CLO documentation provides downside protection to investors
We know the wider investor community is often sceptical about banks (an unfortunate overhang from the GFC despite how they’ve largely performed since) and this morning we have another story that will fuel the contagion theories and therefore in the short term will act as a catalyst to weaken the banking sector globally. Our first thoughts are as follows:
Silicon Valley Bank (SVB) in California is a regional and very specialised lender focussing on higher risk tech sector start-ups. Worries about lending quality and also crypto deposits resulted in a sharp level of customer deposit outflows, which in turn required the bank to liquidate balance sheet assets to meet the cash-flight. Concerns that these asset sales created mark-to-market losses (due in part because of the rate rises over the past year) led to further deposit outflows and a 60pc decline in the equity price of the bank.
Fundamentally, we think this should be seen as a clear idiosyncratic event in a regional lender in the US, but we have seen contagion spread across other US banks, and this in turn has negatively impacted European lenders this morning. In a direct read-across from SVB’s situation we have listened to the media this morning talk about banks holding assets on their treasury books that are likely to have negative value on a mark-to-market basis (due to the recent rise in rates), but banks do not have to mark-to-market these assets (only those on trading books) as they are generally held to maturity. These assets might need to be sold if there is a reduction on the deposit side of the balance sheet. Clearly this could be a source of risk for other banks should there be systemic deposit outflows. However, the magnitude of that risk will clearly depend on the mismatch in duration between deposits and treasury positions held. Normally speaking, banks would not be taking big duration bets with deposits, but with such rapid rate rises it is clear why investors could be worried and are selling now and asking questions later. For some smaller, less well-regulated banks with vulnerable deposit bases, this could well be an actual problem, but for the larger well-regulated banks we think the worries will subside quite quickly.
The risk for the European lenders is therefore less in our opinion for the following reasons. Firstly, there is minimal exposure to tech and crypto lending. Secondly the competition for customer deposits is far less than it is for the smaller regional lenders in the US. Thirdly, It should also be noted that European bank treasury accounts typically hold short-dated government bonds, which limit the size of the potential mark-to-market loss in the event of a forced sale. Finally, the European banks typically hold more capital than US counterparts and are better regulated, including down to the smallest more focussed lenders.
We expect some weakness in European bank stocks today, with some price declines in the bonds (particularly AT1s) but we expect this to be short-lived as investors begin to appreciate that with higher rates the real benefit is stronger net interest margins actually strengthening the balance sheet. However we would not be surprised to see more news stories like the SVB one coming from the US in the coming days.