March 24, 2023
Things didn’t get any easier for the Fed going into this week’s FOMC meeting.
This week some further developments came to light in the wake of the SVB and Signature Bank meltdowns. Developments that I believe shed a little more light on the state of the banking system.
Last week I opined…
Frankly, while there’ll probably be more aftershocks from this episode as smaller and mid-sized banks are scrutinized, I don’t believe anything systemic is threatening the economy. There was no massive loan fraud that fueled a bubble. Leverage hadn’t become out of control.
Also, there didn’t appear to be any kind of obvious “contagion” — like the waves of worthless CDOs banks were holding by 2007 — that could cause a domino effect.
But looking at what’s taken place since Friday, it would appear that, while they won’t come out and say it, the Fed does think a potential contagion exists.
Let’s break it down…
Small but Mighty
The SVB failure exploded onto the headlines for a couple reasons. First, bank failures are headline material — especially considering the size of the bank (it was the second largest failure in history). But second, it was the speed in which the bank went under.
Small to mid-sized regional banks are usually thought of as local financial centers. It turns out, they’re more important to the economy than most probably realize.
That’s a sizable amount of lending fueling the economy. But notice that those are broad categories split between businesses and consumers. It doesn’t really tell us how those funds are distributed in those categories.
Last week I explained that SVB catered almost exclusively to the green tech crowd which contributed to their downfall. Earlier this week financial columnist Charlie Gasparino lent a little more color to that statement:
One of my sources worked at SVB until about a year ago, and here’s how he described the bank’s business model: “Loans to VC-backed companies that made no money, asset-based credit lines to PE funds and little else. It should never have been given FDIC insurance. This wasn’t a place that made loans to construction companies and took deposits from your aunt.”
Sure, SVB put itself in a unique situation with its choice of bank clientele. But during the growth/momentum stock boom there were a whole lot of companies who were living on cheap money and borrowed time. For instance…
We’ve all heard the “rise and fall” stories of the pandemic poster children Zoom and Peoloton. But there were a lot of companies in the same boat.
In March 2021, another home fitness up-and-comer, Tonal, raised $250 million in a round of funding which, according to the company, valued it at $1.6 billion. An IPO was almost certainly on the horizon.
But by mid-2022, the company was laying off 35% of its staff to prioritize “becoming a self-sustaining business with an emphasis on profitability.”
The company never went public.
This week, according to tech blog The Information:
Tonal, a fitness startup with a cadre of celebrity backers, is crunched for cash after failing to find a buyer. The company now may take a drastic step: raising money at a valuation nearly 90% lower than its last one, in a deal that would effectively wipe out the stakes of many existing investors, people familiar with the matter said.
Private equity firm L Catterton, a current Tonal shareholder, is in talks to lead the funding round, which is expected to total $125 million at a valuation of between $200 million and $300 million, the people said. That would compare to the valuation of $1.6 billion at which Tonal last raised money, in 2021. The potential financing would be one of the harshest down rounds for a once high-flying startup that last raised money during the era of low interest rates.
Their total raise had been over $500 million and any company bleeding upwards of half-a-billion in cash is bound to put a strain on its bank.
Put a couple of those bank customers together, and any bank could have a problem. Put a bunch of them together and it could be a problem for the banking system.
In hindsight, which is always handy, no one should’ve been surprised by the blow up of SVB. Rising interest rates would inevitably cut off the oxygen to growth / momentum stocks (those trading at ridiculous valuations on future earnings). As those companies were squeezed, It would only be a matter of time before those same higher rates threatened an impact on banks that catered to those companies.
The big question is, “how exposed are other banks in the regional sector?”
The overall health of small to mid-sized banks and their loan portfolios likely isn’t fully transparent — possibly even to the Fed.
And while JPow called SVB an “outlier” in his FOMC presser on Wednesday, that doesn’t mean there isn’t a lot more uncertainty out there. The point is, we (and the Fed) don’t know how many banks who had “Tonals” on their books could be susceptible to future liquidity strains.
So Just To Be Safe…
…The Fed stepped in to backstop EVERYTHING.
They immediately set up a bank lending facility called the Bank Term Funding Program.
The number one goal of this facility was to reassure the market and bullet proof the banks from any potential runs. FYI… the Fed handed out roughly $300 billion in loans in the first week.
Then Treasury Secretary Janet Yellen chimed in as well. According to the Wall Street Journal:
Ms. Yellen and other federal regulators used emergency powers to guarantee uninsured deposits at SVB and Signature…
“Our intervention was necessary to protect the broader U.S. banking system. And similar actions could be warranted if smaller institutions suffer deposit runs that pose the risk of contagion,” Ms. Yellen said.
That’s a pretty serious reaction to an “outlier” bank failure.
Again, therein lies the real uncertainty.
Was SVB an outlier?
What SVB’s failure last week showed, among other things, was that while a significant portion of most banks’ assets were held as Held to Maturity (HTM) and not showing up on their bottom lines, should they have to sell those securities, like SVB did, it could be catastrophic.
SVB lost nearly $2 billion on the sale of less than $20 billion in bonds.
According to a study by SSRN published the same week SVB failed:
The U.S. banking system’s market value of assets is $2 trillion lower than suggested by their book value of assets accounting for loan portfolios held to maturity.
Further they said…
Even if only half of uninsured depositors decide to withdraw, almost 190 banks are at a potential risk of impairment to insured depositors…
It’s a vicious circle…
Depositors withdrawing money drains liquidity from banks. Having to sell assets at a loss hurts the banks further. Which in turn sparks more people running to get their money out.
That means, at least as the Fed and the Treasury sees it, the one big (and ironic) threat that the system is facing is… their own depositors!
Just to Be Extra Safe…
And then, in an amazing knee jerk reaction, the Fed made another announcement last weekend…
At 5:00PM EDT on Sunday the Fed announced:
The Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, the Federal Reserve, and the Swiss National Bank… the central banks currently offering U.S. dollar operations have agreed to increase the frequency of 7-day maturity operations from weekly to daily. These daily operations will commence on Monday, March 20, 2023, and will continue at least through the end of April.
The network of swap lines among these central banks is a set of available standing facilities and serve as an important liquidity backstop to ease strains in global funding markets, thereby helping to mitigate the effects of such strains on the supply of credit to households and businesses.
The bottom line of all this is that the Fed has basically unleashed the Kraken to backstop what they wanted you to believe was a mid-sized bank’s liquidity crisis.
The regional banking sector isn’t convinced. As of this writing, the S&P Regional Banking ETF is down over 25% year to date.
SPDR S&P Regional Banking ETF (KRE)
Again, this isn’t what you do if the patient isn’t critical. The Fed may be mouthing the words that the banking system is sound, but their actions are saying something entirely different.
But even more than that, these actions collectively demonstrate how far out over its skis the US economy has gotten. About how dependent the entire economy has become on debt and cheap money.
In All the Excitement…
So what happened at the FOMC this week?
Well, to say the market went a bit schizophrenic over the Fed’s action and Powell’s comments might be putting it mildly. Have a look at the chart below…
S&P 500 (March 22)
The initial report of a 25 basis point hike sent the market soaring, likely on the basis of 1) relief that the wait was over and 2) that by bumping rates again, the Fed signaled that they were confident that all is well where the banking system goes.
Forward expectations by way of the (in)famous “dot plot” were largely unchanged:
FOMC SEP March Dot Plot
Then Powell stepped to the podium.
He started with a big reassurance that they believed everything was fine in the banking sector.
But things really got exciting when he dropped the “dove bomb” saying that the Fed would no longer state that ongoing rate increases are appropriate. Instead it was now their opinion that some further increases may be appropriate. That shift lit a fuse under the market.
At the end of the presser, however, a reporter asked whether a general tightening of credit conditions — caused by the current banking predicament — could lead to the Fed starting to ease again.
JPow said that cuts weren’t in the cards.
The rest was history.
It’s clear to anyone paying any attention the market is still screaming for cheap cash.
And the Fed knows it.
Powell and Co. now have its fire hoses pointed every which way they believe they need to, to pump liquidity anywhere it might be needed to reassure depositors their money really is safe in the bank.
We know the truth…
Make the trend your friend,
Editor, Streetlight Confidential