- 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.
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
- 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.
- 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:
- 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 2nd 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