-term Treasury bills get 100% Liquidity value (Required Stable Funding = 0%), while longer-dated corporate bonds get 50% (Required Stable Funding = 50%) and loans get zero.
• Liabilities get weightings according to the likelihood that someone will want cash back immediately. So overnight repo is weighted at 100% and retail deposits are 90% (Available Stable Funding = 90%). “Hot money” wealth management (0% Available Stable Funding) and corporate deposits only get a 50% weighting (Available Stable Funding)

• If the ratio of the first number to the second is above 100%, then broadly speaking, long-term and illiquid assets are matched by an equivalent amount of long-term and stable liabilities.
• Non-maturity deposits from retail consumers have linkages such as payroll and/or bill payments which tend to be covered by deposit insurance and are favored versus large corporate clients or financial institutions which tend to be flighty in a stress period given that their deposits are largely uninsured. Operational deposits for cash management are favored from a liquidity perspective relative to non-operational deposits.

• With the actions announced by the government on Sunday, of implicitly guaranteeing uninsured deposits (above $250k), we believe that it is more likely that consumers are to stay with their institutions rather than move their entire relationships over, though there will likely be some withdrawals which both NSFR and LCR account for in their risk-weighting under stress.  

Applying Liquidity and Funding Stress Tests to Select U.S. Regional Banks

Available Liquidity (HQLA + Contingent Liquidity) – Short-term Liquidity (<1 year)

Available Liquidity appears to cover about ~80-110% of uninsured deposits (Q4/22) at the below select U.S. regionals (see Table 3 below) and appears that most banks have enacted their Contingent Funding Plans. Replacing low-cost NMD deposits with FHLB/FRB funding or high-cost deposits/funding as a result of deposit outflows is expected to reduce the net interest margin in the short term.  

Table 3 – Available Liquidity (HQLA + Contingent Liquidity) at Select U.S. Regionals

Proforma Net Cash Outflows and LCR at Select U.S. Regionals

Below we have attempted to quantify the deposit outflows based on limited information in public disclosure documents. We find that from an LCR and NSFR perspective, these banks should have enough liquidity to withstand outflows that have been assumed by the regulatory framework over the next 30 days (if contingent liquidity is drawn, range between 140-270% of 30-day stressed outflows).

Despite the different business models/mix between Retail/Commercial deposit bases, we find that all three banks potentially have a weighted average runoff rate on deposits at roughly 27% – See Tables 4-6.  

Looking back at historical bank runs for comparative purposes, we find that 27% appears to be on the high end (see below). We note that deposit velocity outflows at Signature Bank (SBNY) and Silicon Valley Bank (SIVB) were much faster than previous bank runs as well given the speed of technology. At this point, we do not have any concrete evidence of the magnitude of the actual deposit outflows over the past week.

We note that First Republic appears to have a more concentrated deposit base relative to the others, as average commercial deposits are $500,000/account and average personal accounts of $200,000, representing roughly 550,000 clients. The franchise is a high-touch/high-service business model to serve wealthy entrepreneurs.  

The question is if this business model is sustainable if inflation is sustainable and rates remain higher for longer which may increase deposit funding costs with more interest rate sensitivity as deposits reprice higher relative to loans that are typically long-term mortgages that have a much longer effective maturity. It is likely the speed of the Federal Reserve changes and additional stimulus that has likely had an impact as well on the repricing of both loans and deposits since 2019.  

First Republic has only approximately 1/5th the number of deposit accounts compared to the average $100–250 billion U.S. bank, which enables a greater ability to provide extraordinary service and oversight per relationship and has an average client relationship length of 24 years. Deposit betas across the entire deposit books based on the latest rate hiking cycle (2022/23) have been 8% (FRC), 12% (PACW), and 10% (WAL) over the past year.  

With the downgrade of First Republic at S&P/Fitch to BB+ (junk/non-investment grade) from A-, citing deposit outflows and general weakness in funding & liquidity, may also impact some corporate deposits as investment committees/corporate treasuries require their counterparties to be investment grade as a result of their Investment Policy Statements. The impact of the downgrade is yet to be determined as to how much it may impact deposit outflows. Given the immateriality of derivative activities, we have not considered the impact related to a 3-notch downgrade below.   

Typically a downgrade of one notch equates to roughly 25 basis points of additional borrowing costs for a company. However, a four-notch downgrade signals greater potential problems for a company and could result in more stringent loan requirements such as giving up equity for more permanent sources of capital (including deposits and potential equity infusion from larger banks, which may help regain confidence from the general public).

Today it was disclosed that First Republic is to receive up to $30 billion in deposits from Bank of America, JPMorgan, Wells Fargo, Citigroup, Morgan Stanley, and other lenders (with the blessing of the U.S. Government) to provide more permanent sources of capital to replace deposit outflows and restore confidence and trust in the U.S. regional banking system. This amount would represent about 18% of First Republic’s total deposits.

So over the past week, government authorities have implicitly guaranteed uninsured deposits and provided a new liquidity facility, JP Morgan provided an unsecured line of credit and a syndicate of banks and larger significant banks have deposited funds into First Republic Bank.

These three actions are thought to provide further trust and confidence in the functioning and stability of the U.S. Financial System including smaller U.S. regional banks, and hopefully reduce equity market volatility.  

Table 4 – First Republic Bank: Proforma Net Cash Outflows and LCR

 Table 5 – PacWest: Proforma Net Cash Outflows and LCR

Table 6 – Western Alliance: Proforma Net Cash Outflows and LCR

Short-term Liquidity Survival Horizon

Below we estimated based on the net cash flow assumptions above continuing net cash outflows beyond 30 days to see how long could these banks survive without any additional funding (deposits and wholesale funding) based on their cash/securities portfolio + known contingent liquidity available.

We note that First Republic has been more responsive in the past week and prepared itself for further deposit outflows by raising additional liquidity, despite the government de-facto supporting uninsured depositors, by securing additional liquidity and shoring up contingent liquidity. Contingent liquidity has been raised by pledging assets to FHLB/FRB at almost 62% (as of Dec 31/22) of their balance sheet, which is double the amount PacWest and Western Alliance have pledged ~30%, potentially due to more collateral secured by residential real estate.  

First Republic, PacWest, and Western Alliance have an estimated survival horizon of 3.5 months, 1.5 months, and 1 month respectively (see Table 7). This liquidity buffer may allow the banks breathing room to help raise additional capital or negotiate a sale or equity infusion from larger banks to provide permanent capital to replace potential “core deposits” that have left the bank in deposit outflows.  

We note that these banks may raise their survival horizon in the short term through the Federal Reserve Bank Term Funding program (up to 1-year collateralized loan). We note that the survival horizon is based on assumed deposit runoffs based on the underlying deposit characteristics of each balance sheet. The survival horizon could be potentially much shorter if deposit withdrawals are much faster than regulatory parameters which are calibrated based on historical bank runs.

We note that the bank runs at Signature and Silicon Valley Bank were much faster than previous bank runs given the speed customers can move cash across the existing financial system.     

Table 7 – Liquidity Survival Horizon – Select U.S. Regional Banks

Structural Liquidity (Liquidity >1-year) – Net Stable Funding Ratio

We have attempted to estimate NSFR based on our high-level estimates based on publicly available data (see Tables 8-10). Generally, it appears that the U.S. Regional Banks reviewed generally do not appear to have structural liquidity gaps (i.e. funding too many illiquid assets with short-term deposits/shorter-term wholesale funding consider stressed parameters).

We note further information on Corporate Deposits would be required to firm up these estimates to see how much of these deposits are related to Financials/Financial Intermediation, as Financials tend to have higher outflows relative to corporates. Also, Small Business vs corporate delineation could provide some reprieve on liquidity requirements, as small businesses tend to have lower runoffs relative to corporates.  

However, we note that if stressed deposit outflows were greater than regulatory parameters for available stable funding, then a structural liquidity gap would exist. This is why these banks may look to raise equity or equity-like permanent capital to replace any relationship deposits that have a runoff.  

One observation is that the banks currently do not have a lot of term deposits and most of the funding is through non-maturity deposits. Fixed-term funding tends to be more costly given that it is outstanding for a longer period. Non-redeemable fixed term deposits which have been laddered over time to approximate the loan book maturity have been a very useful way to diversify funding and solidify the balance sheet if a deposit run on non-maturity deposits is to occur as maturity and amount is known well in advance. Term deposits at Canadian alternative mortgage lender Home Capital solidified the balance sheet (which they had a greater reliance on relative to non-maturity deposits) when there was a run on non-relationship non-maturity deposits in 2017 and have remained a going concern to this day.

Table 8 – NSFR Estimate – First Republic Bank

Table 9 – NSFR – PacWest

Table 10 – NSFR – Western Alliance

Historical Examples of Deposit Runs and Monthly Runoff

We have reviewed the hypothetical LCR deposit runoffs relative to historical cases in Table 11. The median deposit run has lasted 2 weeks, though there is high dispersion and each case has been unique. We note that LCR runoffs of 27% are about 1.5x the amount of historical median runoffs at 18%, so this gives us some confidence that our hypothetical estimates of liquidity survival horizon are conservative.

Table 11 – Historical Examples of Deposit Runs and Monthly Runoff

Reported Deposit Flows in March From Small U.S. Chartered Banks to Large Banks

Earlier this week, we noted that Bank of America said that they have received $15B in deposit inflow over the last week. We have extended this analysis of $15B inflow/week to each large bank which would equate to about $300B inflow to the large banks in 30 days (see Table 12).  

We have compared these deposit outflow assumptions relative to the LCR runoff assumptions for the remaining U.S. Regional players (FRC, PACW, and WAL). While this analysis is extremely speculative and high level, it supports that the LCR stress runoffs should suffice for a reasonable assumption of potential deposit outflows over 30 days relative to the information we have received to date from Bank of America. We suspect that some of the deposit outflows from banks have been invested in U.S. Treasuries directly as well, however, we are not able to quantify this amount.  

In this type of analysis, the devil is in the details and relative outflows are extremely important when considering the impact on each bank’s current specific liquidity and funding position. It does provide us some assurance that the actual deposit outflows are potentially lower than that assumed in LCR.     

Table 12 – Proforma Deposit Flows over 30-day Period From Small U.S. Chartered Banks to Large Banks

Pledged Assets, Contingent Liquidity, and Unencumbered Assets for Further Liquidity

The next question we ask, is now that we know that it is likely that the select U.S. regional banks have enacted their Contingent Funding Plan, how much additional balance sheet capacity do they have to pledge to extend their liquidity survival horizon even further than our baseline analysis?

The Federal Home Loan Bank (FHLB) System was created by the Federal Home Loan Bank Act of 1932 as a government-sponsored to support mortgage lending and community investment. The System is composed of 11 regional banks which are privately capitalized and owned as cooperatives by their members. Their regional distribution enables each bank to focus on the needs of their individual communities.

FHLBs carry out their core mission of providing liquidity by raising funds in the global financial markets, then lending that money in the form of “advances” (loans) to members and local communities when liquidity is required.

The FHLBs cap the amount of advance credit available to each member at between 20% and 60% of the member’s total assets, with some exceptions available depending on member creditworthiness.

In periods of extreme liquidity stress, banks may also pledge their assets to the Federal Reserve via the discount window, though there is a stigma attached to drawing funds from this source. Federal Reserve lending to depository institutions (the “discount window”) plays an important role in supporting the liquidity and stability of the banking system and the effective implementation of monetary policy.  

By providing ready access to funding, the discount window helps depository institutions manage their liquidity risks efficiently and avoid actions that have negative consequences for their customers, such as withdrawing credit during times of market stress.  Thus, the discount window supports the smooth flow of credit to households and businesses.  Providing liquidity in this way is one of the original purposes of the Federal Reserve System and other central banks around the world. 

We note that First Republic has encumbered about 60% of assets (Table 13) and has about $20B in unencumbered liquidity that it can draw from government entities (FHLB and Federal Reserve). This would likely extend the liquidity survival horizon to 3 months. Given that they have pledged a large portion of their balance sheet, this is likely why First Republic Bank is reviewing all strategic options, including the sale of equity to provide further permanent capital.

On the other hand, PacWest and Western Alliance, have pledged about 30% (Table 13) of their balance sheet. It is likely given the underlying collateral (more unsecured commercial loans relative to secured residential real estate loans), borrowing capacity as % of the balance is likely lower than First Republic.  If they can increase the borrowing capacity based on unencumbered assets, at a high level this would extend the liquidity survival horizon of PacWest up to 5 months and Western Alliance to 4 months (although a detailed analysis of collateral haircuts of underlying loans would need to be undertaken).

Table 13 – Pledged Assets and Contingent Liquidity 

Bank Solvency & Capitalization – Capital Ratios – Where Do we stand?

Bank Solvency/Capitalization appears strong and underlying collateral appears to be performing at this point in the cycle.

We note, that after considering mark-to-market losses as of Q4/22 on Non-eligible securities for Bank Term Funding Program, as well as, lending to venture capital against shares (taking a 50% haircut as a conservative estimate), capital ratios would be below 10.5% total capital requirement for all banks.

Similar to exceptions during COVID-19 around higher-than-average issuance of Sovereign Bonds which impacted the Leverage Ratio negatively, we wonder if bank regulators may temporarily provide some relief/discretion for non-eligible Bank Term Funding Program securities (i.e. Muni Bonds, Corporate Bonds) or potentially widen out the collateral for Bank Term Funding Program similar to Federal Reserve Discount window. These potential changes would need to be handled very carefully not to allow for moral hazard or excess optimization/risk-taking and support the financial stability of the U.S. Banking industry. 

With interest rates falling as much as they have in the past week, we believe the unrealized mark-to-markets on securities would have reversed, so this is a conservative estimate of tangible book value and capital ratios in Tables 14 and 15.

We can conclude that with these regional banks, the story here is much different that Silicon Valley Bank and Signature, as they appear to remain solvent at this point. With the potential for credit contraction and margin compression, the story in the short-term is continuing to have strong liquidity and being able to withstand deposit outflows and maintain net interest margins.  

Table 14 – Price/Tangible Book Value – Select U.S. Regional Banks

Table 15 – Capital Ratios – As Reported and Adjusted (Q4/22)

Other Potential Actions to help Extend Liquidity Survival Horizon and Strengthen Capital Ratios – Contingent Plan (not considered in Liquidity Survival Horizon above)   

• Further liquidity via Bank Term Funding Program/FRB Discount Window
• Collateralized Secured Funding Raise (Securitization of Loans/Residential Mortgages)
• Suspension of Common Dividend
• Increase efficiency/reduce costs
• Other Strategic Options: Capital Raise/Sale/Merger to Larger Bank. In First Republic’s case, RBC may re-approach the First Republic about a merger deal. In the past, RBC has been rejected by the First Republic. It may be a good strategic fit with City National Bank as well.  JP Morgan and Morgan Stanley may also be interested as well.   

Credit Contraction and Replacing Low-Cost Deposits with Bank Term Funding Program to meet near term liquidity needs: Impacting Fundamentals via Net Interest Margin Compression? 

Below we have estimated, the impact of low-cost deposits of withdrawals being replaced by a more expensive Bank Term Funding Program assuming that 30 days’ worth of withdrawals is replaced by BTFP costs (one-time shock).

For example, at First Republic, the replacement of the low-cost deposits of 0.4%, by a more expensive Bank Term Funding Program of 4.50% is 10x the existing funding cost.

In First Republic’s case, given the overall asset mix of more secured real estate lending which represents almost 60% of the loan book (low credit risk and low margin), it may be difficult from a profitability perspective, in the long-term to continue this business model without significant change as having a significant portion of low-cost NMD deposits (say 25% of total deposits), are replaced with Bank Term Funding (1-year secured funding) or Wholesale funding costs.

This is potentially why First Republic is reviewing all strategic options including sales to reduce the cost of funds back to pre-SVB failure by partnering with a strong/stable large bank such as RBC. Replacing low-cost NMD, higher-cost BTFP, or wholesale funding would reduce annual profitability by almost 90% (see Table 16). Given that the business is focused on high touch/high service, the model is quite expensive to maintain over the long term as well and if First Republic’s cost of funding has been permanently impaired, then questioning the high touch/service model may also be on the table.

It appears that earnings in the next 12 months (if FRC can secure BTFP or discount window funding) would be positive as long as deposit runoffs stay below ~30% of overall deposits (assuming a limited change in overall funding costs from current levels) and there are no significant losses on their loan book. The real question is how loyal are the customers to this bank and if they are willing to give up their long-standing relationship – given that bank has a strong franchise and very loyal customer base and has served wealthy/sophisticated clients for roughly 25 years on average with FRC.

This is a temporary situation as they are enacting their liquidity contingency plan, especially when the yield curve is inverted (new loans origination at longer-term rates is falling and short-term rates are rising increasing funding costs), causing further margin compression.

Tapping the Federal Reserve’s Bank Term Funding Program likely extends the Liquidity Survival Horizon further (up to 1 year) and allows the banks to try to secure a cheaper source of funding/capital that is longer-term in nature, over that year, including regain customer deposits via confidence/trust.

Another way to think about the situation is that we are likely, close to the end of the interest rate hiking cycle as there are signs that inflation is starting to come back down to the target and as a result, the likelihood of elevated funding costs at this current level, is not likely to persist in the long-term interest, as rates tend to be mean reverting based on long-term rates of inflation and real GDP growth over time.

This is likely why First Republic is considering a sale, as an infusion of equity capital in the place of deposit outflows would be a permanent source of funding and allow it to continue its high-touch business model (should interest rates remain elevated) without significant changes to customers who have remained loyal and margins would remain relatively similar.  

Looking at PacWest and Western Alliance (see Tables 17-18), margin compression is expected to be more muted than First Republic given the larger Commercial Loan book with a higher interest margin when considering replacing potentially  1 month of deposit outflows (not considering the impact of potential higher loan losses due to reduction in credit availability/potential recession). The negative Earnings impact of such a replacement of deposits at PacWest and Western Alliance would be ~70% and ~40%, respectively. 

Also, their commercial loans (higher proportion at PacWest/Western Alliance) appear to be more rate sensitive as 60% of the loan book is floating rate, with a shorter average term profile of 5 years relative to FRC 90% fixed rate vs 10% floating with an average maturity of 11 years. From a credit risk perspective, FRC losses would be expected to be lower, relative to PacWest/Western Alliance) and may this play out as part of the next step in the credit cycle, as credit potentially contracts.     

As long as all three banks can manage deposit outflows in the short term (which they should be able to as long as deposit outflows remain below regulatory parameters for LCR) and not have a significant portion of their relationship deposits replaced with wholesale funding, then these banks should remain strong from a liquidity perspective and remain a going concern/solvent (assuming credit losses are manageable).   

We also note that we are likely closer to the end of the interest rate hiking cycle, so we are likely seeing close to the top in deposit/wholesale funding cost, and as the liabilities typically have a shorter average life relative to assets, close to the end of incremental margin compression from the inverted yield curve, so the margin compression due to higher funding costs may be short-lived.  

Table 16 – Margin Impact – First Republic Proforma Net Interest Margin

Table 17 – Margin Impact – PacWest Proforma Net Interest Margin

Table 18 – Margin Impact – Western Alliance Proforma Net Interest Margin

Trading in shares of First Republic Bank and Western Alliance Bancorp. was paused after steep initial losses on Monday as bank solvency fears persisted following the failures of Silicon Valley Bank and Silvergate last week. First Republic is down almost 75% and PacWest down almost 40% today.

We believe that it has more to do with available liquidity to total deposits and the mechanics around the Fed’s new Bank Term Funding Program (BTFP). It comes down to eligible collateral. Eligible collateral is U.S. Federal guaranteed securities (U.S. Treasuries, MBS and CMBS) and does not include municipal securities or other private MBS, CMBS or CMO or other structured products. Structured products may be more difficult to sell given general lack of secondary liquidity.

However, we note that interest rates have come down about 30 bps (10-year UST) from December 2022, so we expect that the mark-to-market losses below are overstated on non-eligible securities BTFP. As bond yields drop, these long-duration securities increase in value.

Regional banks have relied on municipal securities and other private securities in their securities book to improve net interest margin, as these securities tend to yield higher than U.S. federally guaranteed securities, given higher credit risk associated. This also relates to our earlier note, that the lack of the Liquidity Coverage ratio requirement has allowed U.S. Regional banks to allocate more of their securities portfolio to these securities given that LCR is punitive to anything other than Level 1 HQLA (essential US Treasuries, Cash) and Level 2 securities are limited to 40% of the overall portfolio.

Based on our interpretation of the way the BFTP works is a 1-year loan that is collateralized by U.S. Federal guaranteed securities. This will allow regional banks to obtain liquidity to meet deposit outflows and reset their interest rate risk management positioning over the next 1-year.

The fear with First Republic and PacWest is the concentration with Venture Capital/Technology firms placing large uninsured deposits and percentage of US Federal guaranteed securities vs. other securities which is why stock prices are down despite the announced liquidity backstop (see Table 1 below).

Though the liquidity profile of these banks have improved, the maximum exposure to deposit outflows is greater than liquidity potentially available as of now as to what we have been able to surmise based on publicly available information. Time will tell if deposit outflows will outstrip liquidity available and the deposit run/confidence crisis continues.

We believe, even if these banks sell their non-eligible BTFP securities and realize losses to help stem further deposit outflows, the Total Capital ratios for these banks should be above minimum standards (this was the issue that caused Silicon Valley Bank to fail).

However, this does not consider future impact on earnings and existing operations or new regulatory requirements (including more stringent stress testing) and potentially impacts the Capital/Liquidity ratios. Uncertainty and fear create potential opportunities.

This whole situation will cause many rethink bank regulations and how risk is transferred rather than transformed in economy (from large banks to small banks around these uninsured institutional deposits), as well as, common place Treasury-related risk management (interest rate risk, liquidity and counterparty credit risk limits for Corporate Treasurers) and potential for new/expansion of businesses such as deposit brokers diversifying excess liquidity within insured deposit limits.

Table 1 – Comparing First Republic and PacWest Contingent Liquidity Positions

Warnings Signs Hiding in Plain Sight – A complete mess that could have been avoided

In this latest blog, we are drawing upon our almost 20 years of experience in Canadian Banks (last year 10 years in senior Treasury positions, including Bank Treasurer), both Large and Small Medium Sized banks to review the situation. 

The U.S. regional banks are significant in the banking industry and represent 33% of total deposits in the U.S. As of the week ending March 1, 2023, Large Banks’ deposits have declined faster than U.S. regional banks, as customers have spent down and reallocated deposits toward interest-yielding assets such as T-bills (Table 1)

Yet with the crisis of confidence, there was fear that deposit outflows would overwhelm the U.S. regional banking space and cause further banks to fail, leading to further market disruption in credit markets.

Table 1 – Deposit Growth Small vs Large U.S. Banks (as of March 1, 2023)

We will review the Silicon Valley Bank (SVB) situation and what caused the market disruption last week.

• Overview and Business Model: SVB was the 16th-largest bank in the United States at the time of its failure on March 10, 2023. The bank’s deposits increased from $62 billion in March 2020 to $124 billion in March 2021, benefitted from the impact of the COVID-19 pandemic on science and technology (work-from-home companies).

• SVB was not able to redeploy the additional $62 billion in deposits, into new loans, and as result, chose to invest in U.S. Treasury and Mortgage-backed Securities (average duration of 4-5 years) as yields at the time in 2021 were higher on fixed-rate securities as compared to floating rate securities and designated as held-to-maturity.   

• While duration or interest rate risk is taken on by banks through the securities book, the primary risks a bank takes on its balance sheet and attempts to manage would be credit risk based on the underlying and maturity mismatch between its loans and deposits and other funding sources.

• The securities book and other hedging via derivatives such as interest rate swaps are used to reduce the inherent maturity mismatch of assets and liabilities and underlying interest rate risk position. The securities book is also used to provide liquidity when deposits are withdrawn by customers, so understanding the liquidity and interest rate characteristics of the deposit base under various interest rate scenarios in a dynamic environment is critically important.    

• SVB’s Business model (Venture Capital, Technology, and Fintech (including Crypto) levered to low-interest rates. The bank’s customers were primarily businesses and wealthy individuals in the technology, life science/healthcare, private equity/venture capital, and premium wine industries.
• These industries would be considered largely long-duration industries (do well when interest rates are low as valuations are high. New money to fund innovation comes into the industry without focusing on profitability given the low cost of capital). As the cost of capital has significantly increased due to higher interest rates, private funding of these businesses has reduced in 2022, and into 2023 (See Table 2).

Table 2 – Venture Capital Investment vs Cost of Capital (10-year U.S. Treasury)

The natural balance sheet position of SVB would be floating rate term loans (~3-year duration) and short-term/non-maturity deposits (< 1-year duration) of venture capital firms and other banking services for the executive/tech teams. The spread between what clients would pay for the loans less interest paid to clients on the deposit would be the reward for the maturity mismatch (between 2-3 years) as well as the credit risk of the underlying firms/individuals.

• As interest rates have risen in 2022-23, startup companies withdrew deposits from the bank to fund operations as private financing became harder to come by.  To raise needed cash to fund the withdrawals, by March 8, the bank sold all of its available-for-sale securities of $29 billion at a US$1.8 billion realized loss. On March 9-10, customers withdrew $42 billion (25% of deposits in 1 day), leaving the bank with a negative cash balance of about ~$1 billion.

• SVB was a pivotal part of the tech world, which has been rocked by mass layoffs in the past year and has relationships with about 50% of America’s venture capital-backed companies, making the impact of its failure potentially far-reaching if uninsured deposits are not fully recovered. The FDIC is looking to find another bank that is willing to merge with SVB, to safeguard uninsured deposits, though a deal is not certain.

• Recent Credit Ratings Pressure: In early March, Moody’s’ threaten to downgrade SVB’s credit rating from single A, based on unrealized securities losses of $15.1B related to US Treasuries, Mortgage-backed securities (MBS), Commercial Mortgage-backed securities (CMBS). The unrealized losses in the held-to-maturity portfolio were a result of the increase in rates over the past 12 months.
• If the held-to-maturity portfolio was reclassified or assets were sold at a realized loss to free up cash to pay depositors, this would severely reduce Total Capital of $18 billion and the capital ratio would be below the regulatory minimum. This caused the bank’s management to consider raising new fresh equity to maintain the capital ratio above the regulatory minimum.
• The bank’s management — with the help of Goldman Sachs, its adviser — chose to raise new equity from the venture capital firm General Atlantic and also to sell a convertible bond to the public. It does not appear that the new equity raising, at least initially, had been made under duress. It was meant to reassure investors. But it had the opposite effect: It so surprised the market that it led the bank’s very smart client base of venture capitalists to direct their portfolio clients to withdraw their deposits en masse. This led to a run on deposits.
• It appears that the collapse could have been avoided — it happened because management bungled how it communicated to its customers and the public and created a crisis of confidence.

Interest Rate Risk & Asset Liability Mismanagement

• As money flowed into Venture Capital, Technology, and Fintech in 2021 as the money supply increased (including the COVID-19 stimulus), deposits increased 95% YoY or $60B at SVB, which was the largest change of all U.S. regional banks.

• Looking at Table 3 below, we note that SVB’s balance sheet growth was significant and there was too much excess liquidity (not enough lending demand to redeploy deposits) and that securities (potentially running a duration mismatch in a low-interest environment) rather than client lending/services were being used to boost earnings.

Table 3 – Balance Sheet Growth of Select U.S. Banks

• Not all Deposits are Created Equally: SVB’s client base and reliance on institutional/Venture Capital funding-related entities rather than diversified retail deposits may have led to the dramatic increase in 2021 and decrease in 2022/23 in deposits. 
• We can see that 90% of deposits were uninsured at SVB supporting that most of the deposit base was largely institutional money which tends to be extremely flighty and exits en masse in periods of liquidity stress. The regulations address deposits from a client perspective and how a bank manages its liquidity position.  

• Deposits created in a period of increasing reserves (during 2020/21) tend to be large institutional deposits (“non-core”); these deposits tend to exhibit higher run-off rates and greater re-pricing sensitivity to rate changes than traditional retail deposits and hence have a shorter duration. There are significant differences in modeled duration for different deposit cohorts; traditional retail deposit durations range from 3 to 7 years while “non-core” deposit durations are about 2 years. It appeared that SVB considered the new deposits, to be  “core deposits” which were sticky and that may be redeployed into long-term assets rather than held in short-duration/liquid assets.

• Loan growth has historically been slow in the first couple of years of an economic recovery.  Slow loan growth in 2021 supported demand for securities given the lack of investment opportunities and the amount of excess liquidity due to high client deposits. Given the lack of lending demand, SVB could not redeploy the excess liquidity gathered through deposits in 2021 and redeployed via the investment portfolio. 

• Buying Bonds in 2021 at Generational Low Fixed Interest Rates to Maximize Current Period Income: This increase in deposits of $60B was invested in long duration held-to-maturity (HTM) portfolio in fixed-rate/fixed term as at the time fixed rate asset yields were greater than floating rate assets at the time, without considering if inflation or interest rates would rise as quickly as they did in 2022. Going back throughout history, it does not appear that SVB has not taken on significant duration risk at this magnitude and appeared to be a shift in Risk Profile/overall Balance Sheet strategy. 

• The investment portfolio (AFS & HTM) represented ~60% of total assets in 2022 (vs. 32% in 2020) which appears to be an outlier relative to other U.S. regional banks (which had roughly 30% of assets in their investment portfolio). The significant shift in the economic environment from 2019 to 2023 and the focus on the underlying client base driving support through the COVID-19 pandemic partially drove this change. It appeared that SVB did not alter its strategy in response to the change in conditions (i.e. inflation was no longer transitory in early 2022).

• Held-to-Maturity as % of Investment Portfolio was 80% which was held at amortized cost (unrealized gains/losses are not recognized in the P&L or Capital Ratio) rather than marked-to-market and recognized in either P&L (Held-for-Trading) or Accumulated Other Comprehensive Income (AOCI) which would have impacted the Capital Ratio quarterly. The size of the HTM portfolio appears to be an outlier relative to the industry as well and may be considered to be an aggressive accounting treatment as the unrealized loss on the mortgage bond portfolio was not recognized until the securities were sold. Something we do not know is the assumptions the company did make around how much of the deposit base was core vs non-core and the assumed maturity portfolio around these deposits. It appears they considered that a large portion of deposits raised, were “core deposits” based on their actions. This accounting treatment likely concerned Moody’s as the unrealized losses were enough to wipe out the equity holders once bonds were sold if deposits were to be withdrawn. 

• Assumptions Around Non-Maturity Deposits likely played into HTM portfolio Duration: Given that there was a surge of deposits in 2021, the underlying business of its client base (i.e. cash burn rate of tech/venture capital), 90% of deposits were uninsured, and the company have stated that deposit beta was 70% (Measures deposit rate changes relative to market rate changes, so with 100 bps change in Fed Funds Rate, 70 bps change in SVB funding costs to maintain deposit balances), it’s likely that core deposit assumptions would be likely less than 50% of the deposit base. Our proforma calculation on deposits for the Liquidity Coverage ratio supports this assumption as well. The Non-core deposits should have been invested in short-duration High-Quality Liquid Assets (i.e. deposits at Fed or less than 3-month T-bills), that would be readily convertible to cash should deposits be withdrawn. We will never know as these assumptions are determined by management and reviewed by the bank’s Asset Liability Committee and potentially by the Risk Committee of the Board of Directors.     

• Through this one change, the balance sheet was transformed from a client-driven balance sheet lending/deposit-taking (largely floating rate exposure, with a maturity mismatch of about 2-3 years between loans/deposits and underlying credit risk of venture capital and private equity) into a large levered mortgage fund in which the market value of the bank’s equity was very sensitive to increased mortgage/interest rates. The held-to-maturity classification would have masked this situation.  

• As liquidity was ample, the loan book increased by $18 billion (2021 vs 2020) so that all the deposit funds of $60 billion could not be redeployed into loans. By transforming the balance sheet into a levered mortgage bond fund, these actions maximized current period income, without considering mark-to-market on the balance sheet if rates increased in the future.

• A test of the impact on the Economic Value of Equity would have revealed the error in judgment. However, as SVB was below the $250 billion threshold which did not require enhanced prudential standards, such as stress testing, the shift in risk appetite did not appear to be stressed across various interest rate shocks. Banks that are required to run stress tests, will typically run interest rate shocks on both:

• 1) Earnings at Risk (EAR) (Current period income perspective)
• 2) Economic Value of Equity (EVE) at Risk (Balance Sheet perspective)

Bank’s trade-off between the short-term (current income) vs long-term (economic value of equity) when determining the interest rate risk balance sheet position. Typically Banks would run stress tests on interest rates monthly under the following six scenarios:

1. parallel shock up of yield curve;
2. parallel shock down;
3. steepener shock (short rates down and long rates up);
4. flattener shock (short rates up and long rates down);
5. short rates shock up; and
6. short rates shock down.

When a review of an institution’s Interest Rate Risk exposure reveals inadequate management or excessive risk relative to capital, earnings, or general risk profile, the regulator will require mitigation actions and/or additional capital.

In Canada, an outlier/materiality test compares an institution’s maximum change in EVE (economic value of equity), under the six prescribed interest rate shock scenarios above, with 15% of its Tier 1 capital.

A parallel shock of 200 bps is a typical scenario that is run by a bank and would have revealed the inherent risk with investing deposits in long-term bonds in 2021, as a change in EVE would far exceed 15% of the SVB’s capital (Table 4) and would have represented almost 60% of the capital levels.

Table 4 – Proforma 200 bps Interest Rate Shock on Investment Portfolio and Total Capital 2021

Running this analysis at the time would have told management to either raise more equity or increase floating rate securities rather than fixed-term securities (i.e. do not maximize current period income at the risk of potential risk in the economic value of equity in the long-term should rates rise).

While this may not have been ideal in the short-term when looking at current period income, the trade-off would be that the bank would have been sustainable in the long term should interest rates increase dramatically during the period the securities were held to maturity.

We note in Table 5, SVB’s floating rate equity exposure was negative and fixed rate exposure was positive, so as the interest rate rose, the bank’s economic value of equity was at risk, as deposits may reprice faster than loans (to keep deposits on the balance sheet continuing to fund the loans) as deposit beta estimated by management was 70% and fixed-rate securities would lose value. 

The unrealized loss of $15.1 billion represented a 16% decline in the value of long-term bonds. Many individual investors would have seen similar losses in their bond portfolios with a duration of 6-7 years in 2022 given the velocity of rate hikes by the Federal Reserve.

However, the real issue here is that banks are levered vehicles (asset-to-equity multiplier of 13x), so losses of 16% are magnified significantly from an Economic Value of Equity perspective, potentially wiping out 80% of Total Risk-based Capital, once the securities are sold (losses are then realized) to meet deposit withdrawals that SVB was facing in March 2023.

The loss of 25% of deposits on March 10 is much higher than regulatory liquidity stress tests on these deposits (between 5-30% runoff in a hypothetical 30-day stress period) and would have triggered and recognized a large portion of the $15.1 billion loss. The deposit book was largely uninsured (~90% of total deposits), so there was an incentive for customers to withdraw as if the bank failed, these depositors would only be covered up to $250,000 per account.

We estimate the proforma total capital ratio would have been ~6%, requiring an infusion of new equity, to come back above regulatory capital requirements.

SVB may have extended its lifeline further, if it went to the Fed discount window, and raised liquidity to meet deposit withdrawals to a point rather than selling down the held-to-maturity securities portfolio which crystallized the unrealized losses requiring new equity. However, it’s difficult to determine from the outside looking how much of SVBs assets were already encumbered by 3^rd parties versus Federal Reserve which would have determined the available liquidity.

There is a stigma associated with going to the discount window which is probably why SVB did not pursue this course of action, though Federal Reserve may have been able to adequately handle the situation, without the disruption that was caused.

Table 5 – SVB’s Interest Rate Risk and Balance Sheet Position (Dec 31, 2022)

A few other issues related to Interest Rate Risk: 

• Concentration risk on long-duration: Both business models/clients (Venture Capital) are levered to low-interest rates. This was exacerbated by SVB’s balance sheet position which was also transformed into a long-duration mortgage bond portfolio in 2021. Most banks fail due to credit risk. The risk that caused SVB to fail was a duration mismatch between High-Quality Liquid Assets (Treasuries and MBS) and deposit liabilities that were not dynamically managed. The deposit surge that occurred during 2021, from hot money Venture Capital firms and other corporate deposits, at the time of generationally low-interest rates, may have been the undoing of SVB.

• Interest Rate Risk mitigation via hedging: Lack of hedging (pay fixed-receive float interest rate swaps) of securities at SVB, despite increasing Fed Funds rate over the last 12 months. The Held-to-Maturity book was too large relative to the balance sheet size at 45% of assets and was an aggressive accounting treatment, given the potential characteristics of the deposits.

• The extra yield of MBS, CMBS, and CMO relative to US Treasuries when the securities were purchased in 2021, was a result of convexity, and these securities are difficult to hedge with interest rate swaps, due to underlying convexity in MBS/CMBS/CMO. Management could have also purchased floating rate securities and altered underlying characteristics with a receive-fix/pay-float interest rate swap.   

• No repositioning of balance sheet or hedging position as interest rates were increased in early 2022: In 2021 Balance Sheet position was similar to 2022 with 60% fixed rate assets (net of swaps) vs. 90% floating rate funding. As rates increased in 2022, asset values fell (bond portfolios), while deposits repriced higher as well (deposit beta was 70% (sensitivity of balances to increase in interest rates)). It does not appear that Treasury or Risk Management attempted to mitigate the risk of higher interest rates on the Bank’s Economic Value of Equity. The Treasury team could have sold off the HTM portfolio taken a much smaller loss in early 2022 when it started to become evident that “inflation was not transitory”, and repositioned the portfolio duration to be much shorter in the book as interest rates increased. This may have also been done synthetically through economic hedging using interest rate swaps (receive float/pay fixed) as well.  The Treasury group is responsible for managing the balance sheet position across the business cycle and is not a “set it and forget it” strategy and ALCO is responsible for management oversight of this process.        

• Regulatory Threshold: CEO Greg Becker, lobbied for reduced regulatory constraints on banks below $250 billion in assets. In 2015, he submitted a statement to a Senate panel pushing legislators to exempt more banks – including his own – from new regulations passed in the wake of the 2008 financial crisis. Despite warnings from some senators, Becker’s lobbying effort was ultimately successful.
• He mentioned at the time: “Without such changes, SVB likely will need to divert significant resources from providing financing to job-creating companies in the innovation economy to complying with enhanced prudential standards and other requirements.” This is a common view in financial services, that risk and compliance requirements would tie up significant resources that are not value-added. This is a reoccurring theme that shows up time and time again when reviewing what went wrong when businesses fail.  

• Liquidity and Funding: As the bank’s assets were below $250 billion, it was not subject to the Liquidity Coverage Ratio or Net Stable Funding ratio.

• The Liquidity Coverage Ratio (LCR) may have highlighted the reduced liquidity of investing in MBS, CMO, and CMBS relative to Treasuries. LCR = High-quality liquid assets (HQLA)/ Total Net Cash flow amount under a 30-day liquidity stress period. The Level 2 cap of 40% of total HQLA would have highlighted the issue of too much MBS, CMBS, and CMO versus US Treasuries/Cash as well. 
• With limited information, we have attempted to roughly calculate the LCR in Table 6, which highlights the risks that SVB was taking from a liquidity perspective as the proforma LCR of 59% would be below the regulatory minimum. SVB was not subject to LCR or NSFR. Though it is a rough calculation (with limited information) almost 50% of deposits were to be held in HQLA and the liquidity buffer would have been able to withstand the 25% runoff on March 9-10.  The calculation also highlights another important theme that as a result of the $250 billion threshold and regulatory arbitrage, banks that did not have to comply with LCR or NSFR could offer higher interest rates to customers for their “low-quality deposit” from financial intermediation (venture capital) from a G-SIB perspective (see below for further information). G-SIBs would have re-priced these deposits in the past, offering little/no interest given the fact that it would constrain the bank’s balance sheet from a liquidity perspective. This is why having G-SIBs acquire regional U.S. banks is probably not a likely outcome, and the government will attempt to backstop liquidity, to ensure deposit outflows are met, given that not all of the risk was transformed under Basel III regulation and merely shifted to other parts of the economy. Risk is required to increase innovation and improve productivity, which is why regulators try to balance regulation for the size, scope and complexity of the underlying business models.
• Net Stable Funding Ratio would have highlighted the Asset Liability mismatch between the investment portfolio and deposits. Assets were 60% fixed-rate, fixed term, funding with largely floating rate/non-maturity deposits, which is double the industry average of investment portfolio as % of total assets.

Table 6 – Proforma Liquidity Coverage Ratio – December 2022

• Stress Testing: Category IV organizations like SVB are subject to supervisory stress tests conducted by the Federal Reserve every other year. Category IV institutions are “not required to conduct and publicly report the results of a company-run stress test” and “reduces the required minimum frequency of liquidity stress tests and granularity of certain liquidity risk-management requirements”. In 2021, SVB passed the threshold of $100 billion under management, triggering some additional scrutiny as a Category IV bank but remaining exempt from the more frequent and detailed analyses that regulators perform to determine whether banks above $250 billion of assets have sufficient capital to withstand a crisis.

• Resolution Planning: SVB submitted a resolution plan on a three-year cycle beginning in 2022. The Bank submitted its resolution plan to the FDIC in December 2022.

• Management Changes: SVB without a Chief Risk Officer (CRO) for much of 2022: New CRO started 10 weeks ago in early 2023. Having a 2nd line of defense may have brought the Interest Rate and Liquidity Risk to the forefront and the bank may have attempted to hedge rates in early to mid-2022 when inflation was no longer “transitory” and rates climbed. Laura Izurieta stepped down from her role as CRO of SVB Financial Group in April 2022, and formally departed the company in October, according to an SVB proxy filing. The bank appointed her permanent successor as CRO, Kim Olson, in January of this year. It is unclear how the bank managed risks in the interim period between the departure of one CRO and the appointment of another.

• Moral Hazard/Risk-taking Behavior: Realizing the writing was on the wall, many executives sold significant stock holding in the month before announcing capital raise in early March. We hope that regulators review this transactions in light of the failure of the bank and potentially create more accountability for actions.

• Regulation Arbitrage and Marketability of SVB to G-SIB Banks: Since adopting Basel III rules, G-SIBs have repriced low-quality deposits (i.e. institutional fast money deposits) and many of these deposits may have found their way into the unregulated space U.S. regional banking space such as SVB. Given the potential for impact on G-SIBs’ Liquidity and Funding ratios, it may be a difficult decision for G-SIBs to acquire the deposit base given the regulatory overhang. However, though we are not experts at bankruptcy law though looking at historical precedence, with the resolution of the bank and selling of separate businesses and assets, equity holders will likely be wiped out (given existing unrealized loss on investment portfolio) and deposit holders should recover most of their money given depositor preference under bankruptcy law. Given that SVB is a large regional player, it may be difficult for other regional players to obtain additional equity and funding in the current environment to take over the failed bank.

• As per the FDIC: “By law, after insured depositors are paid, uninsured depositors are paid next, followed by general creditors and then stockholders. In most cases, general creditors and stockholders realize little or no recovery. Payments of uninsured funds only, called dividends, depend on the net recovered proceeds from the liquidation of the bank’s assets and the payment of bank liabilities according to federal statute. While fully insured deposits are paid promptly after the failure of the bank, the disbursements of uninsured funds may take place over several years based on the timing of the liquidation of the failed bank assets. “Based on our calculations it is likely that uninsured depositors, such likely recover close to ~90% of their deposits subject to the sale of businesses and loan book. Late Sunday afternoon, the government announced a new liquidity facility and guaranteed the uninsured deposits of both SVB and Signature Bank. This will likely reduce the potential flight to safety behavior of customers next week in these regional US Banks that could have moved their deposits to the G-SIBs causing further bank failures.      

Unfortunately, many of the risk safeguards for entities above $250 billion such as liquidity and interest rate risk stress tests would have helped SVB sidestep this situation and continue to be a going concern.

Most of the regulations have been developed drawing on the previous crisis in the past so that they do not repeat in the future like the Great Financial Crisis (Liquidity Risk) and Savings and Loan crisis (Interest Rate Risk). Circumventing regulations may have increased profitability in the short term by taking excessive duration and liquidity risk, though in the long term, these risks were fatal for SVB. 

Other Industry Players:

Some other financial institutions have been feeling tremors from SVB’s fall, and Signature Bank, prominent in the crypto world, saw its shares drop over 23% on Friday while shares of First Republic, a regional bank, fell by 15%, PacWest Bancorp down 37%.  Below we have done a deep dive into their balance sheets to determine if there are similar risks (market and liquidity risk) hiding in plain sight.

Based on our review of select players, it appears that SVB was in a class of its own:

• The large duration mismatch between investment portfolio and deposits, and potential for the capital shortfall in the case of rising rates, deposit outflows, and forced asset sales. If they had to sell off the Held-to-Maturity portfolio, this would have required a capital raise to remain above the regulatory total capital ratio of 10.5%.
• Large Held-to-Maturity portfolio (45% of total Assets) and aggressive accounting treatment of held-to-maturity.
• The highest surge of deposits in 2021 relative to other banks and a large institutional base of depositors as evidenced by 90% uninsured deposits 
• Concentration risk as SVB was the bankers to technology, start-ups, and venture capital firms, and as a result too reliant on one segment of the economy. A high level of deposits from one sector that showed a rising probability of default and laying off employees should have been a sign to increase liquidity and capital, which it did not.

Crypto-friendly Signature Bank was shut down by regulators Sunday, after the collapses of Silicon Valley Bank, Silvergate given the large uninsured deposits and large exposure to digital asset deposits (~20% of total deposits) that would likely flee en masse creating a further crisis of confidence.

On Sunday evening March 12, the U.S. Federal Reserve announced the Bank Term Funding Program (BTFP) which gives banks the ability to exchange their HQLA bonds at par (i.e. no negative mark-to-market) so that they can obtain liquidity and deal with potential deposit outflows.

This new facility solves the problem of forced selling of assets and negatively impacting the capital ratio by opening up this new facility to other Financial Institutions dealing with negative mark-to-market on their securities portfolios.

If SVB had a conversation with U.S. Regulators before reaching out to Goldman Sachs to raise equity, may have avoided the whole situation and liquidity may have been obtained via the Fed discount window. These actions should return confidence to U.S. Banking System. We believe systemic risk in U.S. Banking is low as a result of actions announced.  

See Table 7 below for a comparison of Select U.S. Regional Banks 

Table 7 – Comparing Select U.S. Regional Banks – December 31, 2022

Global Liquidity and better-than-anticipated January data (inflation, payroll, ISM surveys) have supported markets this year so far…Will higher global liquidity offset cyclical weakness via Central/Commercial Bank tightening?

Global Liquidity/Monetary Policy: Central Bank balance sheets (reduced Quantitative Tightening pace since October/22 in the U.S.) appear to be expanding and used to maintain financial stability while slowly withdrawing support without creating significant bond market volatility/sovereign issuers and strongly rated corporates. Supporting equity markets appears to be a by-product of supporting financial stability and credit markets. Earnings multiples (P/E) are altered by liquidity/interest rates/monetary policy, which is largely what we have seen so far. Earnings expectations are coming down.

Does China’s liquidity impulse kick off restarting the global manufacturing cycle that would support corporate earnings and further global consumption and/or another wave of global inflation via higher commodity prices?

Overnight rates/tight monetary policy is being used to manage demand/inflation. The weakening of demand in end clients (U.S., Europe) via higher interest rates and inflation does not support cyclical uplift in the global manufacturing cycle. U.S. Liquidity has continued to decline close to 3% per annum. Coupled with higher interest rates, Commercial banks are also tightening credit standards, which has reduced demand as well historically as liquidity becomes scarce and some customers are not able to roll their debts and eventually default.

Leading indicators have continued to decline and have bottomed and point to a recession in H2/2023. Coincident indicators are still marginally positive, though growth is slowing. The labor market has yet to see significant stress, though there have been lower hours, less temporary staff, part-time and less job openings. These trends tend to occur before full-scale layoffs. Corporate profits expectations will need to deteriorate further before higher layoffs. An uncertain macro environment is supportive of a trend-following strategy (floating rate bonds (TFLO), Chinese Bonds (CBON) and gold (PHYS or GLD) for the current month).

The U.S. housing has yet to bottom. Home prices continue to fall and appear to have more room to fall. Usually for the economy to bottom, the housing sector will need to bottom. Jobless claims tend to follow the housing market on a 10-12 month lag. At this point, the labor market has remained tight and there may be evidence of labor hoarding, which may be partially related to the monetary illusion related to revenue in high inflationary environments. As margins erode due to higher costs and/or sales volumes decline, eventually businesses will cut labor. At this point based on leading indicators, housing and manufacturing sectors appear to be in recession (industrial production -2% on 6-mth smoothed change). We note that inventory-to-sales ratio (tends to spike during recessionary conditions) have continued to climb, which point to more disinflationary trends in forms of price discounting and lower expected future manufacturing activity.

Current corporate operating earnings for FY2022 (92% reported Q4/22) of $196/share, down 6% YoY. FY2023 earnings expectations have been lowered from $225 to $220/share, representing 12% YoY growth and projecting an earnings recession in H1/23 of (4%).  We have seen signs of higher costs reducing profit margins that cannot be recouped via higher prices. Nominal revenues have held up given the monetary illusion of inflation. Inflation-adjusted revenues have remained flat since the middle of 2022. Corporate profit margins are expected to deteriorate further (with 4x companies providing negative outlooks vs positive in Q1/23). Historically, this has led to employer driven-layoffs outstripping employee-driven quits, leading to wage growth coming back closer to the trend. Current consensus 2023 S&P EPS is about 30% above the long-term trend line (earnings growth of 6%) which goes back to the 1880s. Our leading earnings indicator (1-year lead) has us back to the trend line by the end of 2023. Recessions tend to get us back to trend.

Disinflationary trends remain, but appears some service categories remain sticky into H1/23 keeping core inflation elevated at 3.5-4.0%:

Above-trend wage growth due to tightness in the labor market may keep inflation elevated above 2% target in 2023/into 2024 without a recession. Job-switchers have earned a premium of 1.5% higher than job-stayers, which is well above the long-term trend of 0.5%. Employees continue to have bargaining power, though expected to decline over the next 12 months, with wages closer to pre-COVID trend of 3.3%.

Given the pace of the rate hikes in 2022 and lagged impact on the economy, we likely have not seen the full impact of the tightening yet. Monthly coincident data (based on Jan/23) data, growth appears to be re-accelerating employment and personal income growth (though a number of restatements/seasonal adjustments), however, high-frequency data and leading data point to further deterioration. We expect that January data may be revised at a later date.

Global Liquidity growth is almost back to positive in December,  but signs of economic deflation and weakening demand…

Global Liquidity Growth in December (the latest available month) of (0.3%) was far below the trend growth of 7% but bottomed in November. The large increase month-over-month is related to the stimulus provided by China, which offsets the declines in liquidity from the rest of the world. U.S. Liquidity has continued to decline close to 4% per annum.

China’s recent reopening by abandoning zero-COVID and policy support of the property sector via easing the “three-red-lines” policy through more liquidity has enhanced market sentiment across all markets (equities, bonds, and commodities).

The reopening of China and related policy easing may provide an additional deflationary impulse from supply chains, partially offset by potentially higher commodity price inflation later in 2023. Also weakening of demand in end clients (U.S., Europe) via higher interest rates and inflation may not support cyclical uplift in the global manufacturing cycle as we have seen in past cycles (2011, 2016). We have covered the China reopening and its potential implications in more detail in the second part of this document.  This catalyst supported risk assets during January 2023, with the MSCI All Country World Index (ACWI) up 7.5% during the month.

Global Liquidity has been below trend since November 2021 and the trend-following portfolios have been allocated to the Safety portfolio since January 2022 generally as a result of lower-than-trend Global Liquidity growth. Month-over-month liquidity growth momentum has increased as China has increased liquidity and long-duration assets have reacted positively (equities, REITs, and Bonds). Long Duration Equity/Bonds Returns tend to be positively correlated with Global Liquidity growth. With weak general liquidity/funding conditions, allocation to the Safety portfolio is prudent.

This month’s allocation within the safety portfolio (Gold, Chinese Bonds, US Investment-grade bonds)  reflects the market’s anticipation of the continuation of deflationary conditions into 2023 and further global liquidity growth momentum coming back to trend, which may kick off the next cyclical upswing. For January 2023, the Trend-following strategy and investment in the Wave Runner/Safety Portfolio have generated 5.9%. We are starting to see positive momentum in many of the factors in our global risk indicator that may switch at some point to “risk-on” in early 2023 such as improving the Copper-to-Gold ratio, and risk-on sentiment (Discretionary vs Staples). However, we have yet to see Housing Starts bottom yet.

As we cover in the previous posts, historically, bear markets lasting > 1 year and subsequent recessions have resulted in significant drawdowns (~45% for S&P 500 on average) and last 18 months on average as first earnings multiples are repriced, then earnings expectations repriced. The current bear market has been about 13 months, so we may be only halfway through the bottom and start of a new bull market. Generally, a bottom is formed when global liquidity turns positive and yield curve slope starts to steepen and has positive momentum, and Coppock curves are at their lows. We are starting to see indications of a bottoming process. The S&P 500 2023 Consensus EPS is expected to come down in the near term. 

Cyclical growth from China may be lower than in previous cycles as credit growth appears to be ~50% of the previous cycles (2011, 2014, 2016, 2020). Policymakers are not constrained by too-high inflation, and the economy is operating below potential. However, policymakers are also exercising self-restraint against the excesses of “flooding” the system with liquidity and overleveraging. Policymakers must walk a fine line between supporting housing rather than importing commodities, building, and increasing the housing supply for the sake of simply growing GDP. Speculation has made Chinese homes the most expensive in the world on a price-to-income basis.

The property sector is the largest single sector in China’s economy and its ups and downs usually have a meaningful impact on headline GDP growth. About 70% of homes sold since 2018 have been bought by people who already own at least one property. Higher household “excess” deposits appear due to lower housing sales and potentially residing in the upper end of the wealth distribution and consumer confidence is low in China. Much attention has been paid to U$2T domestic deposits available for deployment, however, current sentiment may not be supportive of ‘excessive consumption’ to offset the rest of the world slow down.

Achieving a 3-5% trend GDP growth will require more focus on driving private consumption in China. Household consumption is less than 40% of China’s GDP as of 2020, versus a global average in other countries of roughly 60%. Beijing’s new common prosperity policies focus on redistributing income from the wealthy to the poor and the middle class is expected to support this objective.

Restoring confidence remains crucial for the consumption outlook. Consumer confidence has appeared quite dampened in 2022, and we expect some improvement in 2023. Households’ confidence is closely linked to property prices, food price inflation, and stock market performance – we expect almost all drivers to argue for stronger consumers into 2023, but may not be able to offset weakened demand from the rest of the world. We will continue to track how this story plays out.

This week we have reviewed cyclical and secular trends as it relates to growth and inflation and how these trends may impact asset markets.

But first, an analogy to help us work through the current environment. For those of us that have driven in winter conditions and snowy roads (similar to the picture above), the first rule is to drive slowly (even with snow tires). It’s harder to control or stop your vehicle on a slick or snow-covered road. Increase your following distance enough so that you’ll have plenty of time to stop for vehicles ahead of you. Take the time to learn how a vehicle handles under winter weather driving conditions.

We use this analogy for the challenge that lies ahead for the central banks as they are driving on a snow-covered road (a slowing economy) and have several potential options: 1) keep increasing rates and cause a significant economic downturn (going over the cliff as you round the curve in the picture above) 2) pause and wait for the lagged impact of existing rate hikes/potential economic damage, and 3) start easing off too quickly and have inflationary pressures re-emerge quickly.  

1) Cyclical Trends

Stock markets have been positive 2023YTD and trading close to the 200-day moving average: this appears to be a technical reversal given the bearish sentiment coming into 2023 (weak H1/23, followed by H2/23 recovery). With inflation momentum slowing, a soft landing has become a potential market narrative and financial conditions have loosened since November, however, leading indicators point to further economic pressure and lower EPS in 2023. China’s re-opening and liquidity impulse is expected to be positive and may offset weakness from the rest of the globe. 

Current corporate earnings trajectory may be unsustainable (S&P 500 EPS for 2023F at $225/share represents 13% growth over 2022F) and profit margins are elevated – well above historical trend and margins have reverted to the mean. Consensus EPS have not considered an Earnings recession in 2023. Recessions tend to have (23%) declines in Earnings during recessions since 1949. Based on survey data, pricing power has been diminished and increased labor/input costs are outstripping price increases which compress operating margins. This behavior has lead to layoffs in the past.   Q4/22 Earnings season has kicked off this past week and we expect a lowering of future 2023 guidance over the next few weeks.

Disinflationary trends: Despite the headlines, wages and inflation momentum are falling in lock step back to pre-COVID-19 trend lines. Slowing energy prices have reduced inflation momentum as well. The Fed and administration need to keep inflation expectations anchored to keep interest rates manageable and avoid a similar sovereign debt crisis as we saw with UK in 2022. Bringing down energy prices has been major help in alleviating a surge in inflation, which then influences inflation expectations. A big driver behind the fall in Energy prices has been the Strategic Petroleum Reserve (SPR)  – a reduction of 50% during 2022. Given the pace of the rate hikes in 2022 and lagged impact on the economy, we likely have not seen the full impact of the tightening yet.

Leading indicators continue to decline and have yet to bottom and point to a recession in H2/2023. Coincident indicators are still positive, though growth is slowing. The labor market has yet to see significant stress, though lower hours, less temporary staff, part-time and less job openings. These trends tend to occur before full-scale layoffs. 

An uncertain macro environment is supportive of a trend-following strategy (long-term bonds, gold, and IG Bonds for the current month)

2) Secular Trends

Corporate Earnings and Stock Price (going back to 1881) are well above long-term trends. Recession tends to bring back EPS/prices to historical trend line.

Shiller’s Cyclically Adjusted Price-to-Earnings Ratio (CAPE) (10-year Price-to-earnings) ratio can be modeled using a macro multifactor model of long-term growth and inflation, cyclical deviations, and volatility of growth/inflation.

1)Multifactor Model based on CAPE (dependent variable) and independent variables (average growth (industrial production) over trailing 10-years, average inflation over trailing 10-years, macro uncertainty (standard deviation of growth and inflation over last 10 years), 3-year growth as % of 10-year growth, 3-year inflation as % of 10-year inflation and macro uncertainty (3-year standard deviation of growth and inflation as % of 10-year standard deviation of growth and inflation. )

Higher long-term inflation above 4% and associated inflation/macro uncertainty have historically compressed CAPE below the average of 22x. Historically, valuations/wealth are maximized in low, stable interest rate environments (1960-1970, 1992-2022).

Less globalization/war/pandemic increases macro uncertainty.  Macro uncertainty leads to equity market volatility and reduces valuations/wealth.

Secular forces that have been sped up as a result of COVID-19 (de-globalization/war/multi-polar, larger wage share of GDP/populism, increased wealth/income equality, de-carbonization) point to higher trend inflation (beyond the target of 2%) and more inflation uncertainty. This points to trend inflation between 2.5% and 3.5% going forward and may compress the CAPE ratio closer to the average of 22x from current 29x.

1)Based on the multifactor model Core PCE (dependent variable) and independent variables (Income/Wealth Distribution), Globalization (imports as % of GDI), Employment-to-Pop (25-55 years), Commodity prices, Technology adoption, and Federal Debt as % of GDI. Trained on the 2010-2019 period. 

Happy New year to everyone! We wish you a happy and prosperous 2023.

Review of 2022 and 2023 Outlook

1)In 2022, the Buy & Hold Balanced Benchmark of 60% US Equities and 40% US Bonds had the 6^th worst year since 1871. Portfolio diversification was non-existent as Inflation uncertainty dominated growth uncertainty causing bonds and equities to be positively correlated.  About 65% of the time, the balanced portfolio is back to positive returns the next calendar year after falling the previous year.

2)Equity markets have yet to reprice for potential earnings recession and the current market has repriced earnings multiples due to higher discount rates.  The current EPS Projection for 2023 is well above the trend line (25% above) and tends to mean revert over time (i.e. recessions) due to lags of monetary policy.

3) Current recession probability in the U.S. for the next 12 months is 61% based on the yield curve (10y3m) regression, model. Fed Funds Rate (FFR) (overnight rate) has been higher than the 2-year Treasury rate towards the end of December. Usually, the 2-year rate falling below the FFR has historically been a sign of lower FFR in foreseeable future (within 6 months). 

4)Gold prices are starting to anticipate deflationary conditions and potential responses by central banks through global liquidity increases, yield curves re-steepening, and real yields declining. Central Banks have also be increasing their share of gold as a % of their overall reserves in recent months (China/Russia) as the world trade moves away from globalization/US dollar financial system to a on a multi-polar as the US and China look to decouple their interests due to strategic competition. Re-opening of China also supports demand for gold in the near-term.  Also, the potential for decline of investor trust in the financial system is supportive of gold outperformance relative to equities as liquidity growth increases in an environment of higher than average geopolitical risk. 

5)Credit Standards appear to be tightening along side increases in interest rates. Reduced Credit Availability tends to precede prior recessions and widening of credit spreads/increased equity market volatility.  An important metric to track going forward – High Yield Credit Spreads. High Yield Spreads have widened this year but does not seem to reflect the trajectory of tightening of credit standards and interest rates expected ahead to counter inflation. 

Model Portfolio Summary (January 2023)

1) Global Liquidity Growth in November (the latest available month) of (6%) was far below the trend growth of 7% and may be close to bottoming in the next few months. Global Liquidity has been below trend since November 2021 and the trend-following portfolios have been allocated to the Safety portfolio since January 2022 generally as a result of lower-than-trend Global Liquidity growth. Month-over-month liquidity growth momentum has increased as China has increased liquidity and long-duration assets have reacted positively (equities, REITs, and Bonds). Long Duration Equity/Bonds Returns tend to be positively correlated with Liquidity Growth. With weak general liquidity/funding conditions, allocation to the Safety portfolio is prudent. Commodities’ momentum (Natural Gas, Gasoline, Oil, Wheat) has waned in the current month suggesting slowing demand growth.

2) This month’s allocation within the safety portfolio (Gold, Long-term US Treasuries, Investment-grade bonds)  reflects the market’s anticipation of deflationary conditions into 2023 and further global liquidity growth momentum coming back to trend. For FY2022, the Trend-following strategy and investment in the Wave Runner/Safety Portfolio have generated 3.2% in FY2022, which is far superior to the balanced portfolio benchmark of (18%) (all model portfolios beat the benchmark in 2022).   

3) As we cover in the previous post, historically, bear markets lasting > 1 year and subsequent recessions have resulted in significant drawdowns (~45% for S&P 500 on average) and last 18 months on average as first earnings multiples are repriced, then earnings expectations repriced. The current bear market has been about 12 months, so we may be only halfway through the bottom and start of a new bull market. Generally, a bottom is formed when global liquidity turns positive and yield curve slope starts to steepen and has positive momentum, and Coppock curves are at their lows.    

4) We have begun to publish Coppock curves (which we covered in previous posts) for each model portfolio to track the bottoming process.

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In this post, we cover the recent data regarding the state of the global economy focusing on recent employment and inflation reports (lagging indicators) and trying to glean if we can see the light at the end of the tunnel of the rate hiking cycle/reduction of liquidity.

We have noted in the past the importance of including liquidity trends and market risk appetite and have included this in our global risk indicator to determine when to take additional equity market risk.

The following are the key themes we are tracking:

1)Global Liquidity Trends: Liquidity growth is still well below trend growth, but may have bottomed in September, as in October China’s Liquidity increased, US Liquidity Index continues to tighten overall. Lagging indicators (Employment and Inflation) continue to be at late-cycle levels. Liquidity trends are expected to drive equity markets going forward, so we are going to continue to pay attention to shifts in momentum. As liquidity increases, we expect the $US dollar to continue to weaken, potentially increasing future US corporate profits.

2)Employment growth in November remained positive, though growth trend starting to follow interest rates on a lagged basis (~18-mths historically). There are long variable lags of monetary policy which take time to flow through economy and have only been in the rate hiking cycle for last 9 months. We are seeing deterioration across rate-sensitive industries in which layoffs have tracked the uplift in rates and tend to lead over all employment trends. Most leading indicators of employment have declined and high frequency data such as increasing initial jobless claims/ layoffs, and daily tax withholdings, and contractors have slowed/declined year-over-year pointing to future wage growth slowing.

3)Transportation, Supply Chain and Consumer: Transportation/freight trends have recently weakened and supply chain pressures have subsided. Consumer has remained strong, though credit availability tightens at the same time as interest rates flow through the economy putting pressure on future retail sales and continues to increase inventory levels relative to sales.

4)Inflation remains elevated but has peaked and momentum is slowing given that demand for goods appears to be declining. Momentum across most inflation-leading indicators has continued to decline throughout 2022…The implied shadow Fed Funds rate appeared to peak in October/November and remains above inflation. We are watching the yield curve slope to see if the yield curve starts to steepen (i.e. 2-year rate declines more than the 10-year rate) as central banks start to consider cutting overnight rates, given that the yield curve first inverts, then steepens right before the recession. Based on our research, we note that equity markets tend to bottom when the yield curve troughs and steepens and continues to steepen.

5)US Equities – Valuation/Earnings:

Valuation multiples have recently expanded slightly potentially due to higher net central bank liquidity month-over-month in November – we continue to track this trend. If the Fed sticks to Quantitative Tightening plan of ~$90B per month, we could see S&P 500, re-test October 2022 lows of 3500 if prior correlation holds.

We do not believe a recession has been considered in consensus earnings as consensus EPS of 2% compares with earnings recession of average (23%) from prior recession since 1949 and (25%) estimate from tightening financial conditions from 18-mths before.

6)China Update: China’s growth has been slower when US Dollar has been strong. Industrial Profits declined 2% in October. Credit and money growth in 2022 has been below trend and appears to have bottomed.  Appears that China may gradually turn back on the liquidity taps to support economic growth which could partially offset recession conditions in the rest of the world. Generally, recent global slowdowns when liquidity was tightening, have been offset by liquidity growth in China (2008-2009, 2016-2018). Though given the debt levels/real estate market and potential for higher inflation of imported goods and services, the liquidity provision is expected to be less than prior liquidity injections, so may not offset the potential global recession. Emerging from COVID lockdowns may increase liquidity and commodities prices as well, driving inflation higher.

7)OECD Composite Leading Indicators (CLI): Most countries’ OECD CLI point to slowing economic growth in coming months, however, there appears to be a turn in trend change in OECD CLI momentum as 43% of countries have increased month-over-month….Is there light at end of the tunnel? Could China’s reopening and economic support via liquidity avert the global recession?

Global Liquidity Growth in October (the latest available month) of (6%) was far below the trend growth of 7% and may be close to bottoming in the next few months. Global Liquidity has been below trend since November 2021 and the trend-following portfolios have been allocated to the Safety portfolio since January 2022 generally as a result of lower-than-trend Global Liquidity growth. Long Duration Equity/Bonds Returns tend to be positively correlated with Liquidity Growth. With weak general liquidity/funding conditions, allocation to the Safety portfolio is prudent. Gold has replaced the US dollar in the safety portfolio this month. As we cover in the previous post, Historically, Bear markets lasting > 1 year and subsequent recessions have resulted in significant drawdowns (~45% for S&P 500) and last 18 months on average. The current bear market has been about 11 months, so we may be only halfway through the bottom and start of a new bull market. Generally, a bottom is formed when global liquidity turns positive and the yield curve slope has positive momentum.  

 

Looking at the Fed Funds Rate and comparing it against historical levels of the Fed Funds Rate and inflation may understate the tightening of monetary conditions we have seen in 2022. A proxy rate or a shadow interest rate can be interpreted as indicating what the federal funds rate would typically be associated with prevailing financial market conditions (including the impact of Quantitative Tightening and altering of Forward Guidance, the strength of US dollar, and energy prices) if the fed funds rate were the only monetary policy tool being used and would peg the rate closer to 6.6% rather than current rate of 4.0%, which is much closer to where core inflation rate is running.     

We use cyclical indicators of the business cycle including Long-leading indicators and Short-leading indicators to help determine the forward-looking economic outlook. Long-leading indicators tend to turn 15 months ahead of the recession and Short-leading indicators are 7 months ahead of a recession. So we use short-leading indicators to confirm our long-leading indicators. As of the latest month, all Long-leading indicators are negative and Short-leading indicators (excluding labor market indicators) are negative as well. Labor markets have remained strong, though high-frequency data (daily treasury/tax data, initial claims, contractors) on the labor market appears to show continuing slowing of growth into 2023. Both the yield curve and long-leading indicators suggest that the probability of recession to above historically recession triggers (50-80%) over the next 12 months. 

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