US Banking Groundhog Day?
Is the banking system finally breaking under Jerome Powell’s iron fist? Or is the NYCB crash a company specific issue? Might it even be an opportunity to BTFD?
Disclaimer: The information contained in this article is not and should not be construed as investment advice. This is my investing journey and I simply share what I do and why I do that for educational and entertainment purposes.
This article is entirely free to read.
March 2023 was a noteworthy month for US stock market investors. It was one of only two significant corrections in an otherwise stellar year. The other one was in October driven by an interest rate scare.
Usually a cocktail of several reasons is needed to create a correction. These typically involve technical, seasonal and fundamental/macro factors. The latter were a main driver in March 2023. Is was the time US regional banks got into trouble due to the Fed’s tightening campaign.
The most famous example was Silicon Valley Bank (SVB) which went under as a deposit drain from their struggling tech start-up customers forced them to realize large losses on their loans and securities portfolio. These losses exceeded their equity. And the bank quickly became history.
Many feared a resurfacing of GFC style problems with cascading bank failures leading to a collapse of the US banking system. At the height of that crisis I published the article with the provocative title below.
I argued that depositor fears were overblown, that asset quality was solid in contrast to 15 years ago and that we would quickly move on from that crisis. It was the right call. The S&P advanced almost 20% over the coming four months.
Today, it seems like we’re in for a Déjà vu. On January 31, 2024, New York Community Bancorp NYCB 0.00%↑ published their 4Q23 earnings. They shocked markets with a surprising loss that was mostly driven by an unexpectedly high provision for credit losses. The stock finished the day down 38%. It actually scared the entire market. The S&P finished the day down 1.6%, its worst day in a long time.
While broader markets recovered quickly, NYCB fell further. As of this writing, the stock has hit $3.30 in overnight trading which is 70% lower than its pre earnings level of $10.38.
This begs the question: What is going on here? Is the banking system finally breaking under Jerome Powell’s iron fist? Will this force rate cuts into existence in spite of a challenging inflation outlook? Or is this just a company specific issue? Might it even be an overreaction that can be bought? Let’s take a closer look.
Fallacy Alarm is a reader-supported publication. To receive new posts and support my work, consider becoming a free or paid subscriber.
NYCB shocked markets with a massive increase in their loan provisions which caused a surprise loss. Specifically, they have problems with loan collaterals in their office and multi-family loan portfolios. The former is obviously still struggling the pandemic aftermath. The latter is struggling with rent controls which limit the borrowers’ ability to pass on interest rate increases to tenants.
As a result, the stock is down 70% over the past week and shareholders have suffered a total drawdown of $5bn so far. The company is now trading at just 0.3x P/B. It’s essentially priced to liquidate.
Such violence appears exaggerated at first glance. Their office loan portfolio is merely $3.4bn or 3% of their total asset value. It can’t possibly explain this crash. And the rent controls in their residential portfolio are hardly breaking news. US banks sit on trillions of dollars worth of assets that do not earn their cost of capital. For the past years, markets have given them a pass based on a) speculation on rate cuts healing their business models and b) the existence of intangible assets such as advantageous deposit refinancing and cross-selling opportunities into their customer base.
On the other hand, markets may be correct in their punishment. Banking is a leverage business built on trust. Once trust is gone, the foundation of the business model is gone. If depositors and creditors shun NYCB over solvency concerns, it’s lights out quickly.
So, while this appears like an attractive BTFD opportunity, I am therefore shying away from it for now. Not because I believe their situation is dire in isolation, but because you don’t fight the mob in the streets when they want blood. And as you may know from other articles, I am anyway not too keen on assets with interest rate risk at the moment.
One thing is clear however: This situation is not suitable as a blueprint for the entire banking sector. Banks remain remarkably resilient in light of the manic rate hikes over the past two years. They have deleveraged a lot vs. 2008 and these situations are not at all comparable. It therefore seems unlikely that this can cause contagion into the broader US financial system. Markets are therefore correct in my opinion to move on quickly from this after the initial scare.
NYCB is a typical US regional bank. It’s the 10th largest holding of KRE 0.00%↑, a popular regional banking ETF. I covered this ETF last year here:
They have $116bn in assets which makes them about half the size of SVB. Their assets primarily consist of loans and leases ($85bn), securities ($9bn) and cash ($11bn). These assets are funded by $81bn in deposits, $21bn in borrowings and $11bn in equity.
The problem with their earnings release
At first glance, their earnings do not look that bad. They had a sequential 16% decline in their net interest income, which is not ideal and presumably a manifestation of the margin squeeze felt by banks facing an inverted yield curve.
Remember, their bread and butter business is exploiting the term risk premium by borrowing short-term and lending long-term. This is obviously challenging in the current environment. As deposit rates creep up following overnight money market rates with a lag, banks lose earnings power.
But the true problem can be observed in the second line item below. They built a massive $552m provision for credit losses in 4Q23, which was an order of magnitude higher than in 3Q23 and wiped out most of their net interest income.
This dropped their EPS to a negative $(0.36). If the loss provision had remained at the 3Q23 level, this would have been a positive $0.11. Sequentially weaker, but presumably not much of an existential concern.
What is this loss provision increase about? Here is what they had to say about it in their earnings release:
“For the three months ended December 31, 2023, the provision for credit losses totaled $552 million compared to a $62 million provision for the three months ended September 30, 2023. The increase is primarily attributable to higher net charge-offs, as well as, to address weakness in the office sector, potential repricing risk in the multi-family portfolio, and an increase in classified assets.
Net charge-offs totaled $185 million for the three months ended December 31, 2023, compared with $24 million for the three months ended September 30, 2023. Net charge-offs on a non-annualized basis represented 0.22% and 0.03% of average loans outstanding for the three months ended December 31, 2023 and for the three months ended September 30, 2023, respectively.
Fourth quarter net charge-offs were primarily related to two loans. First, we had one co-op loan with a unique feature that pre-funded capital expenditures. Although the borrower was not in default, the loan was transferred to held for sale during the fourth quarter. We expect the loan to be sold during the first quarter of 2024. We also performed a review of other co-op loans and did not find any other loans with similar characteristics.
Second, we had an additional charge-off on an office loan that went non-accrual during the third quarter, based on an updated valuation. Given the impact of recent credit deterioration within the office portfolio, we determined it prudent to increase the ACL coverage ratio. Together, these two loans accounted for the bulk of the $185 million of net charge-offs we took during the fourth quarter.”
As you can see, NYCB’s situation is quite a bit different from SVB last year. SVB had no issues with their asset quality in the sense that there was no elevated cash flow uncertainty in them. Their assets were simply too low yielding to retain their book values in the new normal of high short term interest rates. When they lost a crucial amount of deposits, they had to realize those losses which wiped out their book value and spooked investors, creditors and depositors enough to close their doors for good.
In contrast to that, NYCB does not (yet) have issues with deposits. But they clearly seem to have asset quality issues. Their problems seem to be mainly in their office and in their multi-family portfolio.
Let’s start with Office first. It’s obviously a highly problematic sector. In spite of an overall normalization of the economy since the pandemic, physical office presence is still subdued.
This causes office tenants to downsize their physical footprint. As a result, national vacancy rates are sitting at record levels. A white collar city like New York gets hit disproportionately from this trend.
Naturally, this is a problem for office real estate lenders because it makes it more challenging for the borrowers to service their debt.
However, looking at NYCB’s office portfolio causes surprisingly little concern. The entire portfolio is only $3.4bn, barely a third of their equity book value and much less than the $5bn market cap decline since last week.
The other problem seems to be in their multi-family portfolio. Total loans in this category amount to $37bn.
There is not really a problem with cash flow uncertainty in this category. After all, in contrast to office demand, residential demand remains strong in the US.
However, NYCB is a particular case because a large chunk of this portfolio is subject to rent control.
Borrowers are in a tough spot with rising interest rates when they are not able to pass those onto tenants due to rent control. The DSCR looks decent, but that may change once those loans are refinanced.
The same is likely true for the LTV ratios. Real estate is typically a decent hedge against an inflationary environment with rising rates because the numerator (rents) rises alongside the denominator (cost of capital). That’s why US home prices have remained remarkably resilient over the past two years. NYCB’s loan collaterals in this category will likely suffer due to the rent controls.
There is a macro and a micro take to make here. From a macro perspective, it seems obvious to me that much of this problem is specific to NYCB due to their New York office exposure and due to their exposure to rent controlled residential real estate.
As a whole, the US banking sector is demonstrating a remarkable resilience against the Fed’s manic hiking campaign. One reason for this may be their fortified balance sheets. I have in the past repeatedly highlighted that they have deleveraged a lot since the GFC and that 2008 can therefore impossibly be a blueprint for today.
On a micro level, NYCB’s shareholders have suffered $5bn worth of losses over the past week. Their P/B is now sitting at just 0.3x.
It’s quite frankly hard to reconcile this with the information received over the past week. Sure, banking is a leveraged business built on trust. When this trust is gone, the business model is gone with it. Access to cheap funding is vital for a bank. If depositors and lenders shy away from an institution over solvency concerns, it’s lights out pretty quickly.
On the other hand, what news did we receive here? They have problems with office loan quality? Yes, but that’s less than 3% of their total assets. They have problems with low yielding residential real estate collaterals? Yes, but didn’t we know that already? US banks have trillions worth of assets on their balance sheets that generate returns below current market yields. They are getting a pass on that from financials based on a) speculation that interest rates will come back down and b) the fact that they have a lot of intangible assets to work with, most importantly deposit intangibles (the ability to cheaply refinance via deposits instead of high money market rates) and customer relationships enabling cross-selling opportunities. What are some present value adjustments on the asset portfolio vs. an eternity of presumably healthy business thereafter?
I find it hard to comprehend that a bank would lose 70% of its market value pretty much overnight because markets suddenly wake up and realize their loans have insufficient yields. But I have been disappointed by a lacking market efficiency a lot over the past months and years.
For what it is worth, NYCB’s non-performing loans (i.e. loans that are not current on their debt service) are still low, but they have started picking up recently. Markets maybe onto something punishing them.
As I am still remembering SVB’s fate vividly, I can’t help but rejecting this seemingly attractive BTFD opportunity for now. Not because I believe their situation is dire in isolation, but because you don’t fight the mob in the streets when they want blood.
I will observe it carefully in the coming days as it may inspire me for a trade eventually.
Your Fallacy Alarm