Crying all the way to the bank

I was researching Japan for an article on the macroeconomic conditions that are currently playing out in Japan and what that means for the global economy. My research led me down the rabbit hole of how the Bank of Japan created one the biggest bubbles in history.

The events in the US and Europe surrounding the banking system feel eerily familiar. Well, you know Mark Twain apparently said “History never repeats itself, but it does often rhyme.”

Post World War II, the Japanese Banks were bankrupt and they held what were called war bonds. The Bank of Japan (BoJ), bought this off of the banks exchanging bad assets for good money.

They instituted something called Window Guidance - the banks were ordered to lend particularly to industrials and real estate to drive growth within the economy. And for a while it worked. But what happens when you have easy money and low rates?

Easy Money: 

• Asset values increase and since banks are taking these as collateral, the loan values are higher.

• The Banks have to meet lending targets and therefore, they tend not to be picky about customers and lend to even those with low credit scores

Low Rates: 

• Banks lend to lower grades of credit in search for yield. Clients with good credit scores have low rates of interest because they are charged a lower margin or premium over government rates. And, clients with poor credit scores tend to pay a higher rate of interest. Since rates in the economy are low as it is, banks start to lend to clients with poorer credit scores, to make more profits, i.e, charge a higher premium.

• The case for Japan was slightly worse because of the controls over their currency. The top clients got loans from overseas at cheaper rates and so Japanese banks had to lend to second and third tier clients, in essence, because they were forced to.

Although the US and Europe do not have Window Guidance, they did have an abundance of liquidity and a significant period of low rates. Both of these lead to the same issues above, similar to what Japan experienced.

But, then as is the case with the situation, the bubble started to grow and prices began to soar such that people began to suffer at every level. In Japan’s case, real estate values increased to unprecedented levels causing extreme stress within the economy.

The BoJ and Ministry of Finance had no choice but, to try and control this. They stopped window guidance and tried to pop the bubble. The result was severe recession leading to deflation.

There are obviously other nuances to this story1 but, the end result was the same:

• Collateral values started to drop and banks were left holding loans for more than the collateral value. For example, say, the bank loan was $70 against $100 of collateral value. As asset values dropped, the loan value perhaps had reduced to $60, while collateral values dropped to $40. The banks have insufficient cover. In extreme cases, they would start to repossess the asset, as they did during the Great Financial Crisis.

• Many of the loans were floating rate loans, which means the interest payment increased as the rates in the economy increased. But, companies saw revenues and profits drop because of demand destruction, and therefore, paying the higher level of interest became a severe stress on the company. They were running out of cash. Add to that, the stress of having to pay back the principal on the loans, as well. (It is said the Ministry of Finance wanted to induce a recession to pop the bubble).

Prior to the Silicon Valley crash, my biggest fear for the banking system was this - real estate backed loans would create financial instability among the banks, not to mention the real estate companies, REITs and property owners. We’ve already seen some of this liquidity crunch with Blackstone. I do believe there’s more to come and I don’t think this story is over.

I posted the chart below on Twitter on Dec 28, 2022. This was already the case at the time. I can only imagine that further stress has spread through the system in the last 2 months.

How much exposure do the banks have? Quite a bit. 

Loans to Commercial Real Estate is 15% and if you count residential mortgages, it’s a total of 35%. That’s a huge chunk of the loan book and from what I understand most of the exposure lies with small to mid-sized banks.

After the Great Financial Crisis, many of the commercial real estate loans were restructured, refinanced and extended. Many of these loans are now coming due and 48% of these are on floating rates, which means the companies have seen their interest payments balloon. ⤵

The inversion of the yield curve has not exactly been helpful for the banks either. As long as the yield curve remains inverted banks who lend on the longer end will make less money because they borrow or take deposits on the shorter end of the curve. Silicon Valley Bank didn’t want to pay as much for deposits and that was one big issue. The last FOMC minutes also made note of the fact that the increases to the deposit rate lags the increases of the Federal Funds Rate.

The Yield Curve has given up some of it’s inversion. In reality, this is not a good sign because the YC tends to steepen when we see a recession coming.

But, most importantly what we have right now is a situation of negative sentiment and panic. As I write this, the banking stress has spread to Europe. Europe is seeing massive declines in their indices with Credit Suisse’s share price falling to it’s all time low. Several banks in Europe have been halted amid the sell off, particularly the French banks, taking US futures down with them as well.

It doesn’t help when the head of the Saudi National Bank, one of Credit Suisse’s biggest shareholders at 9.9%, refused to increase exposure. The truth is they refused because they have a regulatory cap at 10%, which they have already hit but, the market only sees the refusal.

And panic ensues.

WTI Crude traded below $70/bbl for the first time since 2021. Gold is up and traders are pricing in a 100bp rate cut for this year. The USD Index is up. The market is pricing for a recession.

Closing Thoughts

Silicon Valley Bank’s collapse was a story of greed and poor risk controls. But, the fact remains that there’s a storm brewing and we’re seeing glimpses of that. We’ve been putting out a lot of macro data that shows the economy has been progressively weakening - we’ve been calling it cracks in the market.

I think the time is coming that these cracks will give way to a full blown breakdown. We certainly don’t do this for fear mongering or because we are bearish but, rather to warn of what may come and to help protect against the fall out.

It’s better to be safe than sorry!