The Pomp Letter - The Banking Crisis Is Not Over Yet

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To investors,

The second and third largest bank failures in US history happened earlier this year. As more large banks came under pressure around the world, there was concern that the contagion would spread out of control.

The Federal Reserve and US Treasury, along with their counterparts in other countries, stepped in to backstop customer deposits. This action was seen by many to not only be necessary, but a proactive approach to calming fears and reassuring citizens that the banking system was strong.

The government did not save equity or debt investors in these banks. This is exactly how capitalism should work. The risk-takers were wiped out for making a bad bet. The average citizen was protected and all is well in the world, right?

Not so fast.

There were a number of banks that did not require the government to save them and their depositors, but remain in a really bad situation. Take First Republic Bank (FRB) as an example. The stock price plummeted and customers withdrew billions of dollars as they watched Silicon Valley Bank fail. The largest banks in the country stepped in to contribute ~ $30 billion in deposits to FRB in an attempt to strengthen the prospects of survival.

Crisis averted for the time being. But we are right back where we started in recent days. The bank’s stock is down more than 90% year-to-date and it fell ~50% just yesterday after a disappointing report, which highlighted a 40% drop in customer deposits in Q1. Simply, First Republic Bank is not out of the woods and it is on the brink of collapse.

If First Republic Bank was to fail, it would be one of the five largest bank failures in US history. That would mean that three of the five largest bank failures in history have all happened in the last four months. Insane!

The potential collapse of First Republic Bank is important to pay attention to because it highlights the ongoing problem for financial institutions around the world. They are still holding hundreds of billions of dollars in debt that is underwater. The mark-to-market losses would render many of the organizations insolvent.

The only potential path out of this situation is for the government to step in and save these financial institutions. They can do it in a number of ways — they can try to manipulate the accounting rules as they have done in the past, they can print a significant amount of money, or they can let the banks fail while saving the depositors. I don’t think they will pursue the first strategy, so my expectation is for the government to print more money over the next 12 months.

We are not only facing a private sector bank crisis though. There are a number of central banks that are under immense pressure as well. Let’s use Argentina as the example — inflation is over 100% in the country in the last 12 months and the central bank just raised interest rates to 81%. Think about how crazy that is. Anyone holding pesos has lost 50% of their purchasing power in the last year. The definition of destroying a currency and your citizen’s savings.

Whether we are talking about central banks or the private banking sector, the pain is only just beginning it appears. Jason Karaian and Stacy Cowley wrote in the New York Times:

On Friday, Moody’s downgraded the ratings of 11 regional banks, citing “a deterioration in the operating environment and funding conditions.”

In calls with investors about their latest financial results last week, regional bank leaders tried to cast the crisis as a moment that had passed. The banks also distanced themselves from rivals still caught in the storm, like First Republic, which reported on Monday that it had lost $102 billion in customer deposits.

The leadership of the banks continue to say everything is fine. Moody’s is downgrading many of them. First Republic Bank is on the brink of failure. And it feels like the average citizen in America is asleep at the wheel. They believe the banking crisis has been thwarted. We have all moved on.

That is a dangerous situation. The banking crisis is still underway. It doesn’t mean that catastrophic failure is inevitable. In fact, I would argue that the banking sector will survive this test and thrive on the other side. The government and central bank are heavily incentivized to protect depositors and prevent a full-on bank run of the system.

They don’t have very many tools to accomplish that mission though. So turn on the money printer and watch it go BRRRR! Markets need liquidity. Everyone knows the Fed was going to create tighter financial conditions until something breaks. It looks like we are watching many of the largest banks around the world buckle under the pressure. The question is — has there been enough pain? Or will the Fed seek more before they waive the white flag?

Your guess is as good as mine. Hope you all have a great day. I’ll talk to everyone tomorrow.

-Pomp

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