Serving Two Masters; A Changing World (Mar 2023)

Risk Commentary

Serving Two Masters; A Changing World (Mar 2023)

Announcement: 2022 was a record year for Egan-Jones Ratings. The firm continued to cement its position as the leader in private debt ratings by issuing approximately 2,700 ratings - more than in any prior year. Our performance statistics continue to demonstrate our favorable default experience in 2022. Only one of our rated transactions in 2022 defaulted. It was previously rated CCC+. This was similar to prior years' default experience.

Serving Two Masters

The adage that it is impossible to serve two masters is readily becoming apparent. The FED cannot both curb inflation by raising rates and keep the banking system solvent. The TINA (there is no alternative) conditions that were present in the market as of several years ago encouraged investors to take credit and interest rate risks. More recently, the unprecedented rise (400+ bps over 12 months) in interest rates whipsawed some investors with investment losses particularly those who did not match fund nor hedge interest rate risk. By definition, banks fund short and invest long; they are suffering consequences.

Figure I: Short-Term US Yields Plunge After SVB Crisis (% Yield)

A Changing World

Stemming Depositor Runs
Oftentimes the world has changed because of technology, but it takes times to adjust to that change. The past 10 days events have made it obvious that banks and their capital base are rather fragile and that runs now occur over a few hours rather than the typical weeks or months. While the FDIC has provided a wholesale guarantee for depositors, it is only for one year and it applies solely to the domestic banks.

Note, the current crisis has some similarities to the S&L crisis of the 1980s whereby low yielding assets were funded via short-term deposits which increased in rates as inflation rose. In this case, although credit quality was stable, interest rate risk was massive.

Providing Asset Liquidity
Regarding providing funding to banks, the Bank Term Funding Program (BTFP) provides funding to eligible depository institutions funding at par, but solely for one year for such as U.S. Treasuries, U.S. agency securities, and U.S. agency mortgage-backed securities (Eligible Assets). There are two problems: (i) the funding via the BTFP is only for one year and (ii) it only covers a portion of the typical bank assets (i.e., Eligible Assets). Hence, there is no funding mechanism in place after one year and many other bank assets are not covered.

Filling Capitalization Holes
Now for the hard part. To maintain comfortable capitalization levels (and offsets unrealized losses in Held to Maturity (HTM) accounts), banks and other depository institutions will be forced to raise equity levels and probably increase interest rates on deposits.

Other Likely Outcomes
The speed and breadth of the recent banking events have jarred the markets. While it will take time to ascertain the full scale of the fallout of the crisis, a likely takeaway is the banks withdrawing from the business of holding assets with maturities of more than a few years. The private debt markets are likely to increase market share (at the expense of banks) since the loans in the private debt market are typically match funded. Yes, banks will continue to originate mortgage loans, auto loans, and credit card receivables provided those can be readily sold in the secondary markets. (Additionally, the trend for deposits to be shifted to the “too big to fail banks” is likely to continue.)

There will continue to be an important role for community and commercial banks which are often loved by their customers, but more care will be devoted to asset/liability management. Lastly, the FED hopefully will be more cognizant of the secondary and tertiary effects of their actions.

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