MAY 1-5, 2023

Heading into a busy week of announcements and volatility headlined by the state of the banking crisis followed by a contested Fed’s rate decision, Sowell’s technical signals rest in a defensive neutral position (60/40).

Major stock indexes rallied during the week, with the S&P 500 and Nasdaq composites, respectively, gaining +0.89% and +1.28% as earnings for the most recent quarter continued to impress on earnings surprise, especially from industry heavyweights like Coca-Cola, Exxon Mobil, Google, McDonald's, Meta, and Microsoft. There was also an economic tailwind of bad news is good news, with confirmation that the economy is slowing as GDP rose a meager 1.1% during the 1st quarter, below the 2% annual estimate. But inflation and Fed fears remain as core PCE (personal consumption expenditures) gained 4.9% instead of coming below the consensus average of 4.7%. Economic pundits fear another possible rate hike of 25 bps at next week's FOMC meeting. Market expectations of a deepening recession have softened on slower but not negative growth. As consumer spending and consumption remain resilient – let's not forget China's re-opening and its expected impact on global consumption and GDP, as referenced by Goldman Sachs. China reported a first-quarter GDP growth of 4.5% and is expected to grow 6% for the full year.

The week ahead will focus on calming the financial markets as First Republic Bank woes have resurfaced from the Q1 earnings report revealing it lost $72 billion in net deposits. Over the weekend, the FDIC placed the bank up for auction awaiting its outcome. Well into the earnings seasons, the earnings focus now will be on the broader market after leading with Financials and Technology as a whole and providing guidance on the state of the economy. But much of the intensity will shift to the Fed's interest rate decision and FOMC statement on Wednesday. The Fed's upcoming decision faces unknown implications for the banking crisis, the economy, and most importantly, the federal debt and its cost of capital. A quarter-percent rate increase should not be a blunt instrument and be heavy-handed. Consequently, the FOMC should learn and leverage time as a tool and take a wait-and-see approach.

"When so many more products or services became digitized and connected, so many more things became "dual use." That is, technologies that can easily be converted from civilian tools to military weapons, or vice versa." – Thomas L. Friedman, New York Times Opinion Columnist, America, China and a Crisis of Trust, April 14, 2023

The Current Banking Fallout

First Republic

First Republic Bank's shares have fallen sharply following disclosures that it suffered substantial deposit outflows in late March. CNBC, among others, reported that US bank regulators are considering downgrading their internal rating of the bank, the so-called CAMELS rating. The Fed's Bank Term Funding Program (BTFP) is only available to banks with CAMELS ratings of one to three (on a scale of one to five). The bank's current CAMELS rating is unknown because the ratings are not disclosed. However, a rating downgrade to four or lower would limit the bank's access to the BTFP, a development that has sparked credit concerns. Government officials have urged the bank to do something about its situation, by selling assets to other banks, for example.

When comparing the situation with SVB vs. FRC, SVB's unrealized losses on its held-to-maturity bonds were close to the number of its net assets. The Fed's vice chair for supervision told the Senate Banking Committee on March 28th that the bank lost more than 80% of its deposits in just two days, March 9-10. The outflows were quick, as 88% of SVB's deposits were uninsured by the FDIC, and before the Fed created the BTFP, the bank sold held-to-maturity bonds and realized losses in the process. Given the sharp decline in net assets, the government determined that the bank had effectively failed.
Changes in First Republic Bank's balance sheet usage between end-December and end-March show the bank secured cash using the Fed's new BTFP and existing discount window lending. Excluding the $30bn infusion of deposits from larger banks in March, outflows of deposits were substantial, with the number of uninsured deposits (excluding the larger banks' deposits) down 83% from end-December. The remaining amount of uninsured deposits is only $19.8bn. Cash and available-for-sale securities amount to $16.5bn, and held-to-maturity bonds to $31.4bn. The unrealized losses as of end-March for held-to-maturity bonds are not disclosed, but as of end-December, they were $4.76bn relative to a book value of the holdings of $28.3bn. The book value of held-to-maturity bonds has risen by $3bn, but given the decline in superlong yields, the unrealized losses as of end-March were not higher than in end-December. Based on net assets and unrealized losses on held-to-maturity bonds, the bank is unlikely to be insolvent, and net assets effectively are in sufficiently positive territory. The situation thus does not call for an immediate government bailout, and the thinking is that the US government would like private-sector banks to work out a solution involving an acquisition. Thus, the media reported that the government had no intention of bailing out the bank, which led to panic among market participants. Optimism is not warranted, but the thought here is the market is likely to be overreacting. Potential acquirers are stalling to get favorable terms. In a move to calm markets the week ahead, the FDIC stepped in over the weekend to attempt a distressed auction of First Republic. It was announced by this Monday morning JP Morgan is the winner.

Despite headline news touting a full-blown banking crisis, this is not a case of suddenly tightening in the face of an overheated market. The reason for the concern about commercial real estate loans following the failure of SVB is that 50% of the $5.6trn of commercial real estate loans outstanding as of end-2022 were by commercial banks and that 70% of this 50% were by banks other than the top twenty-five in terms of assets. However, delinquency and charge-off rates are at historical lows and lower at small and mid-sized banks. Nevertheless, banks have tightened their lending standards since last summer, a move better seen as helping to prevent a commercial real estate bubble. If banks tighten their standards further, the number of outstanding loans will likely decline this autumn, constraining the construction of non-residential and multi-family properties. However, housing demand will probably have picked up by then, helped by lower interest rates. What does pose a risk, however, is that 70% of commercial real estate loans are to partnerships and other noncorporate businesses and that US households have $17.0trn of equity in these businesses.

The current state of the banking crisis is showing signs of stabilization; the background to SVB's failure on March 10th had invested most of the deposits of its customers, most of whom were large businesses from the tech sector of the economy, in long-term securities. In doing so, it was taking on significant risk with liquidity and rising interest rates. Its failure was not the result of any weakness in the banking system or excessive lending that led to the accumulation of non-performing loans (Figure 13).

On March 12th, the US Treasury, the Fed, and the Federal Deposit Insurance Corporation announced that, by way of exception, they would guarantee all deposits at the failed bank, including uninsured amounts, while the Fed launched the Bank Term Funding Program (BTFP) that would allow banks with unrealized losses on their securities holdings and at risk of deposit outflows to borrow from the Fed for up to one year at par value of eligible securities such as US Treasuries and agency mortgage-backed securities in what was a swift and appropriate response (Figure 14). The crisis is being resolved, at least for the time being - Partly because of this, outflows of deposits from small and mid-sized banks, which reached a record level in the week to March 15th, stopped the following week, at least for the time being. Borrowing at the Fed's discount window, which reached a record level in the week of March 15th, also declined, with the outstanding amount halving in the week of March 29th (Figures 1 and 2). Lending by small and mid-sized banks, which was feared would be subject to tighter lending standards, has continued to grow, while the ratio of these banks' securities holdings to their deposits has held at just below 30% (Figure 3). The bank failure on March 10th has not proven to be a systemic risk.

Figure 1. Crisis background = outflow of deposits triggered by unrealized losses on Securities; settled for now. Figure 2. Dealing with unrealized losses and deposit outflow                                                                                               

Note: Collateral requirements at the discount window eased from March 12. For USD liquidity swap lines, the frequency of 7-day maturity operations increased from weekly to daily from March 20 through the end of April.

Figure 3. Deposits, loans, and security-deposit ratios at banks other than the top twenty-five by assets

Advisory services offered through Sowell Management, a Registered Investment Advisor. The views expressed represent the opinion of Sowell Management. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment. Stated information is derived from proprietary and non-proprietary sources that have not been independently verified for accuracy or completeness. While Sowell Management believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and Sowell Management’s view as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumptions that may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements. Investing in securities involves risks, including the potential loss of principal. While equities may offer the potential for greater long-term growth than most debt securities, they generally have higher volatility. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles, or from economic or political instability in other nations. Past performance is not indicative of future results.


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