In this note:

• Preserving Capital: Discussing how market structure is more important to financial sector investors during sell-offs.
• How bonds are affecting banks – the securitization market frees up high margin loan growth.
• How bonds are affecting banks – higher incidence of construction or bridge loans festering on books, or turning nonperforming.
• How bonds are affecting banks – deposit strategies needed.
• How bonds are affecting banks – when bond values fall, capital gets stretched, rewarding smart capital management.

1. During every sell-off, market structure matters most

A reasonable rule of thumb for bank investors is that about most of the time, share prices are driven mostly by how companies and a sector perform. During certain periods, broader economic and market factors take over. These periods produce margin calls or euphoria, and generally are a good opportunity for disciplined observers to profit until the “micro” returns.

In this backdrop, consider a checklist before heavily allocating capital in today’s “macro” market:

• Find the core reason the market is crashing – follow bonds. Why did the 1999 tech bubble burst? Was it because there were too many routers and too few customers in the end, or would the bubble have not gone systemwide if Greenspan had not foolishly kept rates low expecting computer glitches in 2000 would affect confidence? (this really happened, Greenspan foolishness)Today, much like in 2000, the simplest answer is the bond market again ripping apart “long duration” stocks, notably technology. Tracing this further, bonds fell because inflation rose, with labor and energy costs higher up the chain of causes.

Just look at the below. A year ago, the market priced rates below 2% out to 15 years. Today, the market thinks 2% is a year away.

In other words, everyone was having to limbo under a bar that was 5 feet high, and the referee just lowered it to 3 feet. No wonder so many folks are dropping out.

In this light, a glimmer of hope in the current market is the fact that bonds have been stable the last few weeks.

A few other key considerations:

• Who else owns shares with you? Bear markets are a good reminder that you aren’t in control of some random investor’s capital being pulled or a family office turning over a strategy. Bank of Butterfield and Truxton Trust are two banks similar in many ways. Truxton is owned largely by individuals and Butterfield almost entirely by institutions.You might think it doesn’t matter, but it’s a problem for Butterfield. The market could and should pay less for an asset with higher volatility, because it hurts the most at the worst times. Incidentally Butterfield benefits highly from rising rates, may be printing money in 2H22, and EPS estimates may be conservative (NTB trades about 7x forward earnings).
• Are there options outstanding? They stoke volatility. Typically market caps over $500 million trade options. Tesla and Apple share prices are materially impacted by the options market in a given week. Note options prices rises with increased rates, so this effect may dampens some in the quarters ahead.

  

   

Is the company in an index / are Blackrock and Vanguard the biggest holders? This also tends to increase volatility because ETFs are essentially momentum following funds. We can see below with Customers’ Bancorp (CUBI) that blind money owns almost 1/3 of the company. So, if one of the page 2 hedge fund holders dumps $5 million of stock because of a signal, Blackrock is inclined to sell alongside as they rebalance.

• Russell rebalance Companies joining and exiting an index like the Russell 2000 can see a 15-20% tender in either direction, as we frequently discuss in this blog.
• Is a buyback ongoing? This lowers volatility. An active or even aggressive buyback in a distressed market not only rewards portfolios in the near term but also typically enhances shareholder return over long periods.
• Duration Stocks that are a play on something happening in 2024 or 2025 become temporarily uninvestable, again because stocks arguably have durations, just like bonds. Crypto is a long-duration instrument. A company repurchasing lots of stock is a short duration instrument. Gold is a strange gray area.
• Less leverage inside a company is preferable.

There are several other components to dive into (like fund flows) but the point is to get beyond “ABC Bank just had a great quarter so I don’t understand why the stock is down”. I would be glad to chat with readers on other components you see moving stocks in unusual ways.

 

Four ways the bond market is affecting banks.

2. Banks are getting share back from the securitization market.

Axos Bank CEO Garabrants mentioned this in the company’s first quarter call.

What he means is he is going to be booking many 5%+ yielding large mortgages, ideally with money market deposits from his securities business yielding 0.50%-1.00%.

One easy way to track securitization demand is the ETF for owning Commercial Mortgage-Backed Issuance, CMBS, which has fallen ~20% in recent weeks on rate and, perhaps also credit forecasts.

Put another way, look at the yellow portion of the bars below. Yellow represents loans and debt typically against business or real estate, and has almost stopped:

 

The opportunity is that while banks have been forced to carry increasingly substantial capital and liquidity balances for the past decade, private equity, insurers, funds and entities like commodity brokers have not. Many shadow banks become quick sellers in market disruption, while banks have almost become agents of stabilization. Any market disruption is therefore an opportunity for market share transfer such as is described by Garrabrants.

3. Banks are writing construction and commercial real estate loans that may carry greater risk than understood.

Banks have been searching for loan growth for several quarters, and now not only it it upon them, but it comes at wide spreads vs checking account deposits.

CRE is a primary source of this growth. CRE, and particularly construction, may run into issues in rapidly evolving rate markets. The three problems are:

1. The projects don’t get sold. Bridge loans may not find support under perm. Most developers over the past 1-2 years assumed they could sell a project to a buyer who would use a 4-5% rate. A 6-7% rate of financing may leave the project stalled, particularly on non-recourse credits where the borrower’s loss is capped at equity contribution.
2. Variable loans may breach debt service. A move in the cost of debt from 4% to 6% is, you guessed it, a 50% increase in interest costs. Most loans are written to a 120 – 130% debt service coverage. If you have a 5 year loan with 20 year amortization and 4% loan, a refinance at 6% can, as discussed in 5 Points April, easily take your debt service below 100%, not to mention your loan to value over 100% as valuations update. That loan is technically non-performing whenever the bank decides to admit it, unless a strong guarantor is in place.
3. Projects run into unexpected delays or other related challenges. Below is a simple outline from a friend with many years experience not investing in construction banks, on some of the things that can go wrong.

 

“We couldn’t get the concrete at the price we wanted.”

“The supplier ordered rebar from Shanghai.”

“The zoning board has been sitting on our application for 3 months after the mayor told us it was an easy sell.”

One of many examples of this is Bancorp (TBBK) – a bank with a clever management team but turbulent record in CRE.

Bancorp recently began adding non-recourse CRE bridge loans – these are typically value-add projects meant to be stabilized and refinanced. Many are $20 million apartment loans in Texas. In a short timeframe TBBK has built this book to over 35% (!) of total loans.

At least these are apartments and not retail, office or mixed use. But…

…What about rent growth? It’s true that the US banking system is comprised of thousands of unique markets and all broad arguments have exceptions. In this case, it’s no accident TBBK has chosen Texas. Our own investments generally shy from stagnant blue states in part for this reason. Still, rent growth may need to be double digit to provide appropriate cushion for a 79% LTV loan in the current rate backdrop, and it tends not to apply to CRE subsectors like retail, storage, or office. Warehouse and hotel appear to be volatile at the moment.

4. Bond stress means banks need a deposit strategy

People ask what “quantitative easing” does, and one of the simplest answers is “It adds a lot of deposits to the banking system.”

You can see that below, with the jump in deposits occurring with dramatic easing as Covid shut down our economy:

Don’t be surprised to see more dramatic deposit outflows over the course of 2022 as this reverses. What this will mean:

• Scramble for deposits, and higher rates. Some, like SOFI, will just pay high rates. Some will hire commercial relationship managers. Many will poach from Wells and Regions, like always. When we say “deposit strategy” we mean things like payroll companies, prepaid cards, correspondent banking, a securities custodian partnership, or any of 50+ strategies banks use to get customers to park money with them.
• Some capital relief , with in many cases smaller asset sizes and higher capital ratios to allow for share repurchases as securities mature. However…

5. Bond declines pressure capital ratios. This affects our desired buybacks, and stresses capital management.

I just attended a conference, and 6 of the 8 banks I visited were unable to repurchase shares, almost regardless of valuation, because they

• Had hired multiple teams of lenders from BBVA, First Horizon, and BB&T, and there seem to be a lot of teams available from those three banks.
• Bought another bank recently.
• Got hit on the values of their bond portfolio.

A few managed to combine all three of the above.

If these banks were portfolio managers, you might consider them to be fully invested, or on margin, into a market decline.

How bonds affect bank capital We can use several examples but I choose Ledyard Financial (LFGP), a quiet lender and trust bank next to Dartmouth University. Ledyard, like hundreds of other banks, did nothing except categorize a good sized portfolio of 1% yielding bonds as “available for sale”. This meant their book value was obliterated in 1Q.

While this effect gradually eases as the bond move toward maturity, 2Q may be nearly as bad for banks.

The outcome is simple – these banks are now powerless to protect shareholder value if the market comes after their stock. Oriental (OFG), a buyback happy Puerto Rican bank, is one example of many showing the difference this tool can make, materially outperforming the market and other banks since recent turbulence.

Thanks for reading, and feel free to share corrections or important notes that you believe may support the investment process.

Disclaimer: The writings in “five points” do not advise readers on investment transactions. Only clients who have executed an account management agreement with Colarion LLC are under advisement from Colarion, so that their particular tolerances and objectives may be considered. Readers should assume Colarion may be long or short any and all tickers mentioned in this publication, and that investing in securities includes inherent risks which may lead to the loss of capital.

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