The Liquidity Phase Of The Bank Crisis Is Over... But The Solvency Phase Is Getting Worse
The acute phase of the banking crisis appears to be over.
As was revealed late on Sunday just around the time futures opened for trading, the Fed's new Bank Term Funding Program (BTFP which should stand for Buy The Fucking Pivot) - a facility designed to avoid banks that are facing deposit outflows from being forced to sell their bond holdings at a loss, and which as JPMorgan concluded is a stealth form of QE which can be as big as $2 trillion (and even bigger if required) - will serve to backstop small bank impaired assets for the foreseeable future.
Then, today's "deposit consortium" plan unveiled as part of a coordinated rescue of First Republic Bank, which envisions big banks like JPM, C and BofA injecting tens of billions of (newly received) deposits into the troubled bank and which are meant to replenishing its own lost deposits (which ended up fleeing to the same big banks which are now recycling them in the form of a bailout) has created a blueprint of how to backstop the liability side of small banks. Simply said, any deposit that JPM received from regional/small bank XYZ, will be promptly recycled as a new deposit back into regional/small bank XYZ to keep it liquid.
That last word is critical, because between the asset and liability backstop, the liquidity phase of the banking crisis is now over. But what about the solvency phase?
Well, therein lies the rub, because as readers will recall, around the time the regional banks started slumping we wrote "Why Small Banks Are In Big Trouble: As Hedge Funds Pile Into The New "Big Short", The Next 'Credit Event' Emerges", which focused not on the small bank net unrealized losses on their Held to Maturity portfolios (or the bank run sparked by the sudden collapse of SIVB which was still quite solvent at the time of our article), but on the real solvency risk facing the regional bank sector: their exposure to commercial real estate in general, and office buildings in particular.
Specifically, in the article we explained why after residential real estate, malls, and hotels - all of which represented the various Big Shorts over the past 15 years - it was now offices' turn to crumble. We won't republished the whole article here (it can be read in its entirety here), but we will rephrase the big rhetorical question we asked then:
... what happens as the troubles in the office sector - which had been isolated to the RE realm so far - start spreading to the broader banking sector? After all, both previous Big Shorts, versions 2.0 and 3.0, were mostly isolated phenomena thanks to the low rates that prevailed in 2020 and much of 2021.
That has now changed, and suddenly investors are starting to look at who among the US banks has the most exposure to crashing commercial real estate (and offices in particular). For now, investors are taking a shot gun approach, dumping the regional and small banks en masse, with the KRE ETF plunging to the lowest level in two years, the broader BKW bank index suffering its worst day since June 2020...
... little did we know just how much worse it would get int he next two days...
... while arguably the most popular office REIT, Vornado, just hit the lowest since 1997!
As we concluded, "the problem, and this is where the discussion of the coming 'credit event' kicks in, is that while large banks still are very well capitalized, small banks - the core constituents of the KRE index - are in big trouble because as the following chart from TS Lombard shows, their reserves (as a % of total assets) have collapsed as a source of funding for loans and are back to levels when the Fed needed to do QE to reload their reserves!"
We then excerpted from TS Lombard's Steven Blitz (full note available to pro subs) explaining why we may be this close to another banking crisis (spoiler alert: we were):
Banks – and especially small banks – are now sitting with reserves pretty much at their lowest comfort level, There is not much of a cash-to-asset cushion left for small banks as a whole, so a funding crisis can easily get rolling if large depositors decide too many loans in commercial real estate and other areas are about to go bad. The Fed will make funds available to keep these banks afloat, but that alone will get some push-back from Congress because of the increased concentration of bank deposits in an increasingly smaller number of banks.
Small banks could have slipped below the promised macro-supervision radar owing to the political direction to lighten the regulatory burden on small, community banks. The belief is that they should not be subject to the same reporting requirements as G-SIBs.
Ahead of any banking problem rooted in bad loans turning into a funding problem, banks are going to pull back on lending at an even faster pace.
... and concluded:
Translation: not only are banks once again reserve constrained, but small banks are especially desperate for reserves.
Well, we were right: as JPMorgan's Nick Panigirtzoglou conceded today, our take was spot on, because not only were small banks reserve constrained - and imploded promptly after we wrote our preview of the "New Big Short" - but the Fed launched a new Stealth QE program in the form of the BTFP facility which may have to expand to $2 trillion or more, and which means that we now live in a time when i) the Fed is hiking, ii) the Fed is shrinking its balance sheet via QT, and iii) it is also injecting up to $2 trillion in liquidity via the BTFP facility, aka Stealth QE.
Our conclusion from Thursday was also prophetic:
In conclusion, even without the office real estate crisis, small banks were already headed for an unsettling mix of reduced funding and more underperforming loans. Throw in a cascade of bad debt in exposure to office real estate and you could see a repeat of the 2009 banking crisis for the small banks... if only in the beginning, because once the small banks go down, the big banks won't be far behind.
Less than a week later, as noted above we have gone through a full-blown small bank crisis cycle and the acute (liquidity) phase is over. But the solvency part remains.
And after that very long preamble we finally present the core of today's post, namely that even as regional banks are surging today on the easing in liquidity, the solvency part is getting worse.
Recall, in our Thursday post we said that readers should keep a close eye on the office sector -i.e., the "Big Short 4.0" trade, whether in the form of the CMBX S15 (BBB-) tranche, or equities and REITs. And today, while everything else is surging, one sector is having a very hard time.
You guessed it: office CRE.
As shown in the charts below, office-building landlords are some of the biggest decliners among US real estate stocks Thursday, on pace for the lowest close since August 2009.
Below we summarize the damage: the S&P Composite 1500 Office REITs Index drops as much as 4.9%..
... with the S&P Composite 1500 Real Estate Index dropping as much as 2% as the banking crisis continues to weigh on real estate stocks.
Office giants such as Vornado Realty, Hudson Pacific and SL Green are falling as much as 7% or more; other decliners include Piedmont Office Realty Trust (-4.5%), Cousins Properties Inc. (-5.9%) and Kilroy Realty Corp. (-6%).
A longer-term chart of Vornado is terrifying: the stock is back to levels last seen in November 1996.
Our preferred trade - which we highlighted last week - the CMBX S15 BBB- tranche which has outsized exposure to offices, just hit a new lifetime low.
And so on.
The bottom line: the acute phase of the bank crisis may now be over thanks to the Fed's Stealth QE and JPMorgan's recycling of newly acquired regional bank deposits back into the same regional banks that saw bank runs in the past week; but now the slow burning - solvency - phase is starting to accelerate and until the Fed cuts rates, expect a mood, sentiment and price rollercoaster as investor focus increasingly turns to what is the next big threat, not to mention Next Big Short, facing the financial sector.