It’s Not All Speculators As Real Stress Lingers In US Banks

Authored by Simon White, Bloomberg macro strategist,

Even though short sellers are targeting the stocks of weaker US regional banks, the fed funds market shows that there remains fundamental underlying weakness among some lenders.

Banks use the fed funds market to borrow and lend bank reserves to help with their settlement balances. Larger banks, such as JPMorgan, have more reserves than they want (hence their reluctance to raise deposit rates), but many smaller banks often do not, and must borrow in the fed funds market to obtain them.

We know some stress in the banking sector remains as there are still banks who are paying above the top of Fed’s range for fed funds, i.e. 5.25%, to borrow reserves. Discount window (DW) usage has fallen, but this has simply been transferred to the new BTFP facility, which has better terms than the DW. It is thus evident some smaller lenders continue to face fundamental problems.

Nonetheless, recent consolidation in the sector through rescues and mergers should have steadied the boat for the sector as a whole. The fact that it has not is because short sellers are trying to pick off what they see as the weakest links among smaller banks. Even lenders whose deposit outflows have stabilized, such as PacWest and Western Alliance, have found their stocks under attack.

Illiquid and underperforming commercial real estate (CRE) loans and large, underwater hold-to-maturity (HTM) portfolios are two of the most obvious risks for smaller banks in the US. That seems to be a pretty good rule of thumb for gauging how a bank’s stock has performed, and probably one for speculators in choosing who to go after.

The chart below shows a clear relationship between banks’ total of CRE loans and HTM portfolios as a percentage of total assets versus drawdown in their share price from 52-week high. A similar chart showing net income with 52-week share drawdown does not show any relationship.

Banks with greater exposure to CRE + HTM have fared worse, and vice-versa. PB is the most obvious outlier in the above chart, with the bank recently merging with First Bancshares of Texas, explaining why its share price is not lower than the relationship would anticipate.

Paradoxically, a weaker economy might help banks’ plight. Worse than expected jobs data today, for instance, might be enough to precipitate a short squeeze, taking many speculators out. Stranger things have happened.