It’s the Punch You Don’t See Coming That Knocks You Out
The banking crisis has been in the news for better than a month now, but we suspect that the real crisis is ahead of us, not behind us. The ‘disappearing deposits’ problem, that brought down SVB, Signature, and most recently First Republic, could be nothing more than a prelim to the main event. Next on deck are PacWest (PACW), Western Alliance (WAL) and First Horizon (FHN), which had a buyout deal with TD Bank terminated. Although these, and other bank stocks, rallied on Friday, all are down 50% to 75% since March. The deposit run may be over, but the bank crisis is not.
Here are some basics to help understand what’s going on.
How Banks Work
Fundamentally, banks make money three ways:
- They earn interest on securities that they hold, like treasury securities
- Customer fees, (we’ve all experienced those), and
- Net Interest Income. This is simply the spread between what they pay for capital and what they earn when they make loans, which simply means as long as what they earn on a loan is more than what they have to pay for deposits, they are making money
Any banks cost of capital is a function of how the bank chooses to raise capital. Publicly traded banks have sold shares of stock to raise capital, they might also borrow to raise capital, and, of course, customer deposits are also a source of capital which can be lent out and are generally the least expensive capital the bank has.
Why the Deposit Drain Matters
No matter the source of capital, the bank is required to maintain a certain level of reserves on hand to meet customer cash needs. Although deposits are the least expensive, they are also the least permanent. What that means is that when deposits flee a bank, as they have done for many regional banks since March, reserves must be increased to stay in compliance. That means less money is available for lending.
If that happens to one bank, it doesn’t matter much, but when it happens to a large number of banks, it is a big problem. Credit is generally less available and what credit is available is more expensive. Less credit availability and a higher rate on the credit that is available, can suck the life out of an economy.
Declining Commercial Real Estate Values Portend Loan Losses to Come
When banks make loans, they attempt to do so on a conservative basis. A traditional home mortgage is based on a 20% down payment, so the loan to value ratio at the start is 80%, and as the debt is paid and real estate prices rise over time, that loan to value ratio tends to improve. That ratio is the banks safety net. In the event of a problem, that home would have to decline by more than 20% for bank to lose money on the loan.
We are starting to see that margin of safety completely disappearing for some commercial property, particularly, office buildings. Last week the WSJ ran a story about an office building on San Francisco. This 20-story building was valued 4 years ago at about $300 million. It is expected to bring about $60 million at auction. That’s a problem for any lender. The margin of safety is long gone as the property is experiencing a valuation hit that was inconceivable only a few years ago. With 30% of office space in San Francisco vacant, this auction in San Francisco will begin to set the price for other buildings in a similar situation, and that story will get repeated in major cities all around the U.S.
We don’t know who is caught in this particular mess, but there is always a ‘last domino’ that cannot pass off losses to anyone else. A fair percentage of the time, a bank is the last domino and the smaller regional banks are responsible for a large percentage of this type of loan. This is one of the key sources of concern for regional banks
The impact of these changes is just beginning to be felt could build over the next few years. Commercial real estate loans are typically for fairly short periods, roughly five years, and then must be re-financed. If capital is scare and occupancy rate remain low, more property owners will default and simply turn over the keys.
Don’t Forget the Shadow Banks
A shadow bank is a ‘non-bank’ bank. That is, it acts like a bank, but it isn’t technically a bank. Rocket Mortgage is an example. Rocket is the largest residential mortgage lender in the U.S., but it is not a bank. The shadow banks are significantly less regulated than banks, but they are not the ‘last domino’. They originate loans, but those are largely sold to Wall Street and repackaged as Mortgage-Backed Securities (MBS; commercial mortgage securities are CMBS). Those securities often reside in many bond funds owned by investors, 401k plans, etc. (BTW, we do not own those).
What Comes Next?
While deposit runs have been the primary worry to date, under the hood, there are growing fears of loan losses. That is a very bad combination for banks and one that leads not only to increasing credit costs, but also a crimp on credit availability. That could be a knockout blow to the broader economy. At the moment, it’s hard to tell exactly where the next blow will come from, so we need to keep our eyes open. It’s the punch you don’t see coming that knocks you out.
What We’re Reading
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