Why Some Banks Are Buckling

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It's like the Goldilocks scenario. You did want higher rates and banks were a major beneficiary of higher rates, but you didn't want too much. And look, I mean, what we had was 500 basis points of rate hikes in 12 months. Which was very significant.

Hello and welcome to the Barron Streetwise Podcast. I'm Jack Howe, and the voice you just heard is Richard Ramsden. He leads bank coverage for a bank, Goldman Sachs, and he's just the guy to explain what the heck is going on with regional banks, all these lingering fears and occasional share price plunges. We'll also hear from a Princeton economist and historian who has made a study of the link between economic crises and globalization. And he says that what everyone thinks is about to happen now isn't about to happen. Was that, was that teasy enough? Was that too teasy? Did I not give enough info for that to qualify as a tease, or is that a tease?

Oh yeah, most definitely a teaser.

I might have under-teased. Listening in is our audio producer, Meta. Hi, Meta.

Hi, Jeff.

I go away for a week and another bank is seized by regulators and sold to a big bank. First Republic was sold to JPMorgan Chase. And now I'm back and there's another bank that has one of these sharp share price declines that gets everyone worried.. It's called PacWest Bancorp. It was down more than 23% this past Thursday. It's down about 80% for the year. And it's hard to tell with these banks because normally you'd look at a balance sheet and you'd say, well, there's, you know, this or that concern here. But what seems to happen is that you just hear from a bank that they had a sudden rush out the door of deposits and then the share price declines and that makes people more worried. And we see where it takes us. So how do you tell which one is next? It's a good question. It seems like you have to look at all kinds of metrics that people didn't think about in the past. Does this bank have a lot of depositors who are over the insurance limit, the FDIC insurance limit? Does it have a lot of depositors who kind of all look the same and might move as a group? Does the bank pay a rate of interest that is competitive with other banks? Or does it pay too little that might cause people to leave? And of course, you have to look at the assets the bank has bought. But I think the rules of sizing up these banks are shifting a bit and it's making investors nervous. One thing I'm struck by is that banks said for years, hey, just wait until interest rates are higher and we'll have better earnings because loan spreads were compressed. Banks were paying people close to zero. On their deposit accounts. And that was kind of a floor because banks generally don't want to charge their customers interest for savings accounts. Right. But then loan rates were way down. So banks weren't making as much money as they used to on the difference between what they charge for loans and what they pay on deposits. So the thinking was that when interest rates went back up, these loan spreads that had gotten squished would sort of plump back up and banks would have better results. But here we are with higher interest rates and it seems more worrisome than before. These are the kinds of questions that I put to Richard Ramsden, who covers banks for Goldman Sachs. We spoke Thursday morning, right, Mada? And that was just before the PacWest stock price plunge. Yep. And one of the things I asked him was, are these types of declines behind us. And you'll hear him say that disorderly bankruptcies, he thinks, are probably behind us because regulators are now so aware of the risks. He doesn't characterize what happened to First Republic as disorderly because it went into receivership and it was sold over a weekend. From a customer standpoint, he points out, there wasn't much of an impact. Let's hear that conversation. I've read with great interest your report on the state of banks. I want to try to figure out two things. One, whether we're going to have another bank-related blowup that's going to take down people's stock portfolios. And two, whether any of these banks out there look like attractive deals to you. Could I just start by asking you what has gone wrong and where we stand in it? I mean, I get that banks bought a lot of treasuries that went down in value and that created problems for them. What do you think are the root causes of the problems we've been seeing?

Well, look, I mean, this bank crisis obviously does look very different to ones that we've been through recently, especially 2008. You know, most bank crises come about when the economy is deteriorating, investors start to worry about credit quality, credit quality starts to get a lot worse, and that leads to concerns around the capital position of the banking system. I mean, this crisis has come about at a time that unemployment is very low and the economy is very healthy. And it's also happened at a time that bank capital ratios are actually relatively good compared to history. You know, so to your point, I think, look, this has really been more about liquidity issues in certain banks. And I think there's a couple of things that have happened here. The first is you talked briefly about this, which is, you know, banks had a lot of deposit inflows around COVID. Deposits grew 35% in the 2-year period around COVID. That happened at a time that loan demand was weak. So, Rather than redeploying those deposits into loans, they reinvested them into securities. And then obviously interest rates went up a great deal. They went up 500 basis points and those securities were underwater. That in itself wasn't the problem per se. The problem was the fact that that was coupled with deposit outflows in the banking system. So if you look at deposits from the peak, core deposits are down about 8 or 9%, and that caused some of these banks to have to sell securities at a loss. Crystallize those losses through their capital ratios. And that obviously caused some concerns. So this has really come about because of the very significant tightening of financial conditions. It's come about because of the deposit outflows. And it's also come about because obviously some banks really didn't think about duration and interest rate risk probably in the way that they should have done. I think they worked under the assumption that interest rates were going to remain low for a protracted period of time.

It seems like customers, depositors, you know, when rates were near zero, no one cared, no one asked what their banks were paying on deposits, but now the rates are meaningful. You know, you can get 4% and change. And that combined with mobile banking means that they can quickly move their money. Is that now a risk? Do you have to look across the bank landscape and say, not just what are your ratios, but what are you actually paying depositors? Are you not paying them enough? And is that putting you in a risky position?

I think that's exactly right. So look, two things are happening concurrently. I mean, the first is, look, depositors, especially uninsured depositors to a degree, are thinking like creditors, i.e., you know, they're asking the question, look, where is my money? And is there counterparty risk? You know, 'cause obviously if you are above the uninsured limit, which is $250,000, you know, there is a risk that in the event of, you know, the bank going into receivership, that you're not gonna be able to access your money or you may not get all of your money back. There has been money moving within the banking system and really it's been flowing from some of the smaller regionals to the large G-SIBs. And that's happening because the largest banks, the G-SIBs, globally systemically important banks, are just held to very, very different capital and liquidity requirements. You know, so if you are looking at where your money is purely through a counterparty lens, you know, it does make sense that money has gone to these large institutions that have obviously got just higher capital and higher liquidity requirements. The second thing that's happened is that money has also started leaving the banking system. And that money is leaving because there is a very significant difference in terms of rate that you can get on deposits relative to money market funds. So if you look at the first quarter of this year, the average rate paid on deposits across the US banking system was about 1.4%. You can get over 300 basis points more than that in a money market fund. And you're also protected in a money market fund in a different way in that It's typically in a custody account. So in the event of a bankruptcy, you know, you are treated differently relative to a bank depositor. So you have seen money flowing into money market funds, you know, mainly I think because of the yield differential. And that's something that obviously can continue. Now, the banking system is obviously responding. There's been a significant uptick in terms of special offers around things like CDs, and you have seen interest rates on deposits go up. But clearly in turn, that is putting pressure on funding costs for the banking system, which in turn is pressurizing profitability.

Any broad takeaways from first quarter earnings? Anything you saw there that people should know?

I mean, first quarter earnings feels like an eternity ago, but I point to a few things. I mean, the first is you are seeing this bifurcation in terms of deposit flow by bank. So in the first quarter of this year, about 3, You saw about 3% deposit shrinkage across the system. The largest banks only saw 1.5% deposit shrinkage. Obviously, some of the smaller institutions saw more than 10%. So there's a very significant bifurcation. Secondly, credit quality continues to be relatively benign. Obviously, there's a lot of focus on commercial real estate. And I think most banks actually did a good job just setting out what their commercial real estate exposure is and what the reserves are that they have, which I think was reassuring. And then I think the third thing is, you know, these banks do continue to build capital relatively quickly, just given the relatively high levels of profitability. You know, as banks have obviously benefited from rate hikes so far, and you have seen very considerable expansion of net interest margins in particular.

Two things I heard in conversations, you know, when I had an opportunity to speak with bank CEOs in recent years, they would say the The industry is very strong. The industry has gotten much stronger financially. And they would say, we're doing all right now, but just wait until interest rates rise. When interest rates rise, it's going to unlock some new profit potential and we're all going to be better off. And now interest rates have risen and banks are wobbling. Is there an optimal level for interest rates in order for the profitability of banks? Are we at it? Are we too high? Are we too low? What do you make of it?

You're exactly right. It's like the Goldilocks scenario. You did want higher rates and banks were a major beneficiary of higher rates, but you didn't want too much. And look, I mean, what we had was 500 basis points of rate hikes in 12 months, you know, which was very significant. So what banks saw was what they hoped to see, which is net interest margins expand because what they paid on deposits did not keep up with what happened to the policy rate. So obviously there was an expansion in what they were making. Between the funding part or the liability part of the balance sheet relative to the asset part. But I don't think what any of these banks were really expecting is that increasing rates at the speed that we've seen was going to lead to this liquidity drain out of the banking system. You know, so I think most banks were going into this thinking we're just going to see margin expansion, deposits are going to remain stable. And what we have seen is obviously very rapid shrinkage in deposits as rates have moved up so rapidly. And as that money has sought a higher yield. So I think to your point, what these banks would've preferred to have seen is a much more gradual increase in rates than what we've had. You know, and that I think would've given banks a lot more time to prepare in terms of hedging their balance sheet against some of the risks that we've seen. And I think it would've also probably led to less of a liquidity drain across the banking system.

Are we done with big bank scares? Call it big regional banks. Do you think another one of them might get into trouble in the months ahead? And what do you think will come of this in terms of a regulatory response? What will help the situation?

I think the disorderly bankruptcies are probably behind us in the following respect is I think Silicon Valley and Signature Bank, when they failed, I don't think anybody was really expecting that. So I don't think the regulators had really thought about what could happen. And certainly I don't think they had thought about potential buyers for failed banks going through the FDIC process because we haven't really seen much in the last 15 years. I think the regulators now are acutely aware of these risks. And I think there's a few things to keep in mind. The first is, as you saw with First Republic, it went into receivership on a Friday and it reopened on a Monday under obviously a different name, JP Morgan. But from a business disruption standpoint, as a customer of that bank, there wasn't much of an impact. And I think if there are additional failures, I think they're gonna follow that blueprint, which I think is important. And secondly, look, the regulators are now starting to respond. I mean, they have put in place some measures that I do think will help in terms of providing liquidity to the banking system. You know, one of the big measures they put in place was the Bank Term Funding Program, And that does allow banks to borrow at relatively attractive rates against their securities portfolio if they are seeing deposit outflows. And look, I think if things get worse from here, I think it's important to understand that there will be additional regulatory responses. So don't underestimate the ability of the Treasury and the Fed to put in place measures that will stabilize the banking system if things do deteriorate from here.

And lastly, Richard, should investors buy bank shares here? And if they should, should they prefer maybe the regional banks where they've seen prices beaten way down or the big banks that have come through this fine and might be in a situation where the strong are getting stronger?

I mean, we certainly have a preference for some of the larger banks because the risks I think are easier to assess, even though to your point, they have outperformed, but we are looking areas where we think the market has perhaps been too negative around the valuations. We certainly think there is value emerging in some of the super-regional banks. I think for the smaller banks, really the concern from here is what is the path for regulation? So what's making it very difficult to value some of the smaller banks is there is going to be increased regulation, which means increased capital requirements, increased liquidity requirements, which will translate to lower returns as well as higher costs. At this stage, it's just very difficult to calibrate what that means for the return on equity profile for some of those banks.

What are maybe two of those big banks that you and your team like here for investors?

So Bank of America and Wells Fargo are the two that we would look at. I mean, we do like JPMorgan. It's just outperformed considerably. Bank of America, there's been concerns around losses in the held-to-maturity book. We are not overly concerned about that at Bank of America because we do think their deposit base is going to be a lot more stable than others, so they don't need to crystallize those losses. And then Wells Fargo, we think, is an interesting idiosyncratic story around ability to reduce costs, the potential for the asset cap to be lifted, as well as a bank that actually has considerable excess capital, which is very valuable at this point in the economic cycle.

Thank you, Richard. Coming up, remember that segment I under-teased at the beginning of this episode? Let's give it tease now. Meta, I don't want to over-tease here. Let me know when I get high enough on the tease meter. We're going to speak with Harold James. He's an economic historian at Princeton University. He's the author of a book called Seven Crashes: The Economic Crises That Shaped Globalization. And we're going to talk about the pandemic and the effect that—

Hey, Jack, I think you're getting too teasy.

Good point. That's next after this quick break.

Data is everywhere, but is it ready for consumption? Morningstar developed the language of global investment data so you have the right ingredients to help you shine. Morningstar, where data speaks.

Welcome back. This past week we got a fresh reading on inflation. And separately, I had an opportunity to speak with Harold James. He's an economic historian at Princeton University, and he's the author of a new book called Seven Crashes: The Economic Crises That Shaped Globalization. Meta, I know what you're thinking. What does the subject of globalization and crises have to do with inflation? I'm going to make that link right now. I'm going to walk listeners from one to the other. It's going to require some dexterity. I'm going to limber up beforehand. If you played Eye of the Tiger, would we have to pay someone for that? Yes, I can hum it. Okay, let's hear it then. Oh, that's not humming. You know what? You know what? I already feel motivated. I feel like you've nailed it. You're welcome. Okay, so the latest number for CPI was 4.9%. 4.9% price growth from a year ago., and that ticked down from 5% the month before. It's the 10th month in a row that inflation has moved lower, and the inflation rate is now below the Fed funds rate. So if the Federal Reserve was raising interest rates to fight high inflation and inflation is now steadily coming down, it makes you think maybe the Fed is done with rate hikes for now. Maybe at some point they'll be able to bring interest rates back down, and that seems to be what the market is pricing in. Now, we've heard from people on this podcast who think that inflation will ultimately prove stickier than investors expect, that we're not going to go right back to these levels of price growth below 2%. And if you believe that, one reason might be a decline or reversal in globalization. Globalization was a force that for decades helped push price growth lower. The world manufactured more goods in low labor cost countries and then use cheap transport to bring them to countries with plenty of buying power. And that kept the prices that we all have seen at Walmart and car dealerships and so forth lower. During the pandemic, of course, we talked about supply chain bottlenecks. Some manufacturing centers were shut down. Shipping became enormously expensive. Companies had a hard time getting goods to customers who wanted to buy them. And then the question rose, did supply chains become too lean? Has there been too much focus on cost and efficiency and not enough focus on redundancy? Maybe we could use a little more fat. And now we hear more about reshoring and nearshoring, making more goods closer to markets where they're bought and consumed. And that would make supply chains more resilient, but it also might make for higher costs. So in other words, it's reasonable to conclude that this crisis, the pandemic, will lead to a period of deglobalization and that that could lead to higher prices than we'd otherwise have. And that's important for investors because it could lead to higher interest rates than we would otherwise have. And interest rates are closely related to asset prices and investment returns. But Harold James has made a study of past crises And he doesn't think that we're headed for deglobalization now.

There was a lot of talk about the end of globalization last year. Larry Fink and BlackRock had a famous analysis that said this is the end of globalization. Many, many people believe that the world is fragmenting or splitting up into blocks, and that's not really the pattern that I recognized in the past. What I saw in the past was that globalization has shock moments, but it reacts in very different ways according to the kind of shock that the world economy receives. And so demand shocks, where demand collapses, are characteristically associated with deglobalization, but supply shocks are actually associated in the end with a turn to more global opening and to more economic connectedness.

Harold has researched many past crises for the book. They were all, of course, associated with grief and loss and hardship, but not all of them had awful economic outcomes. There were examples of bad events that had positive long-term economic effects, and the, the difference has to do with whether they were prompted by a lack of supply or a lack of demand. So an example of a crisis that had negative long-term economic effects was the financial crisis of 2007-2008. Now, a harvest crisis in Europe in the middle of the 19th century, including the potato famine in Ireland in the 1840s, that was obviously a dreadful event. But Harold says it also started the first age of globalization because European countries needed food from other countries. He says the latest crisis, the pandemic, has made the world more interconnected, not the other way around.

If you just take the vaccines that were used to provide an answer to the pandemic, they take research and development and production in many, many different countries. And so the estimate for, for instance, the, um, Pfizer-BioNTech vaccine is that it requires bits, components, glass vials, delivery mechanisms, et cetera, from 24 different countries. It's a really brilliant example of the way in which the world is interconnected. And my reflection on that is that you are not going easily to get rid of that. If you think about it, it's just about conceivable that in a very, very large country, in the United States or in China, you might be able to move towards more national self-sufficiency. But if you think of what it's like in a small country or even a medium-sized European country, that's just not feasible. And yes, I mean, I think it's changing somewhat in the sense that China is expanding its connections with Vietnam or with Indonesia. But actually, you know, fascinatingly, since the outbreak of the pandemic in 2020, China-US trade has been increasing as well. So, you know, we see a lot of deglobalization in people's talking, but we don't see it in the figures, in the statistics.

Here's another example of how a crisis caused by lack of supply can lead to increased globalization, innovation, lower prices, and growth. In the 1970s, we had two oil shocks that made the cost of shipping go up dramatically. At the time, the containerization of global shipping, you know, the big ships with all those trucking containers stacked on top of them, that was still in its infancy. But the oil crisis helped it take off.

These negative supply shocks were in the past exactly the moment when already existing technologies were taken up but adopted widely and become transformative. Container shipping had been there for a long time, but it's only when trade becomes really expensive and difficult in the 1970s, that you start to use container ships in a big way.

Containerization ultimately drove shipping costs much lower and led to a boom in global trade. So that was a dividend that came from a crisis and led to a long stretch of growth.

We've got the same today. I think the way in which AI has been advancing, and also, by the way, the vaccine itself, the use of mRNA vaccines, they been around since the 1990s were used for really rare tropical diseases. Then in the pandemic, you saw that they could be used to fight the COVID infection, the virus. And now it's really eminently plausible that they're going to be used for a wide variety of common diseases, including many cancers.

I hesitate to call any of this a silver lining to the pandemic. If you're a member of a family who lost someone to the pandemic, there are no silver linings. Harold says the pandemic might ultimately yield a period of growth and lowering of costs in important areas.

You know, where the greatest squeeze on people's income was in the last 30 years, 40 years, was about medical costs, education costs, and housing costs. And all of those have been actually thrown into turmoil by the aftermath of the pandemic. Medicine, you know, much more telemedicine, much more remote medicine, use doctors in other countries, use AI to do diagnoses. It's got a radical cost reduction effect. Education, if you think of something like the Khan Academy, you know, this is offering first-class education for free to anybody who has an internet connection anywhere in the world. Housing, we don't need to live in major metropolitan cities anymore. So, you know, in the past you had to be in London or you had to be in New York. Now you can be somewhere else and go to meetings, you know, maybe a couple of times a month. But it's actually got long and profound transformative qualities. But when you say, are there likely to be more crises? Of course, because, you know, something like commercial real estate is really affected by this. And you think of the turmoil in US banking, it's to do to quite considerable extent with commercial real estate loans. And that's an adjustment issue, adjustment problem. People won't need that amount of office space.

Thank you, Harold. Harold mentioned office space and commercial real estate loans, and so did Richard earlier when he was talking about bank earnings. And we've had some listener questions on office REITs, real estate investment trusts. I think we should say something about that in the podcast. Is that next week, Meta? Yep. And we're also going to have— dare I tease— the CEO of a major car company. Can't tell you which one. Rhymes with schmoord.

That's all I'm going to say.

Now that's a tease. Thank you, Harold and Richard. And thank all of you for listening. If you have a question you'd like to hear answered on the podcast, just tape it on your phone, use the voice memo app, and you can send it to jack.hough@barons.com. Metta Lutzoff is our producer. You can subscribe to the podcast on Apple Podcasts, Spotify, or wherever you listen. If you listen on Apple, write us a review. Hey, public service announcement: if you do leave a review, um, don't tell me how much you like the dad jokes. Now, I know you mean well, but I want to raise awareness here for the dad community out there. This is an important issue, right, Meta? I mean, a dad joke. Not every joke that is told by a dad is a dad joke. Now, a dad joke is like a short and corny joke that's often pun-based. Let me give you an example that I read on a Reader's Digest list titled 100 and Something Dad Jokes That Are Actually Pretty Funny. Uh, none of them are pretty funny. Here's the joke: Why didn't Han Solo enjoy his steak dinner? I don't know. It was chewy. It was chewy. Now notice your lack of laughter. Meta. That's, that's a, that's a good—

something's wrong with my microphone.

I think that's a good indication that you've just heard a dad joke. That's just the kind of joke that we won't— I mean, except for now— that we won't typically be telling in this podcast. I'm a dad. Once in a while I make a joke. That doesn't make them dad jokes, folks.

I think that's probably a good place to leave it.

I had some more thoughts on the subject, but okay. Thanks and see you next week.

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