PARTICIPANTS
Tom Dicker
Guest Host, Vice President & Portfolio Manager
Nick Stogdill
Portfolio Manager
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Tom: Welcome to another edition of On the Money. I'm your guest host Tom Dicker, Vice President, and Portfolio Manager at Dynamic Funds. We're here for a special edition of On the Money to talk to you about the ongoing crisis in the banking sector. I'm here with the perfect guest, Nick Stogdill, Portfolio Manager of the Dynamic Financial Services Fund and the Dynamic Alternative Yield Fund.
Nick has been with Dynamics Equity Income Team since 2017 and prior to that was a financial analyst for eight years at Credit Suisse. Prior to that, Nick was an accountant, so he's got lots of expertise in the financial services area. We're going to dig right into what happened with Silicon Valley Bank, Signature Bank, and Credit Suisse. We'll compare the current situation to 2008.
What's similar? What's different? Compare the situation in Canada to the differences with the US. Talk about what caused the problems, address some of the risks, and risks of contagion. Nick, thank you for joining me. I keep hearing that the US Federal Reserve will hike interest rates until something breaks. How important was Silicon Valley Bank and how did it break?
Nick: Let's maybe take a step back and put Silicon Valley Bank in the context of the US banking market first. The US banking market is very big. There's over 4000 banks and really you can kind of break it into two pieces. There's the big money center banks that have national operations, diversified franchises with retail banking and wealth management, and investment banking. These are names like JPMorgan and Bank of America and Citibank.
Then you have US regional banks. Regional banks are certain banks that only operate in the Midwest of the US, some that only operate in the Southeast, some that only operate in the West, and less diversified than these money center banks but they are an important part of the overall US economy and the banking system. Silicon Valley Bank was the 16th largest bank in the US as you've probably heard. They were not overly material to the overall banking system, but it was a large bank with over $200 billion in assets.
That said, Silicon Valley Bank did not look like your typical bank. It had a very niche strategy. It was focused on clients in high-growth areas, high-growth industries, technology, venture capital, growth equity, private equity, these niche businesses. It was really more of a monoline bank and it did not look like these big money center banks. Just for more context, the top five banks in the US hold something in the range of 50% of the overall deposits and the remaining thousands have the remaining 50% share of the deposits. It was this niche strategy.
There were really two elements that I think effectively broke Silicon Valley Bank. The first is just monetary policy. The Fed started to raise rates a year ago, and as rates go up the intention is to tighten things up in the system to reduce the lubrication in the economy. You never know how that's going to work its way into the system and ultimately this was just an outcome of that tightening monetary policy. You never know where it's going to pop up. The second element of Silicon Valley Bank that really broke the back of it was just poor risk management of the business. To try and simplify this what happened is these niche clients went through a lot of growth in 2020/2021.
Tom: The tech sector clients?
Nick: Exactly the tech sector they brought in a lot of money. All these clients put their deposits into Silicon Valley Bank, and they saw all this money come into their bank. Banks can do one of two things with deposits. They can put them in securities, or they can lend the money out to businesses as loans. A lot of the money that came into Silicon Valley Bank they took it and they put it into fixed income securities, bonds, things like that.
The problem was really that there was a bit of a mismatch if you will. The deposits could be pulled at any time, but the securities really, they weren't supposed to come due for five, 10, or 15 years. There was this mismatch. Then as the Fed started to increase interest rates, the value of those securities went down at the same time Silicon Valley's clients started to face some more challenges in the market and their businesses and they started pulling the cash.
Meaning Silicon Valley Bank had to sell these securities which would have triggered losses and impacted the capital base of their business. That's ultimately what led to the deterioration. It was really a crisis of confidence that caused its downfall. These problems I'm talking about on the mismatch and the money coming out and the losses, they didn't really fully happen. The market saw that, there was the writing on the wall, got nervous and deposits started running for the door. Confidence is everything in the banking market, without confidence there really is no banking.
Tom: It sounds like it was a classic bank run. People just pulled their money all at once. What was different about this bank run compared to some previous bank runs that we've seen in the past? Like say, the biggest one I remember was WaMu, Washington Mutual back in 2008. What was different between this one and that one?
Nick: I think the view in the early days as we see this unfold is just actually really technology, social media, the ability to draw money out digitally, push a button on an app or on a computer screen, and take that money out. The statistic I've heard is that Washington Mutual at the end of its demise and the final weeks it lost something like $17 billion of deposits which was 8% of its deposit base. Silicon Valley Bank lost over $40 billion in a day a-- single day which was a quarter of its deposit-based.
Tom: Staggering.
Nick: That's just unheard of. If you think about it the historic way of a bank run was you line up at your bank and you have to go do it manually and pull the cash out. That's not what happened this time. There was fear spread on social media, on news, and people were able to just electronically withdraw their money and we've never seen anything like this rally in history.
Tom: Silicon Valley Bank wasn't the only failure though. We saw more than one failure over the last couple weeks. The next one to go was Signature Bank of New York, and then we saw Credit Suisse which is obviously a Swiss-based financial institution. What happened there? How did the Dominoes fall from having problems at Silicon Valley Bank into Signature Bank and Credit Suisse?
Nick: Signature Bank did share a few similar attributes with Silicon Valley Bank. They had a lot of clients with bigger size deposit accounts. Those bigger deposit accounts are uninsured, so if you think your bank's going to have a bank run and run out of money, you're a little more scared and hesitant and you pull those deposits out.
Tom: It's easier to pull because it's just one account.
Nick: Exactly. They had some industry overlap and notably Signature a couple years ago had started banking crypto clients. These crypto businesses started leaving money with them as deposits and there's been some concerns there obviously given what's played out over the last year or two, so that might have contributed to it as well.
Tom: Some of the volatility in cryptocurrency could have helped accelerate some of the fears around Signature Bank. Is it safe to say that?
Nick: Exactly. Look, signature Bank also had exposure to real estate, particularly in some areas of concern. Tom, maybe you can get your thoughts on the real estate exposure because I think that's coming up as well in the discussions with Signature. Any thoughts you'd like to share?
Tom: Sure. Yes, there have been some headlines around this and we did some digging on that and of concern in signatures commercial real estate portfolio were loans on multi-family in New York. It wasn't just regular multi-family, it was this stabilized multi-family. In 2019 they changed the laws in New York State where it became very difficult to pass on even inflation in terms of rent increases, so the asset values on these "stabilized assets" in New York have fallen really dramatically.
The view is that these assets are a bit toxic, and these loans would be toxic because the assets themselves have probably depreciated. Estimates that I've seen have been 20% to 60% in terms of a decrease in asset value. People didn't really want those loans when they matured. These loans are still all current. People are still paying their interest. It's just the view is that when they come due, they won't be refinance-able because the asset values have fallen pretty dramatically.
Nick: The underlying clients are paying, and the credit quality is still good. It's more of the rate on the loans and the yield of the loans.
Tom: I would say it's more about the credit quality of the cash flows is good, but the asset value has deteriorated meaningfully. The view would be lenders wouldn't want to have to refinance those loans.
Nick: Another unique attribute of Signature.
Tom: Another call it idiosyncratic difference to other financial institutions that are out there. That Signature Bank-- Credit Suisse is one that was in trouble back as far as 2008 as far as I can remember, and then it's come up a few times since then. What tipped Credit Suisse over the edge to need to be taken over by UBS? What happened there? Obviously, Credit Suisse being your formal employer this is a story you fall for a long time.
Nick: Working there for nearly a decade. They just had some strategic problems with their business that they've been battling. Again, this is sort of idiosyncratic, but it was really an unprofitable business that they had. In the investment bank it was always challenged from a profitability standpoint, and they just never did enough to fix it. It was death by a thousand cuts where they would do a small repositioning, a small restructuring, but it was never enough.
Over the last few years, there was already some money in assets leaving Credit Suisse, but you overlay that with the crisis of confidence you were having in the US with Silicon Valley and Signature along with a few other news headlines and this was the tipping point. This was finally enough to push CS over the edge for a material change and into the hands of UBS. When times get tough that's when things come to a head, and they just didn't do enough until now and they're being forced to take action.
Tom: We often in the investing world think about the stock price as being an output of the fundamentals. Sometimes and I think this is one of these situations where the reverse can also be true. It's this notion that George Soros talks about of reflexivity where the stock price going down can actually negatively influence the fundamentals, and that can actually cause the situation to feed on itself. Where clients see the stock price going down, they worry about their bank, they move their deposits instead of going the other way around where the stock price is more reflecting.
What's going on in the economy or with their clients the stock price can actually influence their client's behavior which is very interesting. Clearly, one of these events takes place in the risky tails of the stock market, one of these statistically abnormal events that we went through although clearly, we've had a few financial crises over the years. How do you think about what's similar this time and so far what you've seen in terms of this relatively small thus far banking crisis? How does it compare now to 2008?
Nick: It's a good question and I've really only started to think about it and I'm sure more thoughts will come in overtime as you do all in the situation and look back. There really aren't a lot of similarities. When you look back there was a tightening cycle with Greenspan starting to raise rates, and that continued right up into 2006 until it eventually set off the chain reaction across the financial sector and leading to a deeper recession. Again, it culminated with the tightening cycle and just worked its way into the system.
I think the other similarity is that problems started to bubble up in the banking sector before they spread out in 2007, 2008 in the global financial crisis. I think there are more differences this time around at least thus far. Again, in 2008 that was really about toxic assets. There was a lot of mortgages to subprime borrowers, people that couldn't afford to make mortgage payments. Things that were not being done properly on the documentation side and all kinds of stuff like that.
Tom: Some pretty egregious stuff in the financial engineering world, all of the alphabet soup, the CLOs, the CMBS that were all leveraged on leverage on leverage. Things that were rated AAA but were really just much lower-rated but diversified pools of assets. It's very different now.
Nick: Exactly. This episode again so far is not at all about toxic assets. In fact, if you look at Silicon Valley's balance sheet, about half of its assets, if not a little more in terms of its yield-oriented securities were in government-backed debt securities. These are backed by the full faith of the US government. These aren't toxic assets. That was clearly not an issue with Silicon Valley Bank. I think the next point was that in 2008 these issues were more widespread and being felt throughout all of the banks.
The large US money center banks that I talked about, small US banks and even some non-US banks that were buying these mortgage securities and involved in the US mortgage market. Today, the problems thus far are largely within a select group of regional banks, which make up a small part of the banking system. Again, without getting into details, banks are run much more conservatively today than 2008. It doesn't mean there can't be issues, but overall risk is lower. Leveraging the system is lower. The banks hold more capital, they hold more liquidity.
You made the point, regulation as always looking back, and they've done a lot of strengthening. Those things weren't there in 2008. The last point I'll touch on again, 2008 was really more about exuberance in the mortgage market, and you can probably touch on this, but that's a big part of the overall economy. Today, the only exuberance we're seeing is in this high-growth venture capital, private equity, some of these industries that might not have ramifications for the broader overall market and economy
Tom: We're definitely of the view that while the root cause of tightening cycle is the same. There are some big differences on what's happening under the surface of the economy this time versus last time. When you look at 2008 real estate really was at the center of the crisis. That does not appear to be the case right now. Even Signature Bank, which is now gone, their multi-family portfolio was 99.5% current. The credit quality is still very, very strong there. That certainly was not the case in 2008. We weren't seeing anything like that.
There were lots of toxic assets. There were the adjustable-rate mortgages-- remember the mortgages that would reset to rates that were much higher than the initial payments and people didn't even know they had them. In many cases, there were the widespread ninja loans and no income, no job, no assets. This is not the same situation in my opinion at all. That doesn't mean that it's not serious, and it doesn't warrant a response from the Fed. Certainly, we're going to see a change in oversight and regulation.
When it comes to regulation in the US there was a big change in 2018 where the regional banks were deregulated, and it caused them to do a lot of different things. One of them was take on a bunch more loans in commercial real estate. In Canada, we haven't seen those same changes to regulation. I think Canadian regulation in the banking sector remains extremely strong. Could you talk a little too generally the differences in regulation in Canada and US, and even more broadly just industry structure the differences in between Canadian and US banking?
Nick: Going back to the first question and the first point I made is just that not all US banks are created equal. Again, we have these US regional banks that were subject to less onerous regulations versus the big money center banks. There are some super-regional banks we call them that have operations across a few different states scenarios.
Tom: That's the US bank core PNC those types of-
Nick: True financial. Yes, exactly. Again, there are some differences even within the US market and even in this crisis so far, the big banks are actually weathering the storm quite well and thriving through it as they're getting more deposits in. They're being viewed as more resilient and viewed as stronger franchises.
Tom: Anti-fragile.
Nick: Exactly. That's in the US alone. Then compare it to Canada, I guess first and foremost the US, as I mentioned, is very fragmented. There's over 4,000 banks in the US Simplistically more banks there equals more competition and potentially more risk-taking. If there's 4,000 banks, there's always going to be somebody willing to want to fight to give a loan. In Canada, again we're much more concentrated. Our big banks have something like 80 to 90% of overall market share, and that means it's just a more rational oligopoly as you have less places to go.
That can work against you in some ways, but in this case, it's very strong to have that concentration across five or six banks. Secondly, I think regulation in the US is more rules-based and that's again, a function of the size and number of banks. Here's the rules, follow the rules. The regulator can't be calling every single bank to make sure they're on top of everything. In fact, Canada's small enough, the regulator has been known and has done this where they've gotten all the banks together in a room with the central bank.
The government they can get everyone together to solve a problem. It's more principles-based and they can work out solutions more quickly. I think that is something that is very beneficial. Again, the point I maybe didn't touch on for the Canadian banks, but these are very diversified franchises well. Over the last 40 years, they've consolidated wealth management and brokerage, insurance in some cases, investment banking, retail banking, commercial banking.
They've even expanded obviously into other jurisdictions like the US They have very resilient diversified franchises. The returns they make on their business are 40 to 50% higher than US banks as a function of their size and scale and diversification. When you make more money you generate more profits and more capital, and you can just withstand tougher times and weather the storm a little bit better.
Tom: You would measure profitability with ROE for Canadian banks. How would they compare Canadian banks and US banks in terms of return on equity?
Nick: Return on equity for Canadian banks over the last decade has been in the mid-teens, we can call it 15%. US banks are around in the 10% range, we'll say fairly similar between the regionals and the large money center banks. That's a pretty noticeable gap.
Tom: Could we shift gears a little bit and talk about the implications of the crisis that's unfolded so far? How is this going to impact the economy, individuals, and businesses?
Nick: I think there's two aspects to that question and how it could impact individuals and businesses. The first is just the broader macro-impact and the economic concerns. Other banks that are outside of Silicon Valley and Signature and Credit Suisse are feeling a little bit more stressed and just looking at the environment. They'll probably tighten up on their lending standards and just make sure they're watching things a bit more carefully.
That was actually already happening as the Fed was-- tightening conditions again usually cause a little bit of loss on the credit side. They were already tightening up. That's the first element. This might just accelerate or accentuate the cyclical tightening that a bank would do. Then secondly, there's less availability of cheap deposits. Deposits are how banks fund loans. Some deposits are moving out of the system, some are moving to different banks, and that can just create dislocation.
Again, less cheap deposits means banks can't make as many loans. That again tightens up for everybody and we'll have broader cyclical implications. Maybe Tom, to throw back to you, banks are big lenders to owners of real estate. What do you expect banks to do with the real estate borrowers, and what will you home in on in the coming months in the real estate space to see if that's happening?
Tom: Certainly, it's too early to tell so far what the impact will be on real estate, but I think the Silicon Valley and Signature situations are instructive in that what you found was the weakest players suffered the quickest. In real estate, what is the weakest player? Right now, that's office. Certainly, office vacancy has gone in downtowns in the US from 10% pre-COVID to 18%, and some estimates are that it's even higher than that. Certainly, in some markets, it's much higher than that still. That's caused by a bunch of things.
One of them is the new supply that was under construction prior to COVID that's been delivered into a market that's been quite weak. Why is the demand market so weak, i.e., why do tenants not want to lease as much space? It's because people want to work from home, it's because companies are rationalizing their space. I think it was Steve Roth, the CEO of Vornado said on the last conference call. The quote is, "I think you have to assume Friday is dead forever."
As a result of that, companies are going to want to think about their office space a little bit differently. Our view is that asset values in office are going to come down a lot because rents are going to come down because there's not a whole lot of demand. We would expect that the lenders that have some of these loans on their balance sheets are not going to want to renew them. That's where we think the stress is already starting to appear. We've seen a couple of instances already of large owners of office default on their mortgages already.
PIMCO defaulted on their Columbia Property Trust acquisition. Before that was at $1.7 billion loan in real estate, that's big. I know that some of the numbers we've been talking about have been much bigger, but in real estate, a $1.7 billion mortgage is quite large. We saw Brookfield also lose some tenants in a downtown Los Angeles portfolio, and they also defaulted on that mortgage. Part of it is due to the fact that as interest rates have gone up, some of these companies have floating rate debt, so their interest payments have ballooned dramatically.
Some of it is because they've just lost the income. They've lost tenants, they've move to newer buildings as new buildings have been completed from that pre-COVID construction that I mention. I think that's the area we're most worried about. When I look at the other areas in real estate, there are lots of areas that remain pretty strong. A strong economy which we have right now is pretty good for real estate. You have very good job growth means multifamily, it remains relatively full, i.e., apartment buildings across the U.S remain relatively full.
The retail landscape was very heavily tested during COVID, but COVID was also such a challenge that almost no new space has been built for the last four, five, six years because it was challenge going into COVID because of e-commerce. The retail landscape I think remains fairly strong, not a lot of new supply, the tenants are pretty healthy still. Then industrial because of e-commerce remains really, really strong. The rents there have skyrocketed since the start of COVID. I look at a lot of areas of commercial real estate and I see still a fair bit of strength.
Office is clearly going to be the area that is going to be most affected by what I think will be a shrinking commercial real estate loan book for many of these regional banks, and maybe even money center banks too. As these loan books shrink, I think office would be the place where they want to shrink at the most, so I would be very cautious there. In our Global Real Estate Fund, we own zero office landlords because we think it's just too risky. I'd love to ask you the elephant-in-the-room question. Will there be contagion from this into other areas even beyond real estate, for example. Do you think there will be? Is it too early to tell? How do you think about that question from where you sit now?
Nick: I think the lesson learned here is that real material risks are impossible to predict, and they just surface in unpredictable ways. No one was talking about deposits leaving the system unmask. A couple of weeks ago, banks and regulators do lots of stress tests and no one was testing for this, so it's very hard to tell truthfully. Maybe a couple thoughts though. Again, Silicon Valley, Signature Bank, CS, Credit Suisse, these are idiosyncratic situations.
Confidence is shaken for the moment, and that can lead to bigger issues if those overseeing the situations do not act with enough force, and enough liquidity, and do enough things to stabilize the system. I don't think there's contagion. Then I think more importantly from an investment landscape and a portfolio perspective it really emphasizes that owning a diversified portfolio of strong businesses that have resilient revenues and earnings and cash flows is just critical for weathering the storm as an investor. That's probably the overarching theme I will leave you with.
Tom: I think that's a great point on active management. I think it's important for our listeners and unit holders to hear like, did you have exposure to Silicon Valley Bank or Signature Bank, or even Credit Suisse?
Nick: Tom, similar to the comments you made on office exposure we try to focus on high-quality companies, and we did not own any of those names in the financial services fund or across the equity income team. It would be great to hear some additional thoughts that you have on active management and how it can play a part in a portfolio to avoid some of these trickier situations in idiosyncratic situations.
Tom: Yes, I'm not sure how big Signature or Silicon Valley were in your benchmark, but certainly for me on the office side covering real estate office for a long time was a really meaningful part of the benchmark. When we were looking at it, even prior to COVID, we didn't really think office had attractive economics. Certainly, post-COVID, the use case for our office was really hurt by working from home. For us, as active managers, we were willing to go to zero weight in what was a sector that at one point was over 10% of the benchmark.
We were willing to go all the way to zero. For passive owners of the real estate index, they had to ride that all the way down to where it is in the US I think it takes up about 4% of the benchmark right now. Let's material capital losses. I think even more important in this situation for us was owning liquid real estate. Often when we look at our competitor set over the last decade, a lot of folks have asked us like, "Shouldn't I just go out and buy a building, or buy a private real estate fund?"
The ability for us to go out and sell these assets, get it out of your portfolio, and recover a bunch of the capital that you've got invested in, what is a problem area? I think in real estate, especially when you make mistakes, if you're a long-term private owner of these assets, it can be really tough to get out. I think there are people all over Canada, whether it's in the pension plans and all over the world that own office buildings right now that wish they didn't.
For us owning a liquid real estate portfolio, at least we were able to kind of mitigate those problems and focus on the areas in real estate where there are really positive fundamentals like cell phone towers, and data centers, and industrial real estate, and manufactured housing and apartments where you're getting tons of inflow of immigrants into Canada. Apartment rent growth has been extremely strong. Wouldn't you rather be there than invested in office? The answer for us is really easy. Obviously, you need to be an active manager, but I think that's one of the things we've been willing to do and clearly you are willing to do it in the financial services fund as well.
[music].
Nick, I think we'll leave it there. Thank you so much for joining us today.
Nick: Thanks, Tom.
Tom: This is a special edition of On The Money, and on behalf of all of us at Dynamic Funds we wish you all continued good health and safety. Thank you for joining us.
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