Yahoo Finance David Rosenberg: Even if this banking crisis is not a repeat of 2008, it won't be a picnic
Nobody seems to have any clue at this point about the degree of the damage already done in the current banking crisis or whether there are more shoes to drop. The knock-on effects from Silicon Valley Bank to First Republic Bank are now obvious, but the investor fear, whether rational or not, is spreading.
Shares of other regional lenders are under heavy pressure — US Bancorp shares slid 19 per cent to close last week, while Comerica Inc. was down more than 25 per cent. Zions Bancorporation shares sagged nearly seven per cent, and PNC Financial Services Group Inc. was off more than nine per cent. PacWest Bancorp and Western Alliance Bancorporation fell 25 per cent and 36 per cent, respectively. The overall KBW Nasdaq Bank Index is off 28 per cent so far this month.
Shrinking valuations
Banking sector valuations, in the aggregate, have shrunk a dramatic US$460 billion just in March alone, which is the sharpest implosion since March 2020 (the slides of March). But back then, the United States Federal Reserve was busy putting out the fire. We need a confidence boost, and we need it fast. Until we get clarity at the very least, and some sort of resolution, expect this meat grinder of a market, and the wild gyrations where an investor can lose US$100 million on a position in a matter of 10 minutes, to persist.
Banking sector crises, whether created by unjustified fears or not, only end with a catalyst. What’s it going to be this time? Resolution Trust Corp. (RTC)? A private investor saviour? Carl Icahn? Bill Ackman? Mark Cuban? Warren Buffett (who was reportedly in talks with the White House … and was the saviour, at least for a while, for Salomon Brothers Inc. in 1990, and for Goldman Sachs Group Inc. in 2008)? A TARP-like capital injection? Forced mergers (already happened with UBS Group AG and Credit Suisse Group AG)?
Let’s face it, the first round of responses hasn’t done squat to stem the problem. I don’t necessarily have the solution, but whatever the government cooks up, it has to be a measure or measures that bolster confidence. Something tells me that a process that leads to weak hands being absorbed by strong hands, as in a forced RTC-style consolidation and industry restructuring, may be the way to go in this regional bank sector that operated for years in the Wild West from a regulatory standpoint much like the S&Ls did in the 1980s.
Keep in mind one thing, we know the story about uninsured deposit concentration, but we don’t know about the quality of the assets on the balance sheets, especially with delinquency rates having already been on the rise, albeit from low levels, even before the cash-flow squeeze from the recession has started. That’s the next chapter of the story, as it shifts from bank liabilities to bank assets.
As for inflation, it seems lost on a whole lot of folks of how the oil price is still such a critical statistic in this regard. WTI closed the week down 13 per cent and that is with the Chinese reopening trade, and at sub-US$67 per barrel, it is now nearly half the cycle peak and at a 52-week low. Is this completely lost on the Fed? No other Fed has ever raised rates amidst a banking crisis, and that includes Paul Volcker in 1982 (Penn Square Bank) and 1984 (Continental Illinois National Bank and Trust Co.) — the funds rate came crashing down both times in the ensuing three to six months and, dare I say, with an inflation rate comparable to where we are today.
Fed Misstep?
But you see, this Jay Powell Fed is filled with hubris and excessive pride and will likely want to flex its anti-inflation credentials one more time. The futures see this as they are priced nearly two-thirds of the way for a 25 beeper this Wednesday. That will be a policy misstep (as Christine Lagarde decided to follow in Jean-Claude Trichet’s ill-fated footsteps last week). One more modest rate hike won’t accomplish much except to make navigating this banking sector crisis that much trickier, and the damage has already been done.
If the Fed does go for one this week, it’s the last one for the cycle. The futures market is dead on. The argument for the Fed to raise rates a further 25 basis points this week is that it’s better to do that and signal a conditional pause, rather than do nothing and have the press statement read with a hawkish message (that the Fed is by no means taking its eye off the inflation ball).
Ben Bernanke cleverly threaded the needle in the summer of 2008 by not tightening into the last leg of the commodity boom-induced inflation bulge, warding off all the Federal Open Market Committee hawks at the time by sounding tough in the press statement, but doing nothing (though Richard Fisher still dissented — nobody seems to remember that and nobody on CNBC ever questions him about that, especially given his current call for the Fed to keep on going).
The clearest argument for the Fed to stand pat is that the tightening in financial conditions this month, equivalent to nearly three 50-basis-point rate hikes, has done the job for the central bank and then some. Maybe the Fed should think of cutting rates instead to provide some offset to this tightening in financial conditions via the run-up in the debt and equity cost of capital and the heightened market volatility. That’s unlikely to happen, but there is a stronger case for that than to use rates to fight yesterday’s-story 12-month rate of inflation at six per cent that has shown no ability to seep into inflation expectations according to any measure, and a knowledge that the lags into the rental components of the consumer price index are going to see to it that inflation absolutely melts in the coming year.
Look at the 10-year implied inflation rate from the Treasury Inflation-Protected Securities (TIPS) market — it’s down to 2.1 per cent. Collapsing 85 basis points in the past year, no less. The five-year/five-year forwards are at the same level — to where they were in April 2019 ahead of a trio of Fed rate cuts in the second half of that year (and from a 2.5-per-cent peak). Come on, hasn’t the war been won?
Financial crisis waiting to happen
The one thing that is certain to be reinforced by these latest handwringing developments in the banking sector is that lending growth will weaken further and quite possibly contract. What people such as economist and former U.S. secretary of the treasury Larry Summers, as bright as he is, do not appreciate is that this credit event we are witnessing is deflationary.
Even prior to this current round of turbulence, the Fed senior loan officer survey showed that a net 61.1 per cent of banks had been tightening their credit guidelines in CRE loans (in the first quarter) compared to a net 16 per cent that were easing their standards a year ago. That is a massive shift. The other times in the past when credit guidelines for commercial real estate were at least this tight were in third quarter of 2020, the first quarter of 2008 to the second quarter of 2009, and the third and fourth quarters of 1990. All credit crunches. All recessions.
As for business credit — commercial and industrial loans — the small banks have really been tightening the reins here: net tightening of loan standards of 43.8 per cent this quarter compared with a net 9.4 per cent balance of banks easing a year ago. Again, we last saw this in the second and third quarter of 2020, second quarter of 2008 and first quarter of 2009, the first quarter of 2001 and the second quarter of 1990. No soft landings in these periods, I hate to tell you.
Why the aggressive credit tightening? Because this group of small banks isn’t so small, collectively with a near-record US$2 trillion of commercial real estate (CRE) loans on their balance sheet or 29 per cent of their asset base. The big banks only have US$850 billion or seven per cent exposure. Everyone talks about “underwater” Treasury securities (and agencies), but these represent 14 per cent of small-bank assets (25 per cent for the big banks).
These small banks have a higher concentration of their assets in CRE, which is an accident waiting to happen and the next shoe to drop, than is the case with the government securities that everyone is paying so much attention to. They also are much more liquidity-constrained seeing as their cash levels as a share of their asset base is down to a four-year low of six per cent (versus nine per cent for the large banks).
In the lead-up to the late-1980s S&L debacle, the small banks were small — collectively US$500 billion of assets. These have ballooned to nearly US$7 trillion and have expanded 240 per cent since the Great Financial Crisis as they became the lending valve with the large banks having spent so much time in the penalty box by the regulators. A credit crunch in the small-business sector this time is critical for the economic outlook because it now accounts for an unprecedented one-third of total banking sector credit (versus less than 20 per cent in the late 1980s) — a share that has soared eight percentage points since the Great Financial Crisis. They became a much more integral part of the credit pie and were far less regulated and supervised than their big bank brothers.
We all know this is not 2008-09 all over again and that the capital strength and liquidity ratios for the big banks are in a different orbit. But we also know that was true in 1989 as the S&L crisis got going, and one-third of the S&L space ended up being taken out of the system, wreaking havoc with the overall financial system, triggering a recession, a cycle of defaults, an elongated credit crunch, a plain-vanilla bear market in equities and a long bull market in Treasuries that saw the Fed end up cutting the funds rate reluctantly from the 9.875 per cent peak to three per cent at the early 1994 lows.
That was no walk through the park, and even the high-quality bank shares got whacked hard, though it did not end up bringing any big bank down as was the case in 2008-09.
Lightning never strikes twice, but what is a consistent pattern following every Fed tightening cycle that inverts the yield curve for many months is a financial crisis somewhere in the system. As such, we are merely living through history. That the big banks end up being just fine does not mean the economy escapes a recession or that we don’t endure a broad credit contraction and default cycle.
This ends with the weak banks being recapitalized and that can take on many forms (equity stakes, mergers) and government policy that instils confidence (so far lacking), and, of course, the Fed will be compelled at some point to cut rates and return the yield curve to its more normal positive slope.
David Rosenberg is founder of independent research firm Rosenberg Research & Associates Inc. You can sign up for a free, one-month trial on Rosenberg’s website.
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