Banking Stress is Back Again

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1:24And now to the top analysis of today's markets.

1:35Are there more bank dominoes to fall? Hi, everyone. Welcome to the Real Vision Daily Briefing. With me today is Andy Constant, CEO of Damped Spring Advisors. Hi, Andy. It's great to see you. Hey, Maggie. Pleasure to be here. So let's start with those banks. First Republic down 47%, I think, maybe even a little bit more as we close here. Cast a real shadow over the market today. What's your sense of what's happening with the U.S. banking system? How worried should we be? Well, so there are lots of things happening. But what I take from the First Republic situation is that the First Republic bank had about, call it, a little over$150 billion of assets.

2:16And those assets are down relative to their deposits. And we saw the deposit flight. First Republic was in a more difficult situation than other banks because their assets are municipal bonds and loans and commercial real estate, mostly mortgages. And those were not federally backed, so they couldn't be used in any of the more traditional banking programs, the new programs that were announced. And so what we saw, and based on their earnings recently, we saw that First Republic has most of its liabilities are either small about or are insured depositors. And then most of the rest is loans given to them by the funding given to them by the FHLB, the discount window, and the 30 bank consortium.

3:15And so that deposit base is actually very, very sticky. So we don't have a bank run situation going on in FRB. So I think that's really important is everyone's looking at this and just wondering, you know, is it going to sort of catch fire, right? Is this if there's trouble here and it's contained, but, you know, what's next? What's coming next? Is your sense that this is a more case by case basis? Is the system as a whole functioning or are we going to kind of see this slow rolling issue where we have problems and they're ring fenced? But then after a little while, you're going to see the strain someplace else.

3:53Well, sure. So the big issue, I think, is that first we have to get through First Republic because it is a large bank and it almost certainly needs to liquidate in some way, whether that takes a long time or happens suddenly. And I think the – but it needs to be resolved. $30 billion of deposits from the consortium come due in 86 days. And so – and we saw today. They've offered$100 billion of their assets for sale. And so that should come to an end relatively quickly. And the question is, will it need any government backing? My point of view on that is every regulator from both the FDIC and the Federal Reserve and likely most of, if not all, of the consortium banks and many others who are interested in the assets of First Republic have been through that balance sheet.

5:03And if that balance sheet's market value was worth less than its liabilities, the FDIC would have seized the bank, and they haven't done that yet. So to me, the resolution will happen relatively quickly, but really has been delayed by the hope of the management to go through time and get back on their feet, which is possible if they just hold everything to maturity. But because their liabilities have this$30 billion private sector deposit, they can't really be a zombie bank as much as we might think they could be because at some point the consortium is going to want their money back. And at that point, the balance sheet has to be sold.

5:59And so I expect it to be sold and I expect it to have very little impact, if at all, on the depositors, the remaining depositors or the government lenders, but may wipe out the equity. And to me, that is a fine resolution of the matter. And then you get into the bigger, more systemic issues, which is the ongoing, well, are there any others? I think we would have begun hearing about others by now. And frankly, First Republic was consuming most of the discount window usage. And the BTFP program was relatively small. And so those two combinations of things indicate that it was mostly a First Republic problem.

6:55And the rest of the banking system, there may be some concentrated another bank. We don't know. I would expect there probably is because that's the way these things go. But is it systemic? It doesn't seem so yet. And the question is, what could happen in the future that could cause banks to suffer more? And there are a variety of reasons. Yeah. So what, and that's exactly what I think where we go, right? We kind of know there might be others, but that hangover of this rolling into something systemic is, I think, what keeps people up at night. What would be a condition that would create that, that you would worry about?

7:33What are you looking at to see whether it jumps to that situation? Well, let's start with the cleaning up of the existing duration risk. That is where Silicon Valley Bank and Signature Bank and now First Republic Bank have suffered. They bought bonds when interest rates were very low, and they didn't hedge them. And so once that gets cleaned up, then we're in a different situation. And that situation is the normal banking situation, which is credit risk. And these banks have credit risk, and the most popular bear case is a weakening office market, and thus the credit risk of the lenders to commercial real estate are going to suffer credit losses.

8:27And that's a risk. And then the other thing, which I think a lot of commentators are discussing, is the deposit rates for every deposit have just begun to tick up. And there are many other competitive places to put your money. And so that squeezes the NIM, the net interest margin of banks, until, by the way, not forever, but until their loan book and their new business book adjusts to the higher interest rates and the loans are carried at a higher interest rate. And so we're in that phase, and that means a headwind on earnings driven by more expensive funding, not nonexistent funding. We're not talking about bank runs.

9:24We're just talking about banks offer a lot of service for their low deposit rate in that you don't have to compete with a T-bill or a money market fund because T-bills don't offer checking. Money markets funds, though they've been offering checking for a long time, have never really been a home for transactional savings. And so anyway, there'll be a pressure, and I think that pressure will be a meaningful headwind on banks going forward. And then add on top of once the duration issue is cleared up, and I think the regulators are going to make significant changes in regulations that will not allow the type of curve running, riding that banks have done in the past.

10:13When those things hit, you know, that'll hurt their profitability as well. But then you have credit risk and the squeeze on their cost of funding. So profitability, not systemic right now. Just a reminder, we are, of course, going to do questions. So go ahead and put them in the chat and we'll get to as many as we can. And I'm going to take one from John right now, which is kind of related to some of this, Andy. But first, just want to let everybody know Microsoft looks like Microsoft and Alphabet out after the close. Looks like both did better on revenue and profit. And importantly, Alphabet going to buy back added shares up to 70 billion, Class A and Class C.

10:54Both of those stocks up 4 % in after hours. So we'll talk about tech a little bit later. But this question, I want to stick on banks and credit for the moment. This question is from John. John, can you comment on why we haven't seen stress in corporate bond land? Looking at the LQD, HYG, JNK, they all bottomed in October 22 after the UK pension crisis. I expected to see them at new lows after the banking issues in March this year. Sure. So banking credit is quite a bit wider. We've seen lots of CDS quotes from banks that are on the verge of breaking. But industrials, they're in pretty good shape.

11:36Their earnings are historic, so they've come down a little bit. Their balance sheets have been financed at extremely low rates that we've experienced for decades. needs. And for the companies that don't have ongoing financing needs, conditions are pretty good. Nominal growth being as high as it is, is very good for earnings and very good for free cash flow. And then you look at just the simple thing. I look at corporates and say corporates are just equity with limited upside and all the downside. So they look like some sort of combination of a long equity position and short a put, or just short a put would be a better way of saying it.

12:29And volatility has also come down a lot. So a combination of low volatility in corporations and pretty high stock prices with very high nominal earnings and very low cost of funding is a pretty good position for corporations until they need money in the future. And that speaks to who needs money and the credits that have credit walls coming up or over-levered, which are not the investment grade, but for the high yield market, over-levered and have bond maturities that are coming up soon. And frankly, that's just not a very large group. Most bonds that are corporate bonds that are issued are five years or longer in maturity.

13:19And anybody who needed money that wanted to borrow could borrow during the COVID crisis at extremely low rates. And so I think their corporate credits are, you know, they're actually my favorite long. And if you've followed me at all, I'm not long any assets right now. If I had to be long any asset, it would be a corporate bond, a corporate credit, not the bond itself. Hey, everyone. We're going to take a quick break right now to hear a word from our partners. We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing.

13:58Okay. So when you're saying that, what do you mean? So not corporate bonds, not an ETF of corporate bonds, or would you? spreads of corporate bonds, which can be found in something like the LQDH, or I believe that's the ticker of the spread product. That is, if corporates do well, you do well, but you don't have interest rate exposure. Okay, that's really important. I'm glad I asked you that. It's a really important distinction. So John, I hope that helps out because the tickers that you quoted were, I think, more direct exposure to. Right, they have both bond and credit exposure, and that may not be what you want.

14:38Bonds have been doing well lately, but that may not be what you want if you want your bet on corporates. Right, great question, John. Thank you for asking it. So, Andy, we were talking a little bit before we came on, and I'm sure a lot of our viewers have been reading it. You've been in a very active back and forth on Twitter with Jim Bianco, another friend of the show, about some of the dynamics happening in the short end of the treasury yield curve, specifically between one month and three month bills, I think. Why is this important? Why are you both looking at this area so much? Or is it important?

15:10What's going on there that caught both of your attention? Well, it's unusual for the three month bill, the one month bill to be so low in yield relative to any other form of one month money, which includes, and that means also shorter money like seven-day or RRP money, which is the reverse repo program, money market fund money, or longer-term money. And so that's an unusual circumstance we're thinking about. And so there are a variety of theories that are going around, and that's what the conversation has been about. So what do you think? Because I have seen, I know, Lin Alden, a bunch of you have been tweeting about the fact that this is sort of unprecedented.

15:59So what do you think is happening there? What is it telling you? Well, so what do we know? We know that in some number of days that people have estimated between 75 and maybe 125 days, the government could shut down. And when the government shuts down, well, we don't know what could happen. I don't think anything bad could happen at all. Just to be clear, I think this will be fine. The odds of the government not honoring its payments to creditors and its accounts, employees, all that sort of thing, I think they're going to pay. But there could be some drama. There will. Let me just say this. I think there very much will be some drama along the way to that resolution.

16:57And in 2013, that resolution required a series of sequestrations in which the Congress essentially took over the spending. And then subsequently, an outright closure of many services, including, you know, we all saw this. It was ugly. Chains linked around Yellowstone National Park and Smithsonian closed. And workers furloughed. Federal employees that were deemed non-essential furloughed. But everyone got their – every bondholder got their payments and every beneficiary of Social Security checks, unemployment insurance, and other entitlements. The military got its salaries. All those things happened.

17:52But ultimately, the Congress decided it was time to move on, and they resolved the issue and raised the debt ceiling. And so we never came to the true crisis where we would have had to take further steps because we run a deficit every day, take further steps which would include prioritizing payments, which could create a significant issue regarding the constitutionality of such a thing. but certain payments like Social Security might have been prioritized over debt payments, etc. And we never came to that. And I don't think we'll come to it again, but there'll be some fear about it and fear generates some activity.

18:39So anyway, that's the long way of saying that date is coming. I don't know what the steps will be and we can all estimate it by dividing the checking account of the bank of the treasury by the daily deficit and make some estimate of that. And we have more certainty now that the big tax inflows in last week came in and we know what they are. I've narrowed it down to somewhere between July 15th and July 30th. But the point being this, so here you are as an investor. And if you have no one to answer to, which is not a typical situation, professional money managers have bosses and they have clients and if you're a money manager who is not an investor but earning money by investing other people's money you get a salary and maybe you get a performance fee but most of the time you have a job and here you are and you own some bonds or bills, or you're looking to buy bills that mature after the debt crisis D-Day?

19:58Well, what I would do is I'd say, hey, listen, boss, client, this is a problem. I don't think you should do anything, but what do you think? And if the boss says, oh, it's your decision, or the client says, it's your decision, and they don't own the responsibility for making the decision, you have only one decision to make, and that is to sell those bonds and buy one-month bills that are safe. Because you have literally no financial upside. And if you make a mistake and there's a delay in which they have access to their money, or God forbid they were to get something really bad and unexpected were to happen, and you couldn't get all your money back in a timely fashion, you're fired.

20:44And so some of that firing is going on that let's let's not get fired. And I sat in a seat like that and experienced firsthand that decision making process. And what we're seeing is the only bill that is certain to not fall into the window that's being auctioned right now is this one month. We're going to take another quick break to hear a word from our partners. We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing.

21:19The one month, right? So people are risk averse from the leaders and people in Washington not making a colossal mistake, and they're not going to take a chance. So it's sort of telling you that they're going where they're safe. So let me ask you this. Jim Bianco, I think we have a chart that Jim tweeted out. One about volume, yeah. I think it's actually the one with the Fed Funds future or the Fed Funds forward market. And so he's sort of wondering that there's, he's kind of reading that as massive amounts of new money coming into money markets and ultra short funds. And he's thinking of it more as a bank walk, not a run, right, but a bank walk, And that people are still moving money out of the deposit system and banking and maybe into really short, again, just because they're unsure, maybe driven by the same fear of what I don't know.

22:17But do you agree with that? And does that concern you that there's still instability or a lack of confidence in the banking system? Right. So I think the dynamic that's occurring, and it's shifting, by the way, real time, is this idea that deposits offer a less competitive rate than other alternatives like bills. Though right now that deposit premium to the one month, the premium of yield on the one month bill isn't anywhere near what it used to be. And so there's a self-correcting nature to that. But yeah, people are saying, even with an insured deposit, what am I doing in a bank that's paying me nothing or close to nothing when I can go into a money market fund?

23:11And so it's a natural flow. And I think that dynamic is occurring. And does that mean the banking system fails? No, what it means is the banking system has to adjust its rates to decide whether to be competitive. And by doing so, it retains its depositors at the expense of profits. Yeah, that's the tough one. So I think you can – and I said that at the beginning. I think you can make a very clear case for a persistent headwind of weaker bank earnings as they compete for deposits. But the idea that interest rates going up pulls deposits out of the system has some basic flaws. Because they don't serve the same purpose as banks, as you mentioned before, with checking and all of the other types of?

24:09Well, what I mean to say is that except when money goes to the reverse repo program, which is only overnight money essentially, any other investment in a T-bill, the person who sells the T-bill to you when you go and buy it is either in the secondary market. and now they have your deposit and it doesn't leave the deposit system. Or the U.S. government sells you the deposit in a primary issuance and they deposit the money into the beneficiary of spending's deposit. So no money leaves the system unless it goes to the reverse repo program. or, and the only way to actually destroy money from the system is to move it to the reverse repo program or have quantitative tightening remove it from the system.

25:18See, this is why we got to get the credit guys on because they help us understand what's happening. Right. So I would say that the idea of anything that anyone who says raising interest rates. If the RRP didn't even exist, it does. So it's an important thing and you have to track it, but it's basically been stable for many months. Even during this crisis, it's been relatively stable. Anyone who says it's interest rates that are pulling money from the banking system isn't really following the money. And you got to follow the money. So So this kind of brings us around to the Fed. And it was really important, I think, to have that conversation about banking because there's a lot of misinformation out there.

26:05So I think it's really, really important to walk through what's happening. There's a lot of fear. But now this sort of comes to the issue of the Fed. So our managing editor, Samuel, sat down with Larry McDonald for the latest episodes of Three Ideas. And Larry made the argument that some of these banking pressures, which have been building since 2008, will eventually force the Fed's hand. Let's have a listen to what he said, and we'll talk on the other side. That whole response to the Lehman crisis from all the federal officials, from the FDIC onto the Fed, onto the OCC, that response has actually created a backdrop that is in some ways helping money move into money market funds, which were backstopped by the Fed during the crisis.

26:51and it also pushes money toward big, you know, too big to fail banks. So in essence, the financial crisis of 2008 is sowing the seeds of the destruction of our regional banking system. And at the end of the day, if the longer the Fed keeps the Fed funds rate near 5%, they will drain the banking system dry. And so the beast in the market is going to force them to stop right here. And I think they probably cut rates by 100 bps by this time next year. And that full interview where Larry gives his three best trade ideas right now is available on our website. If you're not already a member, you can scan the QR code and sign up.

27:34So, Andy, do you think the Fed, like ultimately the Fed will be forced to choose between financial stability and inflation? I mean, is that just where this is going? Well, what I would say is that we don't know. I think that it would be very unlikely that inflation will be permanently stable and at or below target without the economy facing some significant difficulties, which may or may not result in a banking crisis. I'm of the belief that it probably won't result in a banking crisis. But that also makes it much, much more difficult to kill inflation because a banking crisis actually is pretty darn useful for hurting an economy.

28:24And I don't think we're well set up for the type of banking crisis that would hurt the major banks. So we have a question from a bunch of initials. SBD 758. Are you bullish the U.S. dollar in the short term to medium term? Why or why not? So right now, actually, I would love to give you a good answer. Right now, I'm fairly neutral on the U.S. dollar. I actually think that the euro yen is the best cross to play right now. I like the euro more than I like the dollar and much more than I like the yen. But that leaves me fairly neutral, the dollar against major currencies. So I don't have a strong opinion.

29:15So I wouldn't give you an explanation for why I don't have a strong opinion. I'd rather give you one in which I actually have. And so we have earnings coming out. So we kind of brush past them right at the top. But we just had two big tech names come out. They're doing well, but we've got a few more coming down the road. What are you feeling about equities? Some of the earnings we PepsiCo reported today, they seem to be able to deal with pushing these prices on. Coke was better than expected yesterday, but it's been mixed elsewhere. How are you feeling about the U.S. equity market right now? Right.

29:49So I guess overall, I think the important thing is to say I don't have a strong sense of I do believe that eventually to kill inflation, we will need to have something other than a mild recession, something more like a recession without any qualifiers. I think labor needs to – we need to see some unemployment, unfortunately. So now the question is when, and it's a battle between how high and for how long will inflation stays sticky before the tightening causes jobs to get cut, which brings inflation down. And very importantly, quantitative tightening withdraws some of this very significant monetary stimulus that still is flowing through the system.

30:46And so to answer that, I think you have to have a path. And if you are, if you believe, which many do, Larry, for instance, with his quote on forward interest rate cuts, is expecting a recession that will happen fairly quickly, possibly a severe one and possibly led by a banking crisis of some sort. In that world, equities do poorly. It's just that's what they do. And then alternatively, if you have a period of strong nominal growth driven by both okay real growth, sort of slogging along at trend real growth, and higher than normal inflation, that's actually pretty good for earnings. And so that – and unfortunately, the Fed will have to stay higher for longer, won't be able to make the 100 basis point cut Larry referred to in his comments.

31:49And that is actually okay for equities, but pretty bad for bonds. And so my view is nuanced. I think that this is where it comes back to pricing. And right now, someone who is very clearly negative about the economic outcome and stated in his conversation that he expects a year from now interest rates to be 100 basis points lower. And that's because he's negative on the economy. What's ironic about that is that the market already prices 135 basis points of cuts. So even somebody who is pessimistic about the market and about the economy who says who predicts 100 basis point cut the market's way ahead of him the market is fully the short-term interest rate market is fully anticipating a pivot are they wrong well they could be if they're right equities are trashed right if they're right That means a recession.