Podcast: The state of the US banking system a year after SVB

Brian Levitt: Welcome to the Greater Possibilities Podcast from Invesco, where we put concerns into context and opportunities into focus. I'm Brian Levitt.

Jodi Phillips: And I'm Jodi Phillips. And this is the first part of a two-part conversation we’re having with Justin Livengood. Justin is a senior portfolio manager for the Invesco Midcap Growth Strategy, and he's a senior research analyst for our discovery and capital appreciation strategies. His focus is on financials, real estate, and health care. So we last talked to Justin almost a year ago. Brian, did you know that episode was our most downloaded episode for 2023?

Brian Levitt: Oh, is that right?

Jodi Phillips: It is. I checked the numbers.

Brian Levitt: I don't think I knew that. So I guess I'm glad that we're having him back on then. Jodi, as you know, I am paid by the downloads, so.

Jodi Phillips: Oh, really? Okay.

Brian Levitt: Yeah.

Jodi Phillips: You'll have to tell me later, how you got that deal.

Brian Levitt: Oh, you didn't get that deal?

Jodi Phillips: No, no, but we'll worry about that later. As you will remember, Justin came on the week that Silicon Valley Bank failed, and so we brought him on then to give his perspectives and to help ease concerns at that time.

Brian Levitt: Oh, okay. I see. So are you saying it wasn't about Justin, it was just about a crisis? So maybe we just need to manufacture some crises in order to get downloads here?

Jodi Phillips: That is not at all what I'm saying. Those things do tend to go hand in hand, but I would be more than happy to give up a few downloads if it meant fewer crises to deal with.

Brian Levitt: Oh, I would 100% take that trade off also.

Jodi Phillips: All right, look, so do you remember what Justin said on that March 2023 podcast?

Brian Levitt: I do, and I've been rereading it this week. I always write down my key takeaways. So here are the two things that I wrote that Justin had said that month.

Jodi Phillips: All right.

Brian Levitt: Number one, it's not a systemic crisis, and he said that the credit picture in the banking system is clean. And number two, he said, we're returning to a proper equilibrium in monetary policy that may help provide a stronger base for the economy and the stock market from which to operate in the next two to three years.

Jodi Phillips: That's some very thorough note-taking, Brian. That's great. And it feels like he was two for two.

Brian Levitt: It does. Credit to Justin, which is why we're having him back.

Jodi Phillips: Yeah, because despite that, the questions about the health of the US banking system keep emerging, don't they?

Brian Levitt: They do. And I get the sense that investors just feel like something has to break. We can't have the type of interest rate hikes that we've had over the last year without anything meaningfully breaking or impacting the banking system.

Jodi Phillips: So potentially concerns about office space, commercial real estate?

Brian Levitt: Yeah, I think that's the first candidate being put forward by investors.

Jodi Phillips: All right. So these are the questions we'll talk about in the first part of our conversation, and then we've got a lot of other questions we can focus on for the second part. We have a growth manager here, let's take advantage of it. So market concentration, the excitement about the Magnificent 7? Things like artificial intelligence. Is that excitement warranted or are we getting ahead of ourselves?

Brian Levitt: Right. And what would have to happen for markets to broaden out or do we just own growth stocks for the rest of our lives?

Jodi Phillips: All right. Well, let's bring on Justin to discuss. Hi, Justin.

Brian Levitt: Hey, Justin.

Justin Livengood: Hi, Jodi. Hi, Brian. Thanks for having me.

Brian Levitt: Absolutely. Thanks for coming back. So you probably felt pretty good when I was reading verbatim, what you said on the last podcast. So did it feel good what you said and has anything materially changed in your mind?

Justin Livengood: Well, I'm glad the economy has hung in there. I'm frankly shocked the economy has hung in there to the degree it has in the last year. I think the Fed would say the same thing. I think everyone was expecting more of a slowdown than we've seen. I'm also pleased the banking system has hung in. You're right. At the time of the failures of First Republic, Silicon Valley and Signature, there were some very anxious days and weeks, and we got through that relative well. So yeah, I'm happy that all that played out. And as you pointed out in your earlier comments, there's definitely some incremental concerns now to consider, but I don't feel it's nearly as much of a dangerous situation as it was last March.

Brian Levitt: And one of the critical points that you had made last March was that it was not a credit event, it was a mismanagement of the interest rate sensitivity of the bank.

Justin Livengood: Exactly. It was a liquidity event. Those three banks in particular were somewhat unique in how they were built, and they had concentrations in terms of clients and deposits. And especially at Silicon Valley and First Republic, when those depositors got spooked and a meaningful portion of those ran for the exits, it just started a downward spiral in terms of liquidity. And that's what forced the hands of those two. And that's why they were not anticipated properly by the regulators. The regulators don't historically look at much asset liability issues and liquidity. They spend more time looking at credit. So what we're going through right now is actually right in the sweet spot of what the regulators have all been trained to do, dealing with bad loans. That's Banking 101 for a regulator. So this next phase of, we'll call it the slow moving banking – not crisis, but banking challenge – is at least something that the regulators are more adept at handling and we can talk about that.

Jodi Phillips: Yeah, great. Let's do. I think, what was it, late January, Justin, where we saw the concerns flare up a bit around New York Community Bank?

Justin Livengood: That's right.

Jodi Phillips: When it declared its earnings had been well below expectations. And so some concerns may have been lingering in the background, but that really brought it to the fore pretty suddenly for some investors, it may seem. So what are maybe some of the similarities or differences between what happened then versus maybe where we were a year ago?

Justin Livengood: So let's step back a second and think about the banking industry and particularly the regional banking industry. So put aside maybe the top five or six banks, the Chases and the Wells Fargos. Going back three years or so when the pandemic began, you began to see a little bit of concern and emerging pressure on certain types of loans tied to commercial real estate and specifically office. And those have been building for a while. So that didn't just appear in January of this year for the first time. That's been an ongoing issue. Most loans in those categories made by regional banks are five- to seven-year duration loans or term loans. And so those loans are starting to get late in their life at a point when they would typically get refinanced and replaced with new loans.

And of course, as the values of those underlying buildings have come down, the owners of the buildings are having to face the difficult choice of either accepting less equity, writing off a lot of their investment in the property as they take on the new loan, or putting in new equity and trying to take on new debt, but at higher rates. And that puts more pressure on cashflow. So it's a difficult but somewhat predictable and slow process as it plays out over time. It's not a flash like again, we had last March. Last March, again, was not a credit event. It was a reaction by depositors to a — turned out to be a false concern that forced these banks into effectively the regulators' hands. Here, the regulators have had several years to watch and work with a lot of these regional banks as they've been starting to cull their loan portfolios and sift through some of these commercial real estate loans.

And so the good news is what happened in January with New York Community Bank was actually somewhat precipitated by the regulators. It was during the year-end audit of 2023 that the regulators sat down with those bankers, New York Community, and said, "Hey guys, look, you've got a handful of loans that are just not performing and it's time that you accept this and we reclassify them as non-performers. And in doing so, you're going to have to now make some adjustments to your capital ratios. You're going to have to move some things around your balance sheet. You're probably going to need to cut back your dividend."

And this was also happening as New York Community Bank was absorbing, ironically, the legacy assets of Signature Bank. And in doing so, they became bigger in terms of assets, deposits, et cetera. And so that put them under even more and greater requirements, capital ratios and things were changing. So they were under more scrutiny by the regulators just because of that transaction. And as part of that review with the regulators end of the year, said, "Hold on, you've got to come clean on a few of these loans." And that's what was confessed during the Q4 earnings call by New York Community.

Brian Levitt: So should you never come to the rescue, if you're a New York Community Bank or there are spots where if you step in and take over a Signature Bank where it actually works out over time?

Justin Livengood: Oh, it does and I'll show you another example. JPMorgan has absolutely come out like a hero with First Republic. They took over First Republic last March, and it has been a huge home run, both financially I think, as well as just building capital for JPMorgan with the regulators and in the eyes of Washington. So I don't want to suggest that coming to the rescue of a bank isn't a good thing. In this case though, New York Community, by helping take some of those signature assets, got bigger than perhaps they should have in hindsight and it forced them into this new bucket of regulatory scrutiny. As the regulators applied those new rules, they realized, "Wait a minute, you guys aren't completely onsides with at least some of these loans," and that reset is now happening.

It's probably also worth noting. New York Community is a pretty unusual bank. As the name suggests, they're geographically focused in New York and really the Long Island area. They have a very high proportion of their loans in multifamily and office. Although when they say office, they're not talking about buildings in Midtown, they're talking about five- to seven-story buildings in some of the outerlying boroughs and so forth. So it's a much more concentrated loan portfolio in terms of commercial real estate and office than the typical bank. A typical bank has a single-digit percent of its loans in these types of categories, whereas New York Community, it's 30%, 40%. So it exaggerates the optics, the risks, the issues that are very much under scrutiny here.

Brian Levitt: So let's talk about office. You and I are sitting here right now in downtown New York City. We're back in our high rise. I'm here half the time maybe.

Justin Livengood: Right.

Brian Levitt: Same, right? Flexible program. Jodi, you're in the office today or you're-

Jodi Phillips: Not today, not today, but yeah, we definitely have this office in Houston.

Brian Levitt: Well, right now you're in the Phillips office in Houston, Correct?

Jodi Phillips: That's right, that's right. Correct.

Brian Levitt: Yeah. And so how concerned are you about office space? To me, it seems like businesses were needing less office space even before the pandemic happened. You no longer needed rooms for file cabinets or you no longer needed rooms for servers. All of that was moving. Now, I think the last I saw in terms of the number of people swiping in at offices is around 50%, New York City might be a little bit less than that, although my commute would suggest otherwise. And the line downstairs for the salad might suggest otherwise.

Justin Livengood: Exactly.

Brian Levitt: How worried are you when you talk about a slow moving, did you call it a train wreck? A crisis?

Justin Livengood: Yeah, yeah, yeah. It's maybe not quite a train wreck, but it's a slow moving-

Brian Levitt: Derailment?

Justin Livengood: Process.

Brian Levitt: A derailment?

Justin Livengood: Right.

Brian Levitt: And so how worried are you that there's something lurking within that, that's unforeseen? it's comforting to me to hear you talk about the regulators being in front of it with New York Community Bank. Are you concerned that there's something lurking out there?

Justin Livengood: I don't think there's something lurking again, because I think it's fairly well known what everyone in the regional banking industry particularly owns at this point, where their exposures are. And I think there's stress testing that goes on that forces banks to consider what is going to happen to their loans and their assets in different economic scenarios. And there's some pretty punitive scenarios that the regulators make you consider. And then based on how you do in those tests, you have to adjust your dividend policies and perhaps your capital. So the industry right now is really well-capitalized in general, and that even goes down to a lot of the smaller banks. Even New York Community by the way, despite having to disclose those and write down some of those big loans last month, they're still above what is defined as well-capitalized. It removed a cushion, but it wasn't like they had to go out and do a dilutive financing overnight to suddenly get back onsides.

Here are a couple more interesting statistics that I recently read to help maybe frame this. So there are about $40 billion of reserves right now in the banking industry set aside specifically for office and commercial real estate loans. And that represents about a one and a half... Let me put it this way. Right now, one and a half percent of all office loans made by banks are considered delinquent.

Brian Levitt: Okay.

Justin Livengood: If things get as bad as they did in the global financial crisis (GFC) in 2008 and 2009, that delinquency rate would go to 6%. That's where we topped out at in the worst situation that these banks have probably ever faced. And that's the kind of stress test scenario that the banks have been getting put through in recent years. So in other words, you've got room for delinquencies and losses on this category of loans to quadruple, and you're only back to where we were in the GFC on losses.

Brian Levitt: Well, we don't want to be in-

Justin Livengood: We don't want to be there. But if we were hypothetically, you know what the dollar value of losses would be, round numbers? $40 billion.

Brian Levitt: $40 billion.

Justin Livengood: Which happens to be where the industry is roughly reserved. So again, it's not a scenario I want, but if it happened, it wouldn't happen overnight like back in March of '23, it wouldn't be like all of a sudden on a weekend, we're worrying about six banks going under because they suddenly realized they had two bad office loans. Furthermore, as they were taking writedowns on loans, they would presumably just be drawing on reserves already set aside. So the only thing that really concerns me, and I've heard bank CEOs say this, so this isn't really just my opinion, is if the economy were to take a left turn and get worse and other property classes started to struggle, other types of loans-

Brian Levitt: Like multifamily or?

Justin Livengood: Right, or even just residential mortgages.

Brian Levitt: Oh, don't say residential mortgages.

Justin Livengood: Traditional commercial loans. Exactly. If other pockets of a bank's balance sheet started to also see growing losses, which right now isn't happening, then you'd have other things eating away at bank reserves and capital, and then this office/commercial real estate situation would perhaps become more of a concern. But I think at the end of the day, as long as the economy cooperates, and I don't think it needs to do much more than it currently is, it is remarkably resilient at the moment. I think banks are going to have enough time, as will the regulators, to over a two-to-three year period, get the worst of these loans around office buildings and commercial real estate to where they need to be in terms of refinanced, re-equitized, and the industry will be on more solid footing. Now, having said that, there's a second reality that these banks are facing as this process slowly flipped out.

Brian Levitt: Jodi, were you feeling better?

Jodi Phillips: I was.

Brian Levitt: I was feeling so-

Jodi Phillips: I wasn't until we're entering the alternate reality.

Brian Levitt: I'm not good with second reality. My brain only works on one reality.

Jodi Phillips: One reality at a time.

Justin Livengood: It's not all bad. It's not all bad.

Jodi Phillips: Okay, okay.

Brian Levitt: Okay.

Jodi Phillips: If you say so.

Justin Livengood: But banks aren't making as many loans as they used to because of this.

Brian Levitt: Okay. Right.

Justin Livengood: So this isn't just back to business as usual at banks. So this is one of the things we talked about a year ago that I suspected like, "Hey, it's going to take a long time for underwriters and staff at banks to be told and allowed to go back to writing as many loans." And those loans they are writing, they're of course, and I'm not just talking about office, I'm talking about again, loans to individual companies and individuals.

Brian Levitt: If you have 3% inflation, isn't that a good thing? Maybe not 3%, but we were at 4% or 5% inflation. Isn't that a good thing? We were trying to slow down this economy, right?

Justin Livengood: Right.

Brian Levitt: But the problem is you get to 2% inflation and then things continue to slow and then the Fed's got to ease and try and reinvigorate credit creation and economic activity again?

Justin Livengood: Right. Some of this. Okay, there's two issues. One issue which I was driving at is just because banks are still trying to get properly capitalized and reserved for some of these lingering credit issues, they can't make new loans and grow as much as they used to. In fact, the industry basically did not grow in the fourth quarter. New loans were flat in the fourth quarter of 2023, and the outlook that banks gave for '24 is pretty flattish. It varies by type of loan, it varies a little bit by geography, but basically, there isn't credit formation from the banks. Now, there is credit formation happening outside of the banking system.

Brian Levitt: The shadow banking system.

Justin Livengood: This whole private credit phenomenon is real. It's going to have legs and we can come back and talk about this because I'm very close to a lot of the firms that are involved in that space, and I think that is a big durable trend. So what's happening is a mix shift away from the regional banks to other providers. We can call it shadow banking, but that has a little bit of a negative connotation that I'm not sure is fair. I think actually, it's somewhat healthy to have some incremental growth in the private side of the lending market. Now the second thing that you were referring to is what do we want to do in terms of interest rate policy and the Fed?

So the other thing the banks are having to deal with right now is the curve's still inverted and the front end of that curve is still five and a quarter, five and a half percent. That's not good.

Brian Levitt: But they're not paying that, right?

Justin Livengood: Oh, on incremental deposits and borrowings to the Fed window, they are.

Brian Levitt: Okay. But if I go to the bank, I'm getting 0.1%, right?

Justin Livengood: Well, if you're at one of the big banks who don't want your deposits. You're right, chase and BofA aren't going to pay anything. But if you're a smaller bank, a lot of regional banks are still dependent on time deposits like CDs and some money market checking type products, which are, if they're not at the Fed funds rate, they're still elevated. It's three, four and a half percent type things. Bank funding costs over the last 12 to 18 months have gone up faster than anyone expected, notably the banks. And that has squeezed their margins because their loans are priced quickly to rates, but only up to where usually the five or 10 year is because most loans are priced longer term. Deposits and funding are priced short term. So this inverted yield curve that has stubbornly stuck around is slowly squeezing margin on the banks on the industry.

So yeah, the Fed is watching this and having to, of course, juggle lots of different things when they're thinking about setting monetary policy. And one of their concerns is, "Boy, the longer we leave the Fed funds rate where it is in our attempt to fight inflation," which I think is the right move, "We're pressuring those banks who at the very same time we're telling to get their houses in order on some of these loans and get your credit ratio, your capital ratios up." So it is a little bit of a moving game that the banks are having to deal with.

Brian Levitt: Jodi, I got two things for you. One, it sounds like I might have my deposits in the wrong place. I might've been sleeping for the last year and a half.

Jodi Phillips: Perhaps you were.

Brian Levitt: And two, did you notice Justin doing the shape of his yield curve on his elbow?

Jodi Phillips: Yeah, no, that was really impressive.

Brian Levitt: In a podcast. It's going to be good for the podcast.

Justin Livengood: Exactly, right?

Jodi Phillips: We have to add a video component for this one.

Justin Livengood: It was not ideal for an audio only.

Brian Levitt: He's a New Yorker. He speaks with his hands.

Justin Livengood: Gestures. That's right. That's right.

Jodi Phillips: For sure. So Justin, what about any ripple effects in the broader markets? It doesn't really feel like we're feeling anything at this point in time, but in terms of banking concerns, what would you be watching out for just in terms of any broader market impact?

Justin Livengood: I think that as it relates to the economy, we're largely okay in terms of what the banks are doing. And I don't think the banks pose a major risk. Again, there has been now a multi-year period where the majority of banks have been able to get their houses in order, and it's only going to be outliers like New York Community that are going to be in the headlines and running into issues with regulators. The system, by and large, is in great shape.

Jamie Dimon just said that yesterday at a conference. I've heard that song and verse from other large bank CEOs in the last few months. And you listen to the larger banks, the top 25 banks, they just came through Q4 earnings with mostly flat loan loss provisions and non-performing assets were flat to down. So the big diversified banks are if anything, having a great stretch of performance, they're not posing a risk to the economy, they're not posing a risk to the markets. They're very healthy and happy. And smaller banks, again, have had time for the most part, to get into the position they need to be in to manage these credit risks.

So I think they'll continue to be outliers like New York Community. I think there'll be some headlines and some moments of concern, but as long as the economy continues to chug along at an okay rate, and as long as the Fed has at least done tightening and tilting towards making rate cuts as we move into next year, I think the banking industry in general is going to be fine and it's not going to be an impediment to growth.

Brian Levitt: We talked about private and credit as a durable theme. I get a lot of questions, "What are your thoughts on private markets." It's like the new, everybody's focused on it. So somebody says to you, what are your thoughts on the private credit market when you think of it as a durable theme? Should investors be looking in that space? I know you're focusing on it from the financial players in that space, but investors looking for incremental yield or opportunities they may not otherwise have, private credit, makes sense to you it sounds like?

Justin Livengood: Absolutely. So I'll back up. I think credit makes a lot of sense right now. So I also think that public credit is really interesting.

Brian Levitt: Investment grade corporates, 5% yield?

Justin Livengood: Or high yield corporates, even.

Brian Levitt: 8%, 9% yield.

Justin Livengood: Yeah. Going back to where we started a minute ago, Brian, I am stunned at the resiliency of the economy and its ability to absorb what the Fed has done. As we sit here today, unemployment, Q1 expected GDP (gross domestic product), and inflation are all between three and a half and 4%.

Brian Levitt: And people are miserable.

Justin Livengoo...: Well, okay, people are miserable.

Brian Levitt: And that's cost of living.

Justin Livengood: But the stock market is making new highs.

Brian Levitt: New highs, right.

Justin Livengood: But my point is it's stunning that you would have at a moment when the Fed has pushed rates to their highest in over a decade, those three numbers I quoted a moment ago, and as long as those three numbers stay there, I don't think the Fed's going to be in any rush to go anywhere in terms of cutting rates. So I think that's really bullish for credit in general because I think a lot of loans... Now I'm going to segue a little bit to your private credit comment. I think there's a lot of value in, again, high grade and high yield public credit, but even on the private side, they're getting to underwrite new loans to businesses, whether it's tied to real estate or it's just straight up corporate-type lending as though you're going to have a normalized credit experience. And that's not what's happening.

I'm hearing all the time from the Blackstones and the KKRs that I get to talk to, that this is a once in a decade, maybe once in a 20-year career opportunity. You're getting interest rates on new loans that's low double digits with terms that are typically only seen in the best of times from a lender standpoint. And it's because borrowers don't have those regional banks. Those companies that are on the line from a credit standpoint that can't tap the public markets that would normally go to a regional bank or some bank to get that next piece of financing. The banks are saying, "Hold on, I'm in this shutdown mode. I got to finish getting my house in order. I can't give you a competitive loan." So they turn to a lot of these private pools of money. So yeah, I'm actually quite bullish on credit.

It's also a good thing for someone like me that sits in the small-midcap equity world because a lot of my small-midcap companies are in fact those same companies tapping private credit or at least the high yield kinds of public credit markets, and this is fine for them. They're able to get decent funding and execute their business plans and do well. And that's partly why now you're seeing the stock market, both the large cap and smaller cap parts of the market do well. People are comfortable that we've threaded the needle on a soft landing and they're able to get financing where they see growth opportunities. So even though loan growth in the banks I said earlier, has stalled out as an industry, this private capital opportunity, particularly on the private credit side, is adequately filling the hole. And I don't think it's reckless. I don't think it's for the most part-

Brian Levitt: Shadow.

Justin Livengood: Shadow type institutions.

Brian Levitt: It does sound very concerning.

Justin Livengood: I think it's good money and frankly, it's good money or it's a good trend in some ways because it's removing some of the risk from the regulated banking industry. If sophisticated institutional investors at a private credit fund take a loss on a loan, that's probably not a systemic risk. But if a bank goes down because they made a bad loan, well now we've got to tap the FDIC trust fund to repay the depositors and we've got to go deal with the broader systemic risk that could pose to the banking industry. Well, if we're moving some of those risks off to, at the moment, what seems to be a relatively thoughtful and sophisticated private credit industry, that's not a bad thing.

Brian Levitt: Jodi, should we pivot to part two?

Jodi Phillips: Well, I think we should, unless there's a third reality he's about to spring on us, which I hope not because I’m feeling pretty good with where we are. … And that’s the end of the first part of our conversation. In the second part, we’re going to talk to Justin about market concentration and what it might take for market participation to broaden. And we’ll spend some time on the potential impact of artificial intelligence – not only on tech companies, but on other sectors that are using this technology in interesting ways. Thanks for listening.

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Statistics about the loan portfolio of New York Community Bank sourced from the US Federal Reserve.

The Magnificent 7 refers to Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla.

Statistics about the number of people swiping into offices sourced from Kastle Systems.

Reference to $40 billion in reserves set aside for office and commercial real estate loans and references to delinquency rates sourced from the US Federal Reserve.

The hypothetical estimate of the value of losses if the delinquency rate were 6% sourced from Invesco analysis.

References to the rates on the yield curve sourced from Bloomberg as of February 2024.

The yield curve plots interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates to project future interest rate changes and economic activity. An inverted yield curve is one in which shorter-term bonds have a higher yield than longer-term bonds of the same credit quality. In a normal yield curve, longer-term bonds have a higher yield.

References to interest rates paid on bank deposits sourced from Bankrate.com.

The federal funds rate is the rate at which banks lend balances to each other overnight.

References to investment grade yields sourced from Bloomberg, based on the yield to worst of the Bloomberg US Corporate Bond Index, which measures the investment grade, fixed-rate, taxable corporate bond market.

Yield to worst is the lowest potential yield an investor can receive on a bond without the issuer actually defaulting.

References to high yield bond yields sourced from Bloomberg, based on the yield to worst of the Bloomberg US High Yield Corporate Bond Index, which measures the US dollar-denominated, high yield, fixed-rate corporate bond market.

References to unemployment data, gross domestic product (or GDP) and inflation sourced from the US Bureau of Labor Statistics.

References to small and mid-cap performance sourced from Bloomberg. Based on performance of the Russell 2000 and Russell Mid Cap indexes in November and December 2023.

The Russell 2000® Index, a trademark/service mark of the Frank Russell Co.®, is an unmanaged index considered representative of small-cap stocks.

The Russell Midcap® Index is an unmanaged index considered representative of mid-cap stocks.

All Russell indexes mentioned are trademarks of the Frank Russell Co.

FDIC stands for the Federal Deposit Insurance Corporation.

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