Liquidity Fears Drive Selloff In Banks, But BofA, JPMorgan, And Wells Fargo Should Be Fine

Summary:

• SVB Financial triggered significant concerns about bank funding and liquidity when it announced multiple moves intended to improve asset sensitivity and raised capital on dilutive terms.
• Bank of America, JPMorgan, and Wells Fargo aren’t immune to the impact of higher funding costs, but their liquidity situations are far different than SVB’s positioning.
• SVB’s news only adds to the concerns around the banking sector, but well-funded, well-capitalized banks like BAC, JPM, and WFC offer good long-term upside at these levels.

Thursday was a bad day for banks in the U.S. and as of this writing (pre-market Friday), it could well get worse. Investors were already concerned about the liquidity and funding situation for banks that grew aggressively in the post-pandemic period, but SVB Financial (SIVB) threw gasoline on a smoldering fire when it announced a series of moves to shore up its balance sheet, despite having told investors fairly recently that they had multiple funding options available that wouldn’t necessitate selling their securities portfolio at a loss. Now, in what is certainly a “developing situation” there are concerns about whether SVB actually raised enough capital to withstand a potential run on deposits.

I don’t believe what is happening to SVB Financial reflects system-wide problems, and banks like Bank of America (NYSE:BAC), JPMorgan (NYSE:JPM), and Wells Fargo (WFC) are in better positions with respect to their capital, funding, and liquidity. Even so, confidence in capital is critical for banks and when depositors question the ability of a bank to survive and pull their deposits, it basically becomes a self-fulfilling prophecy without government intervention.

More likely than not, this selloff is creating buying opportunities in the shares of high-quality banks that haven’t overstretched their equity, building a balance sheet full of low-yielding loans and mortgage-backed securities. These top-tier banks (BAC, JPM, WFC) will be fine over time, but there could definitely be ugliness in the short term and “over time” could take longer than I expect.

SVB Financial Sets The Wheels Into Motion

SVB Financial triggered this mess when it announced that it was selling $21B in available-for-sale (or AFS) securities, recognizing a substantial loss ($1.8B, or about 15% of tangible equity), to reinvest in shorter-duration Treasuries (shortening the bank’s duration and making it more asset-sensitive) and subsequently raising $2.25B in new equity ($1.75B common, $0.5B preferred) below tangible book and adding $15B in longer-dated borrowings.

At the risk of oversimplifying a complicated situation, here’s what’s going on. SVB has grown aggressively in recent years, using the pandemic-driven surge in no/low-cost deposits to help fund an aggressive expansion of lending and securities investments. With rates now substantially higher, depositors are moving their funds to higher-yielding options and the value of the securities book has meaningfully declined, shrinking SVB’s tangible equity and necessitating a capital raise.

Said differently, SVB Financial basically put itself into a situation where a big chunk of the earning asset base was locked in at sub-200bp rates ($29.4B of AFS securities yielding 1.7% and $85.1B of held-to-maturity securities (or HTM) yielding 1.72% out of $209B in earning assets in Q4’22) while non-interest-bearing deposits were flowing out and new money was costing more than 200bp (and increasing).

When SVB sold the $21B of AFS, they took an $1.8B loss, but the bank also ended the year with around $15B in unrealized losses on its HTM securities versus $11B in tangible equity. Beyond that, you have to consider what the mark-to-market would be on the loan book. With start-ups burning through cash (further reducing deposits) and clients likely to tap available credit lines, it’s an ugly situation and the market reaction clearly shows concerns that SVB Financial may not get the liquidity it needs to make it through this choke point, which is unfortunate. While management clearly didn’t position the company correctly for this phase of the cycle, it has been a successful bank and serves an important role in its niche.

What This Means For The Large Banks

I don’t believe SVB’s initial equity raise went far enough, and again, this is an actively developing situation so there may have been additional developments between the time this is written, the time its published, and the time you’re reading this. But if depositors start withdrawing deposits in earnest, that $2.25B equity raise could be effectively meaningless and the bank will require basically its own “mini-TARP” or a buyer. Given how regulators treated JPMorgan after the WaMu and Bear Stearns bailouts, I’d be shocked if any large bank (like BAC, JPM, WFC, et al) raised their hand to volunteer.

The hit to the values of HTM/AFS security portfolios isn’t new news – it was evident in earnings reports through the second half of the year, so I don’t see all that much risk here for the largest banks. Given their capital positions and their access to other funds (brokered deposits, FHLB advances, et al), I don’t see much risk of forced sales of underwater securities at this point.

JPMorgan ended the year with a cash/average loan ratio of 54% (49% for Citigroup (C), 21% for Bank of America, and 17% for Wells Fargo) and a ratio of deposits to loans plus HTM securities of 154% (145% for Citi, 115% for BAC, and 111% for WFC). Bank of America, Truist (TFC), and U.S. Bancorp (USB) do have larger ratios of unrealized losses to tangible equity than their peers, but not enough to stress their liquidity. While low-cost deposit balances are going to shrink further and deposit costs are going to rise, I see this as a question/issue of profitability for these banks, not liquidity or survivability.

If other banks are forced to liquidate portfolios quickly, that’s not going to be good for the value of those securities, nor overall confidence in the system. Likewise, the Fed recently made it clear that they are most likely not done raising rates, and that’s going to put more pressure on deposit costs. Likewise, I think some banks will now be nervous about selling underwater securities to boost liquidity and will instead prioritize raising more deposits, paying what they must to do so and contributing to further upward pressure on deposit costs.

All told, though, none of these banks (BAC through WFC) are in close to the same liquidity position that SIVB was in before Thursday’s news, and I think it’s reasonable to believe that “contagion risk” is limited to banks with similar business models and liquidity challenges.

The Outlook

I hate the term “clearing event”, but I do think the SVB meltdown is good case-in-point to some of the risks I’ve been talking about with respect to bank funding costs – namely that deposit costs were going to rise more than bank analysts and managements had been expecting at the start of this cycle in 2022 and that there were going to be consequences to earnings.

At this point, I think the Street’s eyes are now open to these risks, and the Street being what it is, valuations for the more liquid banks have probably overcorrected. Likewise, I expect we’re going to see other banks taking steps to boost liquidity, enhance asset sensitivity, and shorten durations on the asset side of their balance sheets. That is likely to be mean a step down in loan growth and a renewed focus on building more robust loan/deposit ratios – and the combination of weaker loan growth and higher deposit costs will create more pressure on earnings for the affected banks.

Again, the relevance to banks like BAC, JPM, and WFC is limited – they aren’t targeting such aggressive loan growth, their loan growth is better-supported by deposits, they have access to ample alternative funding sources, and their unrealized security losses don’t exceed their tangible equity.

The Bottom Line

Of the three banks mentioned, BAC screens the cheapest relative to my expectations, followed by Wells Fargo and JPMorgan. Given that this is only going to add to investor nervousness about banks at a point when sentiment was already weak, I’m tempted to favor JPMorgan (which I do own) on the basis of higher perceived quality even though the return potential isn’t as high. I continue to believe that most high-quality banks remain undervalued, and this could be a good buy-the-dip opportunity, but clearly the sector isn’t out of the woods yet and is going to be under increased scrutiny through at least the next earnings reporting cycle in April/May.

To read my most recent articles on some of the names mentioned, please click here (BAC), here (JPM), here (TFC), here (USB), and here (WFC).

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Disclosure: I/we have a beneficial long position in the shares of JPM, TFC either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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