Winter Comes to the Bank Stocks

Although the now defunct Silicon Valley Bank is viewed as the poster child for gross duration mismatch of bank asset/liability management, the real poster child is the giant Bank of America. ( See: Shulmaven: Random Thoughts on the Economy and the Stock Market - No. 3) How so? As of yearend BAC was sitting on a mark to market loss of a whopping $108 billion in its held to maturity portfolio up from $9 billion the year before. If those losses were recognized on its books it would slash the the common equity capital on its books by 44%. For tangible book value per common share the reduction would be a staggering 62%.

Now lets look at the numbers.

Common Equity/share  -                        $30.61

Adjusted for Mark to Market Loss -      $17.11

Tangible Book Value/Share  -                $21.83

Adjusted for Mark to Market Loss -       $ 8.33

With BAC shares closing Friday at $28.60 this means that instead of trading at a modest 1.3X tangible book value the shares are really trading at a very high 3.4X tangible book. My guess is that when the Federal Reserve adopts new stress tests it will include the hitherto omitted interest rate risk as a key criterion. If that criterion were included it is highly likely that at minimum BAC would be prohibited from buying back stock and increasing its dividend. In fact the Fed might require the bank to cuts its dividend and increase its equity capital. Why? On a mark to market basis BAC currently has book equity capital/assets ratio amounting to a meagre 5.4% compared to its accounting book value of 9.0%. 

Simply put the bank is way under-capitalized. My suggestion for Brian Moynihan, the bank's CEO, is launch a $100 billion rights offering  by issuing 5 billion shares at $20/share on the basis of 1 share for each 1.6 shares held. Sure it would massively dilutive, but the bank would then be freed up to sell its long term bonds and get on with the business of banking.

Mark to market losses of held to maturity assets is not the only issue facing the banking system. FDIC premiums are going to soar to pay for the Silicon Valley Bank depositor bailout and there are huge embedded losses on the banking system's  commercial real estate loan portfolios. As a result much like in the early 1980s when the money center banks were saddled with unrecognized losses on their Latin debt portfolios, bank stocks will have a long slog ahead of them. Winter is here.

Random Thoughts on the Economy and the Stock Market - No. 4

*-The failure of the Silicon Valley Bank last week represents the first bank run of the 21st Century with deposits cascading out with a few clicks on a smart phone being egged on by social media. The Fed and the FDIC came to the rescue by insuring deposits over the $250k limit. This granting of super-deposit insurance was by my reckoning, a mistake. Instead, the FDIC should enforced small haircuts on deposits in excess of $250k. My take would be to offer 95% to those depositors who wanted their money immediately and issue for those who could wait, a one year zero coupon note priced at 95. This would still be a far better deal than one that would have been typical in a bank failure.

*- This episode represents a complete failure of the bank regulatory apparatus in that Silicon Valley's 86% deposit growth in a year represented an unmistakable yellow flag. Further, the bank invested those deposits in long duration assets which should have been viewed as a per se violation of safe and sound banking practice. That would have triggered either the closing of the bank or the firing of its officers. I can't wait to hear the testimony of the regulators from the FDIC, the San Francisco Fed and the State of California testifying before Congress.

* - Despite what Senator Elizabeth Warren said, the Silicon Valley Bank would have passed the stress test that it was exempted from. Why? As usual the Fed was fighting the last war by gearing their stress test to asset quality. Silicon's assets, by and large, were not subject to credit risk; instead they were subject to gigantic interest rate risk that the Fed to ignored. Chalk that up the Fed's zero interest rate policy that finally ended in early 2022.

*- As fears of a generalized run on the banking system catalyzed borrowings at the Fed's discount window surged to record $153 billion, up from $5 billion the prior week. An additional $143 billion was to guarantee the deposits of the three banks that recently failed and $12 billion was allocated to the Fed's new, and dubious, term lending facility.

* - The Fed's Open Market Committee meets this week and only 10 days ago market participants were anticipating a 50bp increase in the Fed Funds rate. Now the debate is whether the Fed will do 25 bps or nothing. There are good arguments on both sides, but my guess is that the Fed will copy the ECB and do a 25 bps increase and signal at least a temporary pause.

* - Unfortunately there will be another shoe to drop. The value of office real estate has plummeted and those losses have yet to be recognized on the balance sheets of banks, CMBS', private equity, and pension funds. Along with bank stocks cratering last week, the shares of the office REIT's collapsed. See below for the price declines of a sample of office REIT's over the past year which are down 55%-71%.

           REIT                                52- Week High         Current Price        % change

BXP (Boston Properties)                   133                           51                       -62%

Cousins Properties                               42                           19                       -55%

Douglas Emmett                                  35                           11                       -69%

Kilroy Realty                                       79                           29                       -63%

SL Green                                             84                            24                       -71%

Vornado Realty                                    47                           14                       -70%

* - As a result my guess is that the path of least resistance for stocks is lower with a retest of the October lows likely.

 

Random Thoughts on the Economy and the Stock Market - No. 3

* Last week a black swan flew over the markets in the form of the failure of the Silicon Valley Bank (SIVB) with assets of $211 billion, making it the second largest bank failure in U.S. history. Although shorts were hovering over the stock for awhile, the suddenness of the collapse shocked the markets. The failure was the result of two cardinal sins of banking: 1) like an early 1980's S&L the yield on its assets were far below its funding cost due to the rapid rise in interest rates and 2) like the Texas banks of the 1980s its assets and deposits were concentrated in one industry; oil in the case of Texas and technology in this case.

Thus far, unlike in 1984 when the FDIC bailed out all of the creditors of the Continental Illinois National Bank, with $40 billion in assets and the it being the 7th largest bank in the U.S., Silicon Valley depositors above the $250k insurance threshold (87% of the deposits) will have to wait in line to get paid out of the receivership. Thus there are more than a few companies that will not be able to meet payroll. Just to note the Continental Illinois bailout gave rise to the term "too big to fail."

* The bank failure triggered a 4.5% weekly decline in the S&P 500 and the yield on two year Treasury notes cratered from 5.07% to 4.59% in two days, the biggest such decline since the Lehman crisis of 2008. As result the Fed will likely ignore the 311,000 February jobs gain accompanied by a modest 0.2% increase in average hourly wages and whatever this week's CPI will bring thereby ignoring the hawkish 50 basis point increase talk of the earlier last week. Thus,  making for a modest 25bps increase in the federal funds rate. Of course, if there is wide fallout from the bank failure any increase would be off the table.

* My sense is that banks stocks will continue to trade under pressure given the recent FDIC report highlighting the fact that the banking system was sitting with $620 billion in embedded securities losses as of yearend and the growing awareness on the part of depositors that the minimal rates banks now pay are unsustainable. Part of Silicon Valley's problem was that deposits were leaving to find higher yielding alternatives. Simply put, net interest margins will be under severe pressure.

*For the stock market as whole, as I wrote previously, I believe we will soon retest the October 3600 low for the S&P 500.