To The Moon

What happened in the bank liquidity crisis? Credit agency downgrades. Last week Moody’s placed several banks on review for downgrade, including $First Republic Bank(FRC)$, $Zions Bancorporation NA(ZIONO)$, $Western Alliance(WAL)$ and $UMB Financial Corp(UMBF)$. Last night S&P downgraded First Republic for the second time in a week, this time from BB+ to B+. Washington. Hearings have already been scheduled, and Senator Warren is - let us be gentle -returning to form. That there will be meaningful changes to the banking system seems a foregone conclusion, but the precise effects on industry structure, stability and profitability are to be determined. Warren Buffett. Mr. Buffett has a history of lending his credibility to financial institutions in need of it, at least when he is comfortable with the fundamentals, and the price is right. His price can be high - preferreds with a generous yield, plus warrants, but the combination of his capital and his endorsement helped restore confidence in Goldman Sachs in 2008 and Bank of America in 2011. Were he to make any bank investments in the near term, the effect would presumably be similar. What's next? First quarter earnings. Mid-April feels a long way away just now, but U.S. banks will begin reporting first quarter results on April 14th, with JP Morgan Chase, Wells Fargo, Citigroup and PNC all scheduled to release that morning. With luck things will have settled down by then, but if not, then the second half of April will offer the market a detailed look at how banks have fared this month. Worst-performing bank stocks. The universe of the worst performing bank stocks since March 8 has included the banks that have faced the most severe liquidity crises in the ensuing days, and without making any forecasts about any specific banks, this looks like a bank we would want to watch closely for signed that the crisis is intensifying or (hopefully) easing. As seen in Figure 1, this list contains some banks that are much larger than the recent failures (in the U.S.); among the key differences is that these larger banks generally have very large retail deposit basis which have historically proven stable during financial crisis. Figure 1: Stock performance since SIVB’s mid-quarter update Source: FactSet Commercial real estate. The effects of rising rates on bank securities books are once again widely appreciated. The effects on loan portfolios have gotten less attention but that may simply be a question of timing. Commercial real estate is the dominant class of collateral in many bank loan portfolios, and while those loans don’t get marked to market like (AFS) securities, the sharp rise in rates still has a meaningful impact. Higher interest rates mean higher cap rates, which mean lower real estate values, which mean CRE loan-to-value ratios will have tended to rise significantly over the past year. In other words, the prospective loss in the event of default has increased. Thus far in this crisis, credit quality is the dog that didn’t bark, but this risk is growing. One immediate effect of bank stress on commercial real estate can be seen in the banks’ role as tenants themselves. As shown in Figure 2, SVB Financial, Signature Bank and First Republic are all among the top 10 tenants for particular REITs. In fact, First Republic is the single largest tenant for Paramount Group. Figure 2: Troubled U.S. Banks Are Top Tenants for Certain REITs Source: FactSet Consolidation. During 2008, it was common for regulators to pre-arrange the acquisition of a failing bank, so that the formal announcement of failure included the acquisition. The quick eruption of the current crisis, coupled with the large deposit outflows (which make it difficult for an acquirer to know what it is getting) has meant that we have gotten failures first, but are now starting to see acquisitions of failed banks’ assets and deposits. Figure 3 shows the ten largest U.S. banks by deposit share. In times of crisis, the 10% national deposit cap won’t preclude acquisitions by banks over the cap – systemic stability and loss mitigation will tend to take precedence – but national deposit share is nonetheless a factor worth bearing in mind given the potential for accelerated industry consolidation. Figure 3: SVB Financial and Signature Bank Were Outliers Source: FactSet The remainder of this article contains comments on the individual banks most impacted by the crisis. $Credit Suisse Group AG(CS)$ UBS acquires Credit Suisse; investor call offers little detail. Last night UBS announced an agreement to acquire Credit Suisse for CHF 0.76 per share, or CHF 3 billion. The transaction is anticipated to yield CHF 8 billion is cost savings by 2027, by which time management expects EPS accretion. UBS enjoys substantial downside protections, and liquidity support from the Swiss National Bank. At the same time as the investor call, the Federal Reserve issued a joint announcement with five other major central banks (including Switzerland’s) regarding changes to swap line operations in order to enhance USD liquidity. On the other hand, the deal was negotiated under such time pressure that management could offer little in the way of additional detail. While entirely understandable, it remains to be seen how this will be received by the market. While UBS and Credit Suisse surely know a great deal about each other, the lack of time for due diligence, and the scale of pending distractions from UBS’ existing strategy may make it difficult for UBS to enjoy the benefit of the doubt from investors. For UBS, staunching the outflow of deposits and AUM is the most pressing matter; Figure 4 illustrates the erosion of Credit Suisse’s wealth management franchise in late 2022. Like the troubled American banks, Credit Suisse was in part a story of customer asset outflows, though in this case AUM in addition to deposits. There may be an immediate wave of outflows from customers who banked with both UBS and Credit Suisse and don’t want their assets concentrated in a single institution, but beyond that one-off impact, with luck the merger will enable UBS to stabilize the outflows. If not, then the real winner in this merger (beyond the stability of the financial system) may prove to be Julius Baer. Figure 4: Credit Suisse Lost AUM and Relationship Managers in Late 2022 Source: Company filings $First Republic Bank(FRC)$ Acquisition is most likely resolution for First Republic. The deposit of a combined $30 billion from 11 competitors (the 8 U.S. G-SIBs, plus the three next-largest banks) seems unlikely to buy First Republic anything more than time to negotiate a sale, particularly in light of the bank’s second ratings downgrade by S&P in a week, to B+. We note that we have never seen anything quite like the aforementioned infusion of deposits, and while we anticipate that it will have the desired effect of buying management time to act deliberately, we also anticipate, with regrettably high confidence, that the precedent set by the use of deposits in this fashion will lead to catastrophe in the future. Underwater mortgage book. First Republic has seen sharp deposit outflows like other banks (68% of First Republic’s deposits were uninsured at year-end 2022 – an improvement from 75% at year-end 2021, but still quite high), but while Silicon Valley had enormous unrecognized losses in the bond book, at First Republic the mortgage portfolio is more remarkable. The unrecognized loss on mortgages (fair value less carrying value) rose, on a tax-adjusted basis, from 15% of tangible common equity at year-end 2021 to 84% at year-end 2022. First Republic Will Likely Be Sold As A Single Entity. While regulators are considering selling SVB Financial’s private bank separately from the core bank, and hiving off Credit Suisse’s wealth management business was a plausible path to resolution, this strikes us as unlikely with First Republic because the wealth management business is so interwoven with the core banking franchise: First Republic Has Leveraged Referrals into AUM. At its Investor Day in November, First Republic highlighted its progress in wealth management. Over the past decade, even as the bank itself has grown substantially, the contribution of wealth management has risen from 7% to 15% of total revenues. First Republic employs a high-touch service model, focused on business owners, which leaves the bank especially well positioned to leverage referrals. Management noted that fully 80% of relationship manager bankers have made referrals to wealth management that yielded AUM. At year-end 2021, the latest figure disclosed by First Republic, total AUM referred from the bank stood at $7.8 billion, having increased by 73% over the preceding two years. Figure 5: Wealth AUM referred by First Republic bankers is up 73% in two years Source: Company filings Deposit Referrals Also Strong. The referrals have gone in the other direction, too; 69% of wealth management clients have deposits with the bank. Deposits referred by wealth management totaled $11.2 billion as of September 30, up 90% in the preceding two years. Combined with sweeps deposits, wealth management accounted for 12.5% of total deposits at First Republic (also as of September 30). Figure 6: Deposits referred by First Republic wealth management are up 90% in two years Source: Company filings Referrals Also Have Helped to Attract Wealth Management Teams. The ability to leverage referrals also has aided First Republic in attracting new wealth management teams, which it has been doing with increasing frequency. In 2020 the bank hired 8 teams away from competitors; in 2021 it added 11 more; in 2022, First Republic has brought on 13 new teams managing an aggregate $12 billion in client assets. To be sure, money talks; First Republic was reported to be offering, at least in some cases, 375% of trailing 12-month revenues. Even in a period of rising offers, that placed the bank at the high end, but with the proven ability to turn referrals into deposits and AUM, 375% may be more profitable for First Republic than smaller bonuses are for many non-bank competitors. $Signature Bank(SBNY)$ New York Community Bank acquires Signature. Last night $New York Community(NYCB)$ New York Community Bank announced an agreement to acquire most assets and deposits of Signature Bank (with the exception of the bank’s roughly $4 billion in crypto-related deposits). It is a logical transaction from both a geographic and a product perspective. Figures 7 and 8 below illustrate the overlap in the NYC-area branch networks. It bears noting that the significant Manhattan presence means that the level of practical overlap may be somewhat overstated; asking a customer to walk 20 blocks in Manhattan is a more substantial imposition than asking a customer to drive an extra mile almost anywhere else in the U.S. Figure 7: SBNY branch and deposit proximity to NYCB branches Source: FactSet Figure 8: SBNY and NYCB have significant branch overlap in the New York City area Source: FactSet $SVB Financial Group(SIVB)$ SVB may be sold as a whole or in pieces. Media reports variously suggest that SVB may be sold to First Citizens (the North Carolina bank that acquired CIT). or split up with the private bank – essentially the legacy Boston Private franchise – sold separately. In contrast with the failures of 2008, at SVB there were no esoteric derivatives or baroque legal structures; it is a dispiritingly simple story. Management failed to manage interest rate risk with even minimal competence, and regulators failed to use their more-than-ample authority to do anything about it. Deploying the surge in deposits in short term instruments would have been the low risk, low return option; chasing yield in long-dated MBS was still perfectly justifiable, if only they had kept it hedged in case they turned out to be wrong about interest rates. Leaving a portfolio so funded unhedged is simply shocking, as is the bovine passivity of regulators in the face of such recklessness. While the fatal problem is now known, it will be interesting to see whether any other problems come to light. Anecdotal reports suggest that certain KYM/AML regulations may have been honored mainly in the breach. In retrospect is may seem remarkable that the bank took so long to blow up. Time will tell. Either way, we look forward to this disposition of SVB’s assets and deposits, and hope that the acquirer can fill SVB’s historical role in supporting the tech sector, on a more responsible and sustainable basis.