On The Verge of a Credit Crunch or Crisis?

By

Hakyung Kim and Sarah Min of CNBC report stocks close higher Friday as investors try to shake off latest bank fears:

Stocks rose Friday after a volatile trading session. Although Friday began with fears that the banking crisis was spilling over to Deutsche Bank, the markets rebounded to end the week on a higher note.

The Dow Jones Industrial Average gained 132.28 points, or 0.41%, closing at 32,237.53. The S&P 500 rose 0.56%, while Nasdaq Composite ticked up 0.3%. The major indexes all had a winning week, with the Dow gaining 0.4% week-to-date as of Friday afternoon, while the S&P 500 and Nasdaq gained 1.4% and 1.6%, respectively.

One factor that helped the market was a bounce back in regional bank stocks. The sector rallied on Friday, with the SPDR S&P Regional Banking ETF gaining 3.01% during the trading session. Amid all the volatility, the KRE ended the week up 0.18%.

A selloff of Deutsche Bank’s U.S.-listed shares Friday morning put downward pressure on market sentiment and the major indexes, before the bank recovered some of its earlier losses. Deutsche Bank closed 3.11% lower Friday, rebounding from a 7% drop earlier in the trading session.

A selloff of shares was triggered after the the German lender’s credit default swaps jumped, but without an apparent catalyst. The move appeared to raise concerns once again over the health of the European banking industry. Earlier this month, Swiss regulators forced a UBS acquisition of rival Credit Suisse. Deutsche Bank shares traded off their worst levels of the session, which caused major U.S. indexes to also cut their losses.

“I think that the market overall is neither frightened nor optimistic — it’s simply confused,” said George Ball, president at Sanders Morris Harris. “The price action for the last month-and-a-half, including today, is a jumble without any direction or conviction.”

European Central Bank President Christine Lagarde tried to ease concerns, saying euro zone banks are resilient with strong capital and liquidity positions. Lagarde said the ECB could provide liquidity if needed.

Investors continued to assess the Fed’s latest policy move announced this week. The central bank hiked rates by a quarter-point. However, it also hinted that its rate-hiking campaign may be ending soon. Meanwhile, Fed Chair Jerome Powell noted that credit conditions have tightened, which could put pressure on the economy.

On Thursday, Treasury Secretary Janet Yellen said regulators are prepared to take more action if needed to stabilize U.S. banks. Her comments are the latest among regulators attempting to buoy confidence in the U.S. banking system in the wake of the Silicon Valley Bank and Signature Bank closures.

Ball said that Deutsche Bank is “very sound financially,” noting that the market was “overreacting” in wake of the earlier bank failures.

″[Deutsche] could be crippled if there’s a big loss of confidence and there’s a run on the bank. There is, however, no fundamental reason why that should occur, other than nervousness.”

Elliott Smith of CNBC also reports Deutsche Bank is not the next Credit Suisse, analysts say as panic spreads:

Deutsche Bank shares slid Friday while the cost of insuring against its default spiked, as the German lender was engulfed by market panic about the stability of the European banking sector.

However, many analysts were left scratching their heads as to why the bank, which has posted 10 consecutive quarters of profit and boasts strong capital and solvency positions, had become the next target of a market seemingly in “seek and destroy” mode.

The emergency rescue of Credit Suisse by UBS, in the wake of the collapse of U.S.-based Silicon Valley Bank, has triggered contagion concern among investors, which was deepened by further monetary policy tightening from the U.S. Federal Reserve on Wednesday.

Central banks and regulators had hoped that the Credit Suisse rescue deal, brokered by Swiss authorities, would help calm investor jitters about the stability of Europe’s banks.

But the fall of the 167-year-old Swiss institution, and the upending of creditor hierarchy rules to wipe out 16 billion Swiss francs ($17.4 billion) of Credit Suisse’s additional tier-one (AT1) bonds, left the market unconvinced that the deal would be sufficient to contain the stresses in the sector.

Deutsche Bank underwent a multibillion-euro restructure in recent years aimed at reducing costs and improving profitability. The lender recorded annual net income of 5 billion euros ($5.4 billion) in 2022, up 159% from the previous year.

Its CET1 ratio — a measure of bank solvency — came in at 13.4% at the end of 2022, while its liquidity coverage ratio was 142% and its net stable funding ratio stood at 119%. These figures would not indicate that there is any cause for concern about the bank’s solvency or liquidity position.

German Chancellor Olaf Scholz told a news conference in Brussels on Friday that Deutsche Bank had “thoroughly reorganized and modernized its business model and is a very profitable bank,” adding that there is no basis to speculate about its future.

‘Just not very scary’

Some of the concerns around Deutsche Bank have centered on its U.S. commercial real estate exposures and substantial derivatives book.

However, research firm Autonomous, a subsidiary of AllianceBernstein, on Friday dismissed these concerns as both “well known” and “just not very scary,” pointing to the bank’s “robust capital and liquidity positions.”

“Our Underperform rating on the stock is simply driven by our view that there are more attractive equity stories elsewhere in the sector (i.e. relative value),” Autonomous strategists Stuart Graham and Leona Li said in a research note.

“We have no concerns about Deutsche’s viability or asset marks. To be crystal clear - Deutsche is NOT the next Credit Suisse.”

Unlike the stricken Swiss lender, they highlighted that Deutsche is “solidly profitable,” and Autonomous forecasts a return on tangible book value of 7.1% for 2023, rising to 8.5% by 2025.

‘Fresh and intense focus’ on liquidity

Credit Suisse’s collapse boiled down to a combination of three causes, according to JPMorgan. These were a “string of governance failures that had eroded confidence in management’s abilities,” a challenging market backdrop that hampered the bank’s restructuring plan, and the market’s “fresh and intense focus on liquidity risk” in the wake of the SVB collapse.

While the latter proved to be the final trigger, the Wall Street bank argued that the importance of the environment in which Credit Suisse was trying to overhaul its business model could not be understated, as illustrated by a comparison with Deutsche.

“The German bank had its own share of headline pressure and governance fumbles, and in our view had a far lower quality franchise to begin with, which while significantly less levered today, still commands a relatively elevated cost base and has relied on its FICC (fixed income, currencies and commodities) trading franchise for organic capital generation and credit re-rating,” JPMorgan strategists said in a note Friday.

“By comparison, although Credit Suisse clearly has shared the struggles of running a cost and capital intensive IB [investment bank], for the longest time it still had up its sleeve both a high-quality Asset and Wealth Management franchise, and a profitable Swiss Bank; all of which was well capitalised from both a RWA [risk-weighted asset] and Leverage exposure standpoint.”

They added that whatever the quality of the franchise, the events of recent months had proven that such institutions “rely entirely on trust.”

“Where Deutsche’s governance fumbles could not incrementally ‘cost’ the bank anything in franchise loss, Credit Suisse’s were immediately punished with investor outflows in the Wealth Management division, causing what should have been seen as the bank’s ‘crown jewel’ to themselves deepen the bank’s P&L losses,” they noted.

At the time of SVB’s collapse, Credit Suisse was already in the spotlight over its liquidity position and had suffered massive outflows in the fourth quarter of 2022 that had yet to reverse.

JPMorgan was unable to determine whether the unprecedented depositor outflows suffered by the Swiss bank had been amassed by themselves in light of SVB’s failure, or had been driven by a fear of those outflows and “lack of conviction in management’s assurances.”

“Indeed, if there is anything depositors might learn from the past few weeks, both in the U.S. and Europe, it is just how far regulators will always go to ensure depositors are protected,” the note said.

“Be that as it may, the lesson for investors (and indeed issuers) here is clear – ultimately, confidence is key, whether derived from the market backdrop as a whole (again recalling Deutsche Bank’s more successful re-rating), or from management’s ability to provide more transparency to otherwise opaque liquidity measures.”

It's incredible that German Chancellor Olaf Scholz told a news conference in Brussels on Friday that Deutsche Bank had “thoroughly reorganized and modernized its business model and is a very profitable bank,” adding that there is no basis to speculate about its future.

What is that all about? Official denial at the highest level is usually done when something very wrong is going on, even if analysts are screaming that Deutsche Bank isn't Credit Suisse:

If we all learned one lesson, banks are all about confidence, the minute clients lose confidence, there's a big problem no matter what government officials state. 

We know concerns around Deutsche Bank have centered on its US commercial real estate exposures and substantial derivatives book, and one thing I can tell you is people are very nervous about commercial real estate loans these days:

Any bank that has high exposure to commercial real estate loans is getting thoroughly vetted these days:

That goes for banks, insurance companies, private equity funds and even pension funds (you better know what you're underwriting and have tight lending standards).

In his Friday afternoon comment, Jeff Cox of CNBC reports that early $100 billion in deposits pulled from banks but officials call system ‘sound and resilient’:

Regulators again assured the public that the banking system is safe, as fresh data showed customers recently pulled nearly $100 billion in deposits.

Treasury Secretary Janet Yellen, Federal Reserve Chairman Jerome Powell and more than a dozen other officials convened a special closed meeting of the Financial Stability Oversight Council on Friday.

A readout from the session indicated that a New York Fed staff member briefed the group on “market developments.”

“The Council discussed current conditions in the banking sector and noted that while some institutions have come under stress, the U.S. banking system remains sound and resilient,” the statement said. “The Council also discussed ongoing efforts at member agencies to monitor financial developments.”

There were no other details provided on the meeting.

The readout, released shortly after the market closed Friday, came around the same time as new Fed data showed that bank customers collectively pulled $98.4 billion from accounts for the week ended March 15.

That would have covered the period when the sudden failures of Silicon Valley Bank and Signature Bank rocked the industry.

The withdrawals brought total deposits down to just over $17.5 trillion and represented about 0.6% of the total. Deposits have been on a steady decline over the past year or so, falling $582.4 billion since February 2022, according to the Fed data released Friday.

Earlier this week, Powell also sought to assure the public that the banking system is safe.

“You’ve seen that we have the tools to protect depositors when there’s a threat of serious harm to the economy or to the financial system, and we’re prepared to use those tools,” Powell said Wednesday during a news conference that followed the Fed’s decision to hike benchmark interest rates another quarter percentage point. “And I think depositors should assume that their deposits are safe.”

Powell noted that deposit flows “have stabilized over the past week” following what he called “powerful actions” from the Fed to backstop the system.

Banks have been flocking to emergency lending facilities set up after the failures of SVB and Signature. Data released Thursday showed that institutions took a daily average of $116.1 billion of loans from the central bank’s discount window, the highest since the financial crisis, and have taken out $53.7 billion from the Bank Term Funding Program.

Indeed, the Fed has backstopped banks through its discount window which is why its balance sheet has been rising the last couple of weeks:

So much for the era of tight money, but I warn my readers to be very careful interpreting the supposed run on banks because while overall deposits fell by $98 billion between March 8 and March 15, they rose $67 billion at the 25 largest banks:

This is what you'd expect as clients (retail + corporate) pull out of regional banks and search for the safety of larger banks.

What else would you expect? You'd expect a lot of corporate and high net worth accounts are buying Treasuries to make sure their deposits are safe:

I doubt the Fed is instructing banks to buy Treasuries, rather its financial conditions which are tightening, making banks less prone to lend money as a looming recession lurks on the horizon.

Of course, the Fed welcomes tighter lending standards, they act like an increase in rates, taking the pressure off it to hike more aggressively:

But the failure of SVB and other regional banks will call for tougher regulations on these smaller banks:

However, let there be no mistake about it, the Fed isn't going to save regional banks at the expense of fighting inflation, this is nonsense:

I'll tell you what else is nonsense, that US banks are sitting on $1.7 trillion of unrealized losses:

Take these figures with a shaker of salt!

I spoke with a former CDPQ fixed income trader earlier today who is very sharp and he told me the following:

Most of the problems are in regional banks which were deregulated in 2018 during Trump's presidency. The big banks were heavily regulated after the GFC, they properly matched long duration liabilities as rates rose last year. The small regional banks borrowed short to invest long and when the curve inverted, they ran into big problems because they weren't hedging properly and nobody was regulating them. Importantly, this wasn't a credit problem, it's a duration problem.

But the Fed doesn't care about a few smaller regional banks going under. It tightens credit conditions which make its job easier as it doesn't need to raise rates by as much. The Fed only cares about systemically important banks and they're fine. 

This is why I disagree with market expectations that rate cuts are coming in the second half of the year. I don't see a depression and I don't think the Fed is pivoting anytime soon. It's just that it will reach its terminal rate faster as credit conditions tighten and then stay put for a long time.

Well, I agree with him the fed is likely to stay put for a long time IF nothing breaks in the market but I see a hard landing ahead and I agree with Francois Trahan, the banking issues we are seeing now are symptomatic of an economy where rates have risen fast (from zero base) and are only now starting to work their way through the economy:

What else? I agree with Joaquin Kritz Lara, Chief Economist & Strategist at Numera Analytics who wrote this on LinkedIn:

Fed remains tough on inflation

The FOMC opted to raise the benchmark Federal funds rate by 25bps yesterday, citing concerns of inflation risks stemming from the labour market.

Importantly, the Fed Board maintained its forecast for the benchmark rate at 5.1% this year. This is in stark contrast with market expectations, which, following the turmoil in the banking sector last week, are now ‘pricing in’ a policy pivot by mid-2023.

As shown below, our models suggest that markets also remain overly optimistic on inflation. Our latest baseline projection is for CPI inflation in the US to overage 3.3% over the next 3 years.

I shared my own thoughts on LinkedIn:

My take: That all-elusive Fed pivot everyone is waiting for might happen if something huge breaks in financial markets necessitating a flood of liquidity but this will NOT be bullish for risk assets, they're going to get killed. More worrisome, what if the Fed pauses, nothing breaks in markets, the economy slows but wage inflation picks up (stagflation), forcing the Fed and other central banks to come back later this year and hike rates more aggressively? This too will kill risk assets.

Francois Trahan has stated many times he hasn't seen a worse macro backdrop in a very long time. I concur, too much complacency out there, lots of Nasdaq FOMO, when the real nasty bear market strikes, a lot of portfolio managers chasing yield are going to get slaughtered. Enjoy the calm before the storm.

Right now, I see plenty of risks in risk assets, especially stocks where Nasdaq FOMO still reigns even if we are on the precipice of a nasty and prolonged earnings recession:

Once earnings start to disappoint, I expect the Nasdaq will sink fast below the 10,000 level and keep sinking lower:

Right now, three mega tech stocks -- Apple, Microsoft and Nvidia -- are driving the recent gains in the Nasdaq, especially Nvidia (aka, hedge funds' beta beast), which is why the Technology Select Sector SPDR Fund (XLK) has held on nicely (those three stocks make up over 50% of this ETF; drop in long bond yield also help):

But I think the rally in long bond yields is overdone in the short run and the backup in yields will impact tech stocks and stocks in general:

And one of the leading indicators I use are small cap shares (IWM) which are set for another steep selloff even if they've been in a trading range lately:

By the way, no surprise, even big banks have been getting hurt lately led by Bank of America:

I leave you with some parting thoughts on why the Fed sees a looming credit crunch:

It's an old saw: A credit crunch is when your bank won't lend to you. A credit crisis is when banks won't lend to each other.

Federal Reserve Chair Jerome Powell said Wednesday Silicon Valley Bank's collapse and the banking system upheaval it triggered "are likely to result in tighter credit conditions for households and businesses, which would in turn affect economic outcomes."

In other words: a credit crunch is coming.

Credit crunches are not new. They are frequent fellow travelers with recessions, but not always so. They also come with varying severity and durations, key factors Powell said remain unknown at the current time. Some small and concentrated crunches can weigh on growth without bringing the full economy to a standstill. Deeper lending clamp-downs can hobble the economy for years.

Here's a look at some of the dynamics from past credit crunches in comparison with what has been observed to now in the current episode.

CRUNCH VS CRISIS

Total credit from commercial banks - consisting of their bond holdings and the full scope of loans to businesses and consumers, from routine business credit and commercial real estate loans to residential mortgages and credit cards - is just off its record high from mid-February.

But the credit growth rate has recently fallen below its historic average to a level that has often been associated with a recession. Overall annual credit growth rarely turns negative, but when it decelerates into the low single-digits as it has now, it shows that the lending that helps fuel overall economic growth is under strain.

Only once since the early 1970s has it actually turned negative, in the aftermath of the 2007-2009 financial crisis. That was indicative of the lasting restraint that episode had on the recovery in credit and economic growth overall.


LESS RISK

When credit conditions tighten, among the first categories of borrowers to feel the pinch are those with lower means or with poorer credit profiles as banks pull back from risk. One place to watch for that dynamic is in the issuance of subprime auto loans.

New York Federal Reserve data shows those volumes hit the highest in nearly two decades in the middle of last year, but had slowed somewhat by year end, though on balance were at the upper end of volumes seen before the pandemic. In the last big credit clamp-down, those loan volumes fell by two-thirds between 2005 and 2009.


CONSUMERS VS BUSINESS

When overall credit conditions tighten, banks usually rein in loans to both consumers and businesses alike, though not always to the same degree and not always at the same moment.

And sometimes special factors will create a pinch for one but not the other. That was the case 8-10 years ago when low oil prices triggered a credit crunch among U.S. oil fracking companies, weighing heavily for a period on overall commercial loan growth while consumer loan growth kept improving.

Excluding the COVID-19 recession - when commercial loan volumes were distorted by pandemic relief efforts for businesses - business credit has suffered the bigger blow in the recessions so far this century. Consumer credit was particularly slow to recover from the 2007-2009 meltdown because of the centrality of residential mortgages and the housing market to that crisis.

Annual growth in the two categories appears to have peaked around the middle of last year, though both remain at around 10% or more - well above the historic average growth rate of about 6.5%.


BANKS IN NEED

When banks find they cannot get the funding they need from traditional sources - one another - they turn to the Fed, borrowing from its "discount window," long dubbed the lender of last resort.

In 2008, the explosion of its use was a clear signal that crunch had turned to crisis as it showed that banks, wary of the stigma associated with turning to the discount window, had run out of other options.

But the Fed has since taken steps to de-stigmatize the discount window, including lowering the penalty interest rate it traditionally charged. It saw widespread use during the early months of the pandemic and usage spiked again in the last two weeks after Silicon Valley Bank's collapse.

And banks aren't the only ones turning to cash, so are retail investors scared to invest in these markets:

That should be bullish for markets but in this case, it isn't bullish, it's an ominous warning signal.

Alright, let me wrap it up there, wish everyone a great weekend.

Below, Fred Tomczyk, former TD Ameritrade CEO, joins 'Closing Bell: Overtime' to discuss how investors should add balance to their portfolio, classic mistakes investors make in this environment and more.

Second, Brian Levitt, Invesco global market strategist, and Brad McMillan, Commonwealth Financial Network CIO, joins 'Closing Bell: Overtime' to discuss the market's second straight positive week, McMillan's thoughts on bond markets and more.

Third, Ron Insana, Contrast Capital partners co-CEO, joins 'CNBC’s ‘Power Lunch’ to discuss why he thinks the Fed has gone too far and helped trigger the ongoing banking crisis and the rising risk of recession.

Fourth, Wharton School Professor Jeremy Siegel joins ‘Closing Bell’ to discuss whether the stock market should be more worried about the message coming from bonds following the Fed's latest rate hike this week and more.

Lastly, Ed Clissold, chief U.S. strategist at Ned Davis Research, joins 'Closing Bell' as tech stocks have outperformed this year while investors flock to the sector amid more rate hikes and bank turmoil.

Comments

Post a Comment