Bill Ackman is worried about financial contagion … UBS buys Credit Suisse … how big is the problem? … how Louis Navellier would fix the issue … a potentially dangerous side-effect
The nation’s biggest banks have swooped in and come to the rescue of First Republic Bank…
Meanwhile, UBS has swooped in and come to the rescue of Credit Suisse…
But are these actual “rescues?” Or more like “financial super-spreader events”?
Let’s begin with First Republic…
Last Friday, we learned that the biggest banks in the U.S. will contribute billions of deposits toward troubled First Republic Bank.
Bank of America, Citi, and Wells Fargo are on the hook for $5 billion each. Goldman Sachs and Morgan Stanley have signed up for $2.5 billion each. And PNC Financial, BNY Mellon, Truist, U.S. Bancorp, and State Street will pony up $1 billion per head.
On the surface, this is great news. The big banks that are well-capitalized are stepping into the void to save the day.
But here’s billionaire hedge fund manager Bill Ackman and his alternate perspective:
[First Republic Bank] default risk is now being spread to our largest banks.
Spreading the risk of financial contagion to achieve a false sense of confidence in [First Republic Bank] is bad policy.
The [systemically important banks] would never have made this low return investment in deposits unless they were pressured to do so and without assurances that [First Republic Bank] deposits would be backstopped if it failed…
We need to stop this now. We are beyond the point where the private sector can solve the problem and are in the hands of our government and regulators.
Tick-tock.
Meanwhile, over the weekend, in an emergency deal brokered by Swiss authorities, UBS has now purchased Credit Suisse.
I should point out that the purchase price was less than half of Credit Suisse’s market valuation as of Friday’s close. And about $17.3 billion of Credit Suisse bonds are now worthless.
Reports are that without this deal, Credit Suisse would have collapsed this week.
Clearly, there’s contagion in the banking sector. But how worried should we be?
Going back to Ackman, he isn’t beyond fearmongering for his own opportunistic gains.
You may recall his doomsday prediction at the beginning of the pandemic “hell is coming” that helped drive a massive market selloff…which netted Ackman $2 billion in profits on his short position against the market.
In answering “how worried should we be?” we have to define the problem and then ask how much exposure to the problem there is
So, what’s the issue? Is this Lehman Pt II?
Not so much. At least not for the U.S. regional banks.
The Lehman collapse was due to insolvency issues from big banks. In other words, due to all the toxic, highly-leveraged mortgage-backed securities the big banks had on their balance sheets, when asset values plummeted, it kneecapped assets relative to liabilities. The bank’s overall losses were greater than the value of some of the banks themselves.
The issue today is more so profitability and liquidity risk.
In short, back when times were good, these failing banks loaded up on government bonds. As the Fed has charged forward with raising interest rates, the value of those bonds crashed, resulting in unrealized losses.
Now, normally, the banks could just ride this out by holding the bonds until maturity. That would avoid having to turn an unrealized loss into an actual loss.
But these aren’t normal times. We have a heavily inverted yield curve that hurts banking revenues and profitability. Some depositors began to grow uneasy with Silicon Valley’s overall health and pulled out their money.
That snowballed, adding to liquidity strains. The bank was forced to sell some of its underwater bond holdings, which locked in big losses.
Silicon Valley Bank tried to resolve things by offering new stock shares to raise liquidity. More investors saw this, panicked at the implications, then yanked their money out of the bank, which made everything worse.
Rinse and repeat.
How big is this issue?
It’s hard to say. The big banks should be in good shape due to much stronger balance sheets (even though Ackman fears contagion).
But we’re not only dealing with the big banks. Obviously, smaller banks plus non-regulated lenders have exposure to bond losses.
Here’s CNN Business:
…SVB isn’t the only institution with [losses from bonds].
US banks were sitting on $620 billion in unrealized losses (assets that have decreased in price but haven’t been sold yet) at the end of 2022, according to the FDIC…
“Many institutions — from central banks, commercial banks and pension funds — sit on assets that are worth significantly less than reported in their financial statements,” said Jens Hagendorff, a finance professor at King’s College London.
“The resulting losses will be large and need to be financed somehow. The scale of the problem is starting to cause concern.”
As to “financing” these losses, well, that’s what the big banks are doing with First Republic. And that’s the move that has Bill Ackman worried.
He’s not wrong to be concerned, but there’s no guarantee his concerns will come to fruition. No one really knows how big this is quite yet. The worst could be behind us…or there could be more to come.
However, it’s a bit unsettling to see that the Fed’s discount window, which provides liquidity and stability to the banking system, just hit an all-time high – even higher than back in 2008.
Chart showing the discount window borrowing reaching higher levels than in '08/'09
Source: Bloomberg
It’s hard to get a feel for potential contagion because banking executives tend to downplay signs of trouble in hopes they can resolve issues quietly. They want to avoid anything that sniffs of a bank run similar to what happened at Silicon Valley Bank.
Sometimes they can quietly fix problems. But when they can’t, the dike breaks and suddenly there’s a new headline event that seems to come out of nowhere.
Louis Navellier’s advice to the Fed for how to fix everything
Prior to building one of the most respected and envied long-term track records in the investment management business, Louis was a banking analyst. He’s very familiar with the source of today’s banking industry woes. And there’s one way for the Fed to fix it.
Let’s jump to Louis’ Special Market Update podcast from Platinum Growth Club last Friday:
You want to fix the banking system?
Just un-invert the yield curve.
To make sure we’re all on the same page, a yield curve is a graphical representation of the yields of all currently available bonds – from short-term to long-term
In normal times, the longer you tie up your money in a bond, the higher the yield you would demand for it. So, you’d expect less yield from a two-year bond and more yield from a 10-year bond.
Given this, in healthy market conditions, we usually see a “lower-left” to “upper-right” yield curve.
But when economic conditions become murky and investors aren’t sure what’s on the way, this can change. Specifically, uncertain economic times tends to flatten the yield curve.
And if the yield curve actually inverts, it’s bad news for banking profitability.
It turns out the yield curve has been inverted since last July. Worse, two weeks ago, the gap reached 110 basis points, which is the deepest inversion since 1981.
With that context behind us, let’s jump back to Louis:
A lot of this [banking sector] damage is self-inflicted by the Fed…
It’s time to un-invert the curve…
The Fed has to intervene with open market action by buying a lot more short- to -intermediate-term treasuries to push that yield down…
If they can un-invert the curve, all these banking issues go away.
Now, I agree with Louis. This is the prescription for un-inverting the yield curve.
But this prescription potentially comes with a side-effect that we must grapple with.
Un-inverting the yield curve could lead to fresh inflation
Un-inverting the yield curve runs the risk of a resurgence in inflation, because it’s basically the Fed doing a complete policy U-turn.
Instead of quantitative tightening – what the Fed is doing now by selling its vast bond portfolio – the Fed would suddenly be pumping billions into the market by buying bonds, which is the definition of quantitative easing.
So, yes, the Fed buying short-term bonds would help the banks, but it would risk adding to inflationary pressures.
As we’ve been saying here in the Digest, the Fed suddenly finds itself stuck between a rock and a hard place of its own making.
The stakes are even higher now for Wednesday’s Fed policy decision and the following comments from Federal Reserve Chairman Jerome Powell at his press conference.
How will the Fed play this?
Will it remain hawkish as it stays-the-course in the inflation fight?
Will it turn dovish in an effort to prop up the stumbling banking system?
Regardless of what the Fed decides, there will consequences and fallout.
