The Problem With Banks
Good morning and welcome to all new subscribers of Grit Alpha. Today we are going to be talking about regional banks, community banks, the extreme volatility and problems they face with rapidly rising interest rates. But before we get into today’s newsletter, first a word from today’s sponsor..
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The Problem With Banks
I’ve spent way too much time the past few days on the U.S. banking industry. When an entire industry gets slammed this hard I always try to focus on it. Find the hidden gems among the fiery car crash that will survive and thrive when the fallout ends.
This time around I have been trading around volatile regional banks and building core positions in stable conservative community banks. I’ve never really been much for trading. It goes against most of my value investing principals. But with the entire sector in the dumps it seemed like an easy layup if you buy a weighted basket of beaten down regionals. Buy on bad days and sell on good days. Rinse, wash, repeat.
The volatility in the space is just nuts to me. First Republic Bank (FRC) and PacWest Bancorp (PACW) were halted an incredible amount of times yesterday. Both names were down 25-30% on the lows yesterday. I ended up buying FRC yesterday when it clipped down 25% and loaded up on more PACW down there as well. When the news broke that JPMorgan and a group of other banks were potentially going to provide liquidity to FRC the names rallied.
FRC and PACW went from being down 25% to up 20% in minutes. More trading halts and volatility continued. I exited both names for a nice gain and have not reentered regionals. I need to take a break from the volatility and a step back to unwind. The two community banks I was buying, I continue to hold. Should regional banks dump again I will probably get back in.
The issue with banks is a fundamental one. Not only are we having problems with deposits fleeing, interest rates negatively impacting security portfolios and book value significantly decreasing from higher rates, but there is likely a real impairment on the loan book across the industry that hasn’t been seen in GAAP financials. Security portfolios fall when interest rates rise as the portfolio is mark-to-market every quarter. This loss shows up in other comprehensive income and directly impacts shareholder’s equity, or book value. The loan portfolio on the other hand is not impaired every quarter as the book isn’t mark-to-market. We don’t get to see the impact higher rates have on the loan portfolio until the bank starts marking loans as non-performing, or the bank is forced to sell these loans at a discount to meet liquidity.
This potential impairment on a loan book makes valuing banks, using traditional book value, quite challenging. No reasonable person can look at a banks loan book and say nothing is impaired. Over the past two years equity valuations have gotten crushed. Consumer confidence is at multi-year lows. The Federal Reserve is aggressively raising rates to create a recession and to pull back inflation. Loan books at banks are likely impaired across the board. If these loan books were mark-to-market, book value would be down even more than it already is from the decrease in security portfolios.
Everything with the loan book is all fine and dandy if the bank isn’t forced to sell the loans to meet a liquidity crunch — assuming non-performing loans remain muted. But if deposits start fleeing for higher returning risk-free treasuries, a bank might have to sell a portion of their loan book under par, resulting in a significant loss to net income. If a bank isn’t forced to sell any of their loans everything will likely work out. They will continue to amortize cash from the loans, recycle the lower interest rate loans into higher rate loans and if rates eventually come down, the security portfolio will recover.
The bank business model works best when rates are steady. When rates rapidly increase, the business model breaks. I have seen far too many “Twitter Gurus” talk how banks would put up great numbers as interest rates increase. They talked in circles how net interest margins would expand. The model doesn’t work like that. If rates move too quickly you get a situation that we are in now. Security portfolios losing value. Deposits fleeing for higher, risk-free treasuries. And loan books potentially getting impaired as asset values across the country decrease. The worst part? Net interest margins get squeezed as banks are forced to compete with risk-free treasuries. When rates move this quickly the lending environment grinds to a halt. It becomes impossible to write new loans at higher rates. At the same time bankers are forced to increase their deposit rates to compete with risk-free treasuries. Rapidly increasing rates are one of the worst things for banks. The Twitter Gurus are out of their mind!
For the most part, I think community banks are going to be fine. Over the past few days I have spoken with management teams at a few community banks to get a sense for the environment they are facing. Everyone I talked to said they are not seeing their deposits flee. One banker even told me individuals at small banks don’t think about putting their money in high yielding instruments to maximize yield. All they want is a safe place to keep their money that is easily accessible. Professional bank investor Phil Timyan has stated similar things…
Regionals on the other hand operate a slightly different business model from sleepy community banks. Regional banks are more subjected to uninsured deposits (over $250k of cash) as they typically cater to businesses and wealthier clients. When Silicon Valley Bank crashed, there was the fear that deposits over $250k were going to be lost. Business owners then responded to this risk by moving their cash to larger banks, like JPMorgan, resulting in a modern day run on the bank. This run has continued at regional banks across the nation as seen in First Republic Bank who was just injected with $50 billion in cash from majors across the nation.
I generally think the situation with banks will get worse before it gets better. It feels like something in the financial world is about to break. If a regional goes under, no big deal. The FDIC will take it over in receivership and deposits will likely remain whole. When things get scary is when a large bank like Credit Suisse collapses. The Credit Suisse debacle is over for now that the Swiss Government put up some money, but there is probably something worse coming down the line. If a major starts to show huge losses in their security portfolio or is at risk of deposits fleeing, the entire financial system will trade meaningfully lower.
There will be plenty of opportunities in the months to come. Volatility will remain at extreme levels. Keep some cash on the side when opportunities emerge and stay nimble. We are just getting started.
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