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We woke up last Monday, May 1st, to cheers from financial media pundits in reaction to the news that J.P. Morgan would acquire the deposits and most of the assets of First Republic Bank, which was seized by the FDIC over the weekend. This was the fourth regional lender to fail in the past two months and the second largest bank failure in U.S. history. J.P. Morgan paid a significant discount for the First Republic assets and received substantial credit guarantees from the FDIC. The S&P 500 opened down, but quickly moved sharply higher — touching SPX 4186, after the money center giant’s CEO, Jamie Dimon, stated “this part of the crisis is over,” and “there are only so many banks that were offsides this way.” But, the S&P finished the day essentially flat, leaving a bearish Gravestone Doji candle line in its wake before plunging by another 120 handles over the next three days.
On Wednesday, May 3rd, at approximately 2:30pm ET, a disheveled looking Jerome Powell, the Chairman of the Federal Reserve Board, approached the podium to address the Washington D.C. press corps following the latest FOMC meeting. With all the characteristics of a man who lacked confidence in his views, Powell read his prepared remarks, which included a statement that “the banking system in the U.S. remains sound and resilient.” During the subsequent Q&A, he struggled with a number of direct questions, stumbling over his words, back-peddling his answers, and at times appearing confused. As post-meeting Fed press conferences go, we’d say that this one qualified as an unmitigated disaster.
The problem wasn’t so much that the Fed raised its funds rates again for the tenth time in the past 14 months. No, the quarter point rate hike was expected — it was a lock. The problem was the fact that the Fed Chairman remained noncommittal toward the idea that the central bank was through raising rates. Moreover, it was the assertion that inflation remained a continued threat, and that the Fed funds rate — now 5.00-5.25% — would remain high until that threat was vanquished. What? No rate cuts this year? The markets did not like that idea one bit. Also of some concern likely, was the complete lack of any concrete plan to deal with the instabilities emerging in the banking system as a result of said rate hikes. Indeed, the DJIA fell some 400 points from its intraday high at the time Powell began his comments into the close of trading that day.
Chairman Powell finished his address by stating, “There were three large banks really from the very beginning that were at the heart of the stress that we saw in early March, the severe period of stress. Those have now all been resolved. I think that the resolution and sale of First Republic kind of draws a line under that period.” Just an hour later, PacWest (PACW) announced that it planned to sell a $2.7 billion loan portfolio, and that it was reviewing its strategic options after being approached by potential “partners and investors.” The stock traded down as much as 60% on heavy volume in the after hours session. It was accompanied by three others, Western Alliance (WAL), Zions Bancorp (ZION), and Comerica (CMA), all of which traded down double digits.
As we wrote in last month’s issue, the failure of Silicon Valley Bank (SBV) likely marked the beginning of a significant crisis for the regional banking sector. The crisis began as a run on the bank at SBV. But, while the run may have been contained by government backstops, the walk continues. It’s not that depositors fear a loss of their capital from a bank failure, it’s that they now know that they can get a greater return on their savings elsewhere, and are fleeing bank accounts yielding 0.50% in search of money markets and Treasury securities yielding 4.50-5.25%.
In a CNBC interview with Michael Milken at the Milken Institute Global Conference on May 2nd, the legendary financier described the current banking crisis as a classic asset-liability mismatch that has played out miserably time and again throughout history. When asked what he would have say to bankers in light of this crisis, Milken pulled no punches, “You shouldn’t have borrowed short and lent long…I mean [its] Finance 101.” What he meant was that many banks were induced by the profit potential of a steep yield curve to borrow heavily at very low overnight rates and purchase long-dated government-backed securities paying 200 bps above their cost of funds. In other words, they were speculating on rates remaining low for a long time. That worked until the Fed began raising interest rates at the fastest pace in over four decades.
Milken now believes that banks’ propensity for lending will be impaired until they’re able to unwind their securities portfolios. But given the enormous losses embedded in those portfolios, that could potentially take years. The result is an impending credit crunch that may already be upon us. According to Bianco Research, bank loan volumes declined 20% on average in March.
While bank securities portfolios may-well be comprised of high quality mortgage-backed and Treasury securities, nearly 38% of the median U.S. bank’s loan portfolio consists of commercial mortgages, according to KBW Research. About one-fifth of those loans are collateralized by office properties and retail malls. This should be concerning, considering that the Green Street Commercial Property index just posted a 15% Y/Y decline at month-end April. Indeed, office properties have experienced the largest decline, with class-A properties falling 25% on average over the last year. Earlier this year, Brookfield Properties defaulted on two trophy office tower assets in Los Angeles. A mostly empty San Francisco office tower located at 350 California Street was purchased for $300 million in 2019. Today, it is expected to sell for $60 million. As the Wall Street Journal (WSJ) recently reported, “not only is the sudden surge in interest rates causing property values to fall, but the rise of remote work and e-commerce is also reducing demand for office and retail space.”
The bond market is sometimes referred to as the ‘smart money’ for its ability to sniff out financial trouble ahead of the stock market. The chart above illustrates the ratio of two volatility indexes. The numerator is represented by the MOVE index, which is a market-implied measure of bond market volatility. The denominator is represented by the VIX, which measures the implied-volatility of the stock market. When the ratio is trending up, the relative volatility of the bond market exceeds that of the stock market. On April 5th, the ratio hit its highest level since mid-2005, just as the housing market was peaking. As housing prices rolled over, a meltdown in residential mortgage-backed securities followed over the subsequent three years. Today, the smart money appears to be sniffing out a problem in another corner of the real estate market. Yep, you guessed it.
If the bond market is correct, then banks are probably the least of our worries. On November 10, 2022, the Federal Reserve’s Financial Stability Board (FSB) released a study finding that liquidity within the shadow banking sector (i.e. non-bank financial intermediaries or NBFIs) is constrained due to interest rate volatility and economic uncertainty. The FSB estimates the size of the shadow banking sector at year-end 2022 to be approximately $240 Trillion – or 10x the total assets at all U.S. commercial banks. Several articles discussing the emerging worry about the shadow banks have recently been featured in the WSJ, The Washington Post, and on Bloomberg. These NBFIs are unregulated, and can carry much higher levels of financial leverage than traditional banks, but are subject to the same market risk, credit risk, and liquidity risk. Our advice: prepare for the coming collapse in commercial mortgage-backed securities.
Terminator: The Rise of the Machines
The education technology firm Chegg provided a stark reminder to us all that there will be some losers as the artificial intelligence (AI) hype reaches a fever pitch. The nascent technology has the potential to upend entire sectors across the economy, and not everyone will benefit from the proposed virtues. On its latest earnings call, Chegg warned that increasingly more students are turning to OpenAI’s “ChatGPT” for help with their homework, That had a severe negative impact on the company’s new customer growth rate.
But students aren’t the only ones trying to cut costs by utilizing AI. Corporations are investing aggressively in AI solutions as well. According to a recent report published by Goldman Sachs, roughly two-thirds of current jobs are likely to be affected to some degree from AI automation. Marco Argenti, Goldman’s CIO, compares the impact of advances in generative artificial intelligence on society to that of the printing press. He says, “Large Language Models can redefine the way we accumulate, codify, and distribute knowledge.” The report estimates that about one-fourth of current work tasks could be automated by AI in the U.S. The technology industry is at the tip of the spear with respect to corporate AI adoption in the U.S. The chart below illustrates the initial