Latest thoughts on the banking sector (part 1)
Regional banks were crushed last spring as Silicon Valley Bank, Signature Bank, and First Republic Bank all went under...
This led to a panic that created some exceptional buying opportunities, which I handed to my readers on a platter. In my May 3 e-mail, I wrote:
I think these fears are way overblown and that yesterday's sell-off – and this hysterical, over-the-top, wrongheaded article – may mark a bottom for the sector...
If the banking sector truly does enter a crisis, the Fed can quickly cease or reverse its rate hikes, eliminating the bondholders' losses...
This is a fundamental difference between today's situation versus the global financial crisis, when banks had actual losses in their loan portfolios.
And as the sector tumbled again the next day, I quoted my friend, "the smartest bank analyst I know," who said:
This is simply false to say that 50% of the banks are insolvent. Yes, there are a big chunk that have seen their capital become thin on a mark-to-market basis, but there are very few that are truly insolvent.
I would agree though with all the commentary about the Fed having created a mess and being hell-bent on continuing to throw fuel into the fire by raising rates again today. The crazy thing is that they have really wounded the banking sector and the availability of credit is going to decline sharply, which will help calm inflation.
The other thing that the markets seem to have wrong is they don't realize that banks have reserved for loan losses and are still going to earn some money as we go through a potential credit cycle. Take Zions Bancorp for example: they have $618 million of loan loss reserves and are expected to earn another $800 million this year. Even if they only earn half of that they still have the power to cover a lot of credit losses.
Not that analysis seems to matter right now, as sentiment in the bank space is as bad as we can ever remember it...
The shorts are being very aggressive in some of the banks like MCB, WAL, ZION, etc. If there is even a hint of an improvement in deposit insurance, we could see a short squeeze for the ages that sends these stocks up 20%-plus in a matter of minutes, and many of them would still be dirt cheap.
Since May 3 through yesterday's close, shares of Metropolitan Bank (MCB), Western Alliance Bancorp (WAL), and Zions Bancorp (ZION) shares are up 150%, 137%, and 98%, respectively. That's good for an average gain of 128% versus the S&P 500 Index's 20% gain over the same time frame.
So are the stocks still buys – or at least holds – today? My friend thinks no...
By happenstance, I was skiing with him last week and he mentioned that he had sold all of his regional-bank stocks.
That caught my attention because he runs a hedge fund that only invests, long and short, in financial stocks, and I've never met anyone with more knowledge, connections, and insights in this sector – which is reflected in his exceptional track record, with only one down year in nearly two decades.
I immediately scheduled a nearly two-hour call with him, and he was also kind enough to share a 39-slide presentation he had recently prepared for his investors.
Now, I can't share the entire presentation because he wishes to remain anonymous. (Side note: It makes sense for hedge-fund managers to be very public, as I was, or very private, as my friend is, but nowhere in between.)
However, he gave me permission to share his latest thinking and a handful of the slides.
All of this is fascinating and important – not just for bank stocks, but also for the broader economy and markets – so I'm going to dedicate a series of e-mails to it, starting with today's...
To summarize his main points:
- There are many headwinds for the banking sector: continued high interest rates, credit risk, deposits declining and becoming more expensive, etc.
- As he puts it: "A pretty positive scenario has to play out for valuations to be warranted – bank stocks are priced for perfection."
- As such, he has sold all of his regional-bank stocks, including MCB, WAL, and ZION.
- He does, however, continue to hold one mega-cap bank, Wells Fargo (WFC), and a handful of small-cap and microcap banks that are special situations.
Regarding the macro environment, my friend started by showing me this slide, which shows that nearly half of the $26 trillion of marketable outstanding U.S. Treasury debt matures in the next two years:
His main question/concern is: who's going to buy it?
The Federal Reserve and banks have been the big buyers in the past, but he thinks both of them will be buying a lot fewer Treasurys going forward.
Regarding the former, it's quite simple. After a huge surge to offset the damage caused by the pandemic, the Fed is now shrinking its balance sheet:
Sharp-eyed readers might wonder what that little spike was early last year...
My friend explained that after the Silicon Valley, Signature, and First Republic banks collapsed, the Fed quickly set up the Bank Term Funding Program ("BTFP").
This allowed banks to borrow against their securities portfolio – critically, at par value rather than the lower market value (incidentally, he thinks had this program been in place earlier, it would have saved Silicon Valley Bank and probably Signature Bank, but not First Republic Bank).
During the crisis, many banks rushed to take advantage of this program, plus the discount window, which is what caused the brief spike before the Fed continued to shrink its balance sheet:
So it's easy to see why the Fed won't likely be buying as many Treasurys as in the past. But what about banks?
My friend's analysis starts with the $5 trillion of pandemic-era stimulus that flowed into the economy – nearly 4 times the level of stimulus that occurred during the global financial crisis:
This tidal wave of cash caused an unprecedented surge in banks' deposits in 2020 and 2021:
However, this has caused two huge problems...
First, deposits are now shrinking back to more normal levels... which means banks have to come up with a lot of cash to give back to their customers.
Second, banks took the excess cash during the pandemic and did what they always do: made loans and bought fixed-rate securities.
But remember what interest rates did at exactly that time? They had plunged to all-time lows, as the Fed cut rates to zero in response to the pandemic. This meant that banks were making loans and buying securities at ultra-low interest rates.
Then, as inflation took off, the Fed hiked rates faster than any other time in history, crushing the value of those loans and securities – and triggering the banking crisis last spring:
I'll continue this story tomorrow... Stay tuned!
Best regards,
Whitney
P.S. I'm flying to Switzerland later this evening to attend my friend Guy Spier's annual VALUEx conference in the Swiss ski town of Klosters tomorrow and Thursday. Maybe I'll get lucky and another friend will share great insights with me on a chairlift!
P.P.S. I welcome your feedback – send me an e-mail by clicking here.