The mini-Banking Crisis is (mostly) over. That’s no reason to relax
In my nearly 20 years in investments there’s one rule that seems to work under any circumstance: Warren Buffet’s “Only when the tide goes out do you discover who's been swimming naked.”
While SVB and Credit Suisse’s failures inescapably evoke images of 2008, we were fairly confident that the latest turmoil wouldn’t turn out to be a Lehman moment. Lehman was an accident, fostered by a year-long credit crunch and triggered by bad judgement calls from governments and regulators. The lessons were well learned. Central banks have made sure that there’s enough liquidity at all times and are ready to release trillions at the blink of an eye.
Treasuries, governments and legislatures are also more sensitive to the dangers of economic instability and contagion. This makes them quicker to react, assured that they will not be faced with a widespread populist revolution for saving the financial system. Assurances that liquidity is ample have eased tensions. Use of deposit Fed liquidity facilities remains significant, but at least it has levelled out.
But the US regional banks that failed and Credit Suisse had something in common. They were troubled entities. SVB didn’t have a risk officer and didn’t properly hedge its bond exposure. Credit Suisse was mired in scandal and hadn’t properly transitioned towards a new banking model. If not for years of quantitative easing, they may have failed earlier.
Cheap lending unavoidably gives rise to moral hazard. Companies with failed business models can easily borrow to keep surviving. Restructuring has risks, and could scare shareholders. Why not just shove everything under a cosy liquidity blanket? This also prevents new competitors with healthier and more innovative approaches from taking market share. Incumbents tend to have higher capitalisation and easier access to capital. However, when liquidity subsides, the weak are quickly exposed, the market cleanses itself and a cycle of growth and moral hazard begins anew.
However, the previous cycle was unusually long, lasting for a decade and a half. Not only that, but the market had become convinced that the absence of inflation and the entrenchment of “secular stagnation”, a trend of subdued consumer demand, would keep rates low forever. After all, high levels of global debt created a huge disincentive towards higher rates. So, CFOs naturally acted on that. They borrowed not only to stay alive, but to expand, to pay dividends and to buy out the competition with less access to market capital.
Thus, many a bad business model survived and thrived. But the return of inflation and higher interest rates are now exposing areas of weakness. Troubled banks may not necessarily initiate a 2008-style contagion event. Rather, they may act as canaries in a coalmine to warn markets of dangers that lie ahead.
So what are the immediate areas of risk we should be focusing on?
Commercial Real Estate. The pandemic changed “The office” forever. A recent survey by the ONS suggests that of those workers who can work in a hybrid fashion, three out of four do. More so in major metropolitan areas, where the commute tends to be more tedious. Offices are emptier on Mondays and Fridays. By some accounts, office usage is down 20% since before the pandemic. Companies are looking to reduce the office cost. In Europe, where the problem is more pronounced (and banks weaker due to the structure of the Eurozone), the commercial real estate market is worth $1.4tr with banks financing most of it. We are not certain exactly what sort of write-downs we are faced with, but the CRE market has only begun to stress the financial system.
Residential real estate. Higher rates have crushed demand for new homes, as fewer people can afford to buy one. House prices are coming down across the board. In the UK, according to Rightmove, we are seeing the worst conditions in twelve years. Banks could soon be faced with asset write-downs and higher delinquencies.
Private Equity Market. The plan of regulators since the GFC had been to reduce bank risks, and transfer those risks to private, non-systemic individuals. Banks were heavily regulated out of proprietary investing and unfettered loan expansion, and private equity funds were happy to pick the mantle. For a decade, fortunes were made by financing primarily tech start-ups. But as rates went up, financing dried up. Exorbitant valuations created by high entry multiples are now coming down. Private equities may not have deposits. But their owners could find themselves in need to cover losses, which means they could take money off financial markets.
Zombies. The more pronounced cross-industry risk is all sorts of zombie companies. Enterprises who have survived and even thrived solely due to low rates. A few bankruptcies here and there won’t make a huge difference. But perversely, as higher capitalisation companies had the more access to cheap capital, it is those bigger players that will have been most undisciplined. When big names are involved and when they happen in sequence, they could severely affect markets. 2008 wasn’t just a story of Lehman. It was a story about AIG, General Motors and others.
We are at an age of high macroeconomic volatility and profound policy uncertainty. Investors looking at short-term movements in bond and equity markets must not be too quick to think “markets believe” something, or “markets are positioned” for something else. The recent turmoil in Deutsche Bank’s CDS was down to a few trades. Bullishness, or bearishness, these days is more a matter of reaction than careful strategic thinking. The short-term, “fast” money markets are all over the place. It is the job now of sanguine long term investors to cut, methodically and for as long as it takes, through the noise.