The banking sector only works as much as people trust in it. The fractional reserve banking system that we use today means that everybody cannot access their money at the same time. One person’s savings is another person’s mortgage which is simultaneously a homebuilder’s profit. The benefit of the system is that one dollar can be used more than once and can permeate across an economy leaving several households better off than a system without fractional reserve banking would. The downside of this system is that it relies on the trust of people to allow their savings to be lent out by a bank, and humans are emotional. It is possible for the trust in banking to erode enough to topple these institutions, and to test the premises on which we have built our economy. The downside of fractional reserve banking is exactly what we are living through right now with three bank failures so far this year.
After the collapse of Silicon Valley Bank and of Signature Bank, we mentioned that economic downturns are essential to a well functioning economy since weak businesses with poor management are trimmed off, leaving stronger and more resilient companies to live on. For banks to fail is simultaneously scarier and less scary than firms in other industries for a few reasons. Banks serve as the backbone of the economy and without their services, no other industry would be able to function in the same way. Banking failures are felt by all. That being said, our government has gotten a lot of practice over the years overseeing bank failures and nobody's deposits were ever at risk in any of these cases. Without a strong and competent FDIC, it is unclear what kind of apocalyptic scenario we would find ourselves in today, a few months after the SVB collapse.
Over the weekend, First Republic Bank, the banking partner of Peak 15 Capital, was seized by the FDIC and sold to JP Morgan & Chase for around $10.6B. Readers of our newsletter might recall us standing by First Republic and stating that FRB was on much better footing than SVB or Signature, and this was true. To understand why this takeover was necessary, we need to understand the period in between March 10th when SVB collapsed, and the present. Often times, when the media reports on financial news, they use terms like “contagion” and “virus” to describe the fears of investors and depositors. In many cases, this language is counterproductive, but in this case it is entirely accurate. First Republic was a bank that catered primarily to wealthy clients and businesses that had deposits greater than $250k. $250k is an important number because anything above that threshold is technically uninsured, and the clients that hold that amount of capital in banks are known to be “flighty” and are more likely to switch banks quickly. From March 10th to April 24th, these depositors were indeed “flighty” as $100B of deposits were pulled out of First Republic. Those deposits were pulled not because of any structural problems or mismanagement of the company, but simply because of fear.
That $100B that was pulled out of First Republic in less than 2 months represented about 41% of its total deposits. No bank could have survived this. This kind of mass exodus from a bank is only possible in today’s age of instant communication and should not reflect poorly on the management of FRB. The “contagion” spread to FRB not because they were exposed to similar kinds of risky assets as Signature or SVB, nor did the contagion spread because FRB lacked risk assessment committees like the other former banks. Instead, the contagion spread to FRB and depositors closed their accounts simply because First Republic was also a regional bank and was a similar size as Silicon Valley Bank. This sounds like a silly reason to lose trust in a bank, and it absolutely is, which is why instead of fleeing from FRB ourselves, we decided to set up a special account to insure all of our deposits even beyond the $250k threshold. More specifically, well before it was clear that First Republic was at risk, we took necessary safeguards to insure all of our deposits (including those above the $250k threshold) while keeping our relationship with FRB. During the events of last weekend, we were able to breath easy knowing that all of our deposits were safe, regardless of the outcome. Now that things have played out, we can say that we are happy with our new banking partner at Chase and all operations of our fund will continue without any hiccups. We went to sleep on Friday night clients of FRB, and woke up on Monday with all of our deposits safe as clients of Chase.
In the middle of all of this, in a truly bizarre turn of events, the Federal Reserve is raising interest rates another 25bps less than a week after another bank was seized by the FDIC. The last rate hike was done under eerily similar events just 12 days after SVB’s demise. Oftentimes, in this very newsletter, we write with confidence about the Fed’s decision and about Chair Powell’s statement. As time goes on, and more economic headlines roll by, the Fed has less decisions to make and are stuck into a predetermined path. Last time, for example, we predicted correctly that the 25 bp increase would be coupled with a dove-ish statement about the strength of the banking sector. This decision and statement will be almost identical, but with one slight change: it is possible, and likely, that Chair Powell signals this decision as the end of rate hikes for the foreseeable future. With the target rate now above 5%, I would begin preparing for this rate to be the plateau that we live on for many months to come.
As we frequently remind our readers, the turmoil that we see in the commercial real estate industry was foreseen by the Peak 15 Capital team. Perhaps the day-to-day drama of a recession is beyond our prediction capabilities, but the broader macroeconomic picture was seen months in advanced, and we planned accordingly with the launch of our Co-GP fund. Charlie Munger, after the First Republic takeover, was asked about his opinion on US based banks and he brought up banking exposure to commercial real estate loans. While it is true that many of these loans were hastily underwritten by the sponsors who received them, we consider this to be an opportunity instead of a threat. In fact, recently we have been seeing more opportunities come to market BECAUSE of the debt market, and the sponsors that are forced to sell are also forced to sell at a discount. This was exactly the opportunity that we foresaw last year when we launched our fund, and the validation of our strategy is unfortunately coming in the form of banking turmoil. It is important to keep in mind that the Fed induced “pain” in the market also leads to opportunity. Sellers being forced to sell in order to escape high interest rate debt is always coupled with a buyer who is purchasing a discounted asset. Through our fund, our investors remain the latter instead of the former.