Volatility returned with a vengeance in the markets on Tuesday. After only one trading session to this point in April where the S&P 500 moved at least 1% in either direction in a day, the index fell some 1.6% in trading on Tuesday. The Nasdaq was off nearly 2% on the day.
After seeing stabilization since the Silicon Valley and Signature Bank (SBNY) implosions in March, regional banks once again came to the front and center of investors' worries during the day.
First Republic Bank (FRC) was cut in half Tuesday after it reported first quarter results. The bank lost 40% of its deposits during the quarter before being rescued by $30 billion in deposits from its bigger brethren. The company is now considering a plan to divest $50 billion to $100 billion of long-dated securities and mortgages as part of a larger restructuring plan, which will also include cutting its employee count by 20% to 25%.
First Republic's problem triggered a better than 4% selloff in SPDR® S&P Regional Banking ETF (KRE) and was a significant headwind across the overall market on Tuesday as well.
Jim Cramer had this to say about yesterdays FRC meltdown: '"There's one big difference between now and 2008: This time there is no systemic contagion. It's a miserable moment for First Republic - once a bank beloved by the rich and famous - but it's an all-clear event for everyone else."
I agreed on some levels with Cramer's take but am still leery as we heard some of the same commentary when the second and third largest bank failures in U.S. history occurred in March. First Republic looks like it may be following the same trajectory. More importantly, throughout recent history political leaders and heads of government agencies always fight their last major battle. This the reason the French were girding for another conflict of trench warfare and attrition on the eve of WWII, only to be overrun in six weeks as they were stuck in a WWI. Which ironically at the time was known as the 'War to end all wars'.
Cramer is right as it is unlikely that First Republic will lead to 'systemic contagion'. This is not a Bernanke 'Subprime is contained' moment. However, regulators and legislation have focused on reducing credit risk since the Financial Crisis of 15 years ago. Via stress tests, strengthening credit criteria and a litany of new rules and regulations, they have insured the financial system is much better prepared for a deterioration of credit risk.
Unfortunately, little attention seems to have been paid to 'duration risk'. The regional banks and other financial entities are in trouble because they put so much of their bond portfolios in instruments like 'risk free' long-dated Treasuries. No one appears to have modeled a scenario of what happens when a bank holds 10-Year Treasuries yielding 2% when money market rates move close to 5%. The resulting deposit flight has caught the system flatfooted.
This situation is unlikely to result in contagion. However, the banking system is going to have to pull back on lending, especially on the regional level. This is going to impact everything from commercial real estate, which is already reeling, to home builders, your local car dealer and other small businesses. The resulting credit crunch looks certain to push the economy into a recession before yearend. And that, and not contagion, is what investors should be bracing for in my view.
