Bank failures, middling economic data, and political wrangling over the debt ceiling did little to slow the American job market. The message among employers is clear: “Damn the torpedoes! Full speed ahead!” This morning the Bureau of Labor Statistics (BLS) reported US companies added 339,000 jobs in May. Moreover, April job openings (JOLTS) ticked back above 10M… yet again! The labor force participation rate held steady at 62.6% MoM even as the official unemployment rate jumped 0.3% to 3.7%. One might suspect that this sort of report would be capped off by a rather strong inflationary headwind. That is not the case this month. Wage pressures moderated on a month over month basis, rising only 0.3%. Mr. Powell’s much hoped for outcome could be taking shape before our very eyes as we enter the summer months-- a soft landing for the US economy could very much be in the offing! Our multifaceted global economy is rebalancing as the domestic transition we discussed at the outset of the year is underway. Of course, there is a lot to address, but let’s return to the balance sheet for a few moments.
Where did we leave off last month? Oh yes, the cost and terms of debt. The cost function is largely encapsulated by the rate of interest on the debt. Some debt is fixed rate and other debt is floating rate. A bank or financial institution will charge a “spread” in excess of a certain benchmark—SOFR (adios, LIBOR!), 10-yr UST, etc…-- to compensate itself for the risk associated with providing financing. The benchmark and spread are VERY important, when combined they determine the “all-in” or effective cost of debt. The advantage of floating rate debt is that the “spread” is typically tighter than fixed rated debt, BUT the interest rate also floats. Thus, the borrower assumes the risk that rates will float higher (or lower) over the term of the loan. Meanwhile, the bank eliminates its interest rate risk. So, at the onset, the assumption would be that the cost of any floating rate loan will be less than a fixed rate loan of the same quality and term, BUT as we have seen in the last 12 months or so, rates can change rather quickly and dramatically!
Going back to our example, let’s assume that the debt is floating rate instead of fixed with the benchmark being the Secured Overnight Financing Rate (SOFR)—incidentally SOFR also happens to be the replacement for yesteryear’s LIBOR. Today, SOFR is clipping along at 5.06%, but roughly a year ago that rate was closer to 0.79%! The bank’s spread will not change; let’s assume our deal from a year ago secured financing at SOFR plus 250 bps (or 2.50%). Last year the debt would have had an all-in rate of 3.29%, but now we are looking at 7.56%! This represents a relative increase of ~2.3X in just 12 months! Yikes! Here’s how the economics of our theoretical real estate deal were impacted (all else equal)…
Return on Asset= 5%
Cost of Financing (T+0)= 3.79%
Cost of Financing (T+12 months)= 7.56%
Leverage Ratio= Debt/ Equity= 80%/ 20%= 4
Please note that T+0 effectively reflects our assumptions at the start of the deal and T+12 months reflects how things have changed in just 12 months. The ROE calculations are as follows:
ROE (T+0)= (4 * (5% - 3.79%)) + 5%
ROE (T+0)= 9.84% (Not bad)
ROE (T+12 months)= (4 * (5% – 7.56%)) + 5%
ROE (T+12 months)= -5.24% (Uhoh!!)
Chasing a tighter spread associated with the floating rate would have turned the tables on the investor in this scenario. Of course, the investor could have chosen a fixed rate option and locked in his financing costs. This illustration has broad ramifications across the financial space. On the consumer level, many mortgages are effectively underpinned by floating rate debt. This is less of a concern in the United States where most mortgage debt is fixed; however, in other parts of the world adjustable rate mortgages are the norm! At the banking level, dramatic shifts in the rate environment have real consequences for loan books and the extension of credit (to businesses and consumers alike).
This is not a problem that can be ignored (or simply explained away as merely “bad management” in the C-suite), especially when bank deposits EVERYWHERE are paying practically nothing! When the relationship between assets and liabilities shifts from symbiotic to antagonistic, a natural outcome among lenders is capital flight. This is a very acute risk that banks can face at precisely the time that the value of their assets (i.e. loans, bonds, etc…) are plummeting. In essence, capital flight is the autobahn of insolvency in the financial space… Just ask Bill Hwang of Archegos fame.
A run on the bank effectively triggers/ forces an unwinding of assets. This process can also be politely described as a “realization of losses” amongst financial institutions. Even if a bank had invested in relatively secure, high- quality bonds AND its intent had been to hold them to maturity, capital flight means the bank must sell at prevailing market rates in order to meet the demands of depositors, which is priority number 1 at ANY bank. Of course, this scenario isn’t good for ANY bank with ANY duration on its books (Note: duration refers to interest rate sensitivity). It wouldn’t be a stretch to call this type of investing environment “unhealthy” or “toxic”, which is why we have been positioned defensively for such a long period of time (more on that soon)! What was a concern regarding the relationship between assets and liabilities at the end of Q1 2022 and a worry in Q3 had become a reality by Q1 2023, but I digress. Naturally, the whole financial system isn’t on the blink, and this is an oversimplified version of what happened to banks like Silicon Valley and First Republic. However, the reality is that the strongest, best capitalized banks will be able to snap up competitors for a song, which is exactly what has happened. The truth is this also has powerful ramifications for investors across the spectrum. More to come as we continue the transition!
News Release: Bureau of Labor Statistics (The Employment Situation- May 2023)