The financial earthquake – some thoughts

Few appreciate liquidity until you don’t have it, and then everybody wants to rush out the exits – this is when you get price crashes.

With major US regional banks trading down significantly (examples: FRC, WAL, ZION, PACW) and with SI, SIVB and SBNY going into FDIC receivership, there will be some other consequences. I’ll write a few of them here:

1. The Fed is offering a “treasuries for par for one year” program. So if you were stupid enough to buy long duration last year, you’ve got a one year term grace period to figure things out – although inevitably your shareholders will have to choke on the loss (unless if the Fed really bails out everybody by dropping interest rates!). This can only be described as a time-limited QE action! However…

2. The yield curve has gone bonkers, with longer-term yields trading significantly down and the Fed Funds rates basically indicating one more quarter-point rate hike and that’s it:

3. Bitcoin and Gold have simultaneously received a huge bid, with BTC up +$4,000 to US$24,000 and an ounce of gold up $50 to $1915. There is obviously a huge pressure in the market for safety at the moment.

What is the big picture here?

1. A bank’s traditional model of riding the yield curve does not work very well in an inverted yield curve environment. The yield curve has been inverted for many months, and customers with zero-interest deposits are not going to be a stable source of capital if you’re running a bank;

2. The question of inflation – the central banks have a mandate to stamp inflation. This is also a function of what the BoC referred to as entrenched expectations of inflation. Ultimately the labour input function of inflation will get stamped down if we start seeing mass unemployment claims come to the fore. I’m suspecting that my prognostications of this happening in January-February 2023 (which I made later in 2022) are simply delayed – I’m going to guess we will see more of it coming, especially in the second half of the year;

3. “This can’t happen in Canada!” – the Bank of Canada in 2008 took considerable measures to backstop the major Canadian schedule 1 banks. The USA has JP Morgan, Bank of America and Citigroup, while Canada has Royal Bank and Toronto-Dominion as key global banks. While the stability of the banking system will be defended at all costs by central banks, whether equity/debt holders or not will take a bath is another question.

Let’s review the business model of a bank. Inherently it is a very simple business. You take deposits from customers and (usually) pay them for the right to hold their money for a time. Say your rate of pay is 2%. Parallel to this, you also lend money out to credit-worthy customers at a higher rate of interest. Say that you lend money out at 5%. In this example, for every dollar your are able to recycle, you get a 3% interest spread. Then you have to subtract all sorts of expenses relating to hiring staff, maintaining IT infrastructure, leasing branches across the country, etc., and after paying taxes on the residual, your shareholders make a profit.

Making a 3% interest spread is not efficient. To increase this amount, you do the procedure twice over – take in one dollar of customer deposits at 2%, and loan out two dollars to customers at 5%. You can do this because you have a deal with the central bank that if you keep a certain amount on deposit, you have a license to create money and leverage it off your net equity figure. If you can pull the 1:2 deal as described on this paragraph, then your effective margin is 6% on a dollar of deposits due to the power of financial leverage.

The magnitude of money you can earn is even greater if you raise a hundred million dollars in equity financing and use that to lend a billion to customers, which is typical for most banks.

Where does this blow up?

One is what happened to SI/SIVB/SBNY – the bank took their liquid customer deposits and dumped them into long-dated government securities which could only be sold for less than what they paid for it, coupled with the depositors wanting their money back, now.

The second mode of failure is if the customers you’ve loaned money to don’t pay back their loans. We haven’t seen this to any material degree (yet). However, if we start seeing defaults on construction loans in Canada, this might become material.

The third mode of failure is more subtle – for a prolonged period of time, you can’t obtain deposits from customers at a cheaper rate of interest than you can loan the money out for. This could happen if would-be depositors start to demand higher rates of interest, coupled with your customer screening division not being able to find credit-worthy customers to lend money to.

4. Financial companies in themselves do not generate wealth in an economy (i.e. manufacturing, farming, natural resource extraction, Netflix, etc.) but they facilitate it. Inevitably if the business that financial companies are financing are unprofitable, financing companies cannot be profitable by definition (businesses won’t be able to pay back loans). Companies that produce economic value, as measured by profitability, will survive this mess, while those participants that are forced to rely on low-cost capital will wither.

5. Hold onto your wallets, this will get pretty wild. I was originally thinking “sell in May and go away”, but perhaps I was a couple months too late with this prognostication.

More later.

The Lehman Brothers moment

Silvergate (NYSE: SI) and Silicon Valley Bank (Nasdaq: SIVB) have both suffered immense market value losses this week.

In the case of SIVB, the story is fairly simple – they had a huge duration mismatch between their (asset) held-to-maturity portfolio and (liability) short-term deposits.

Held-to-maturity assets are held on the balance sheet at cost value, while fair (market) value is indicated.

SIVB had a differential of $15.2 billion between the stated book value and the fair market value of such securities, while the total equity of the firm was $16.3 billion.

Assuming they liquidated everything at once, the entity as a whole would be worthless.

One other problem they had was that their source of capital (zero-interest bearing deposits) was getting pulled out very rapidly and the only thing they could replace them with was high-interest deposits.

It eventually crashed this week – going from $275 per share to what will effectively be a zero. The unsecured debt is trading around 40 cents on the dollar, but it remains to be seen whether there will be any recovery there.

This was a classic bank run, coupled with financial mismanagement by the bank – when the asset duration and liability duration are mismatched, and when your depositors decide they want their money now, if you can’t raise the short-term funds to pay the depositors, you’re forced to sell those held-to-maturity securities and that is when your capital adequacy ratios goes into the toilet – and the FDIC steps in.

The media will make this out to be a crypto/digital-currency related issue, but that was only part of the story (how the bank got all of these short-term non-interest bearing deposits in the first place). The stronger part of the story is mismanagement of the duration risk.

There will be some collateral damage here, but unlike Lehman (which was a much larger entity) I suspect this will be somewhat more contained, although will cause volatility ripples in the next couple weeks in the financial sector as financial institutions shore up their solvency/liquidity books. It is a warning shot across the bow of every institution out there – liquidity is golden.

When a dual-listed company delists on one exchange

On the morning of February 27, 2023, Greenbrook TMS (TSX: GTMS, Nasdaq: GBNH) announced that they are voluntarily delisting from the TSX, effective close of March 13, 2023.

In theory, not being listed on a stock exchange should have no theoretical difference in market value, but certainly on this thinly traded company (prior to this, it was lucky to see more than 10,000 shares a day of volume), it had quite the impact of people trying to stampede out the exits:

The stock went from CAD$2.50 to CAD$1.65 as I write this today, about a 1/3rd drop.

Ordinarily I would be salivating at the opportunity to take advantage of a forced liquidation that is clearly going on here, but financially speaking the company’s contribution to the economy has been paying their massive lease bills and not making nearly enough gross profits to eclipse their fixed expenses.

Teck’s coal spinoff (Elk Valley Resources)

Many smart people have already written about this, and many smart people have traded this. I won’t repeat their analysis.

The key point was this line in the conference call:

Concurrent with the separation, we announced agreements with two of our steelmaking coal joint venture partners and major customers to exchange their minority interest in the Elkview and Greenhills operations or interest in EVR. Notably, Nippon Steels $1 billion cash investment implies an $11.5 billion enterprise value for our steelmaking coal assets.

Given the amount of cash the EVR spinoff is producing at current met coal prices, the EV that they gave the equity stake to is low, which is probably why they got the minority shareholders to subscribe to EVR.

I surmised in my previous post:

What you also do to complete the financial wizardry is that you load the coal operation with debt, say around $10 billion. Give it to the parent company as a dividend, or perhaps give it to shareholders as a dividend in addition to the spun-off equity and the projected return on equity will skyrocket (until the met coal commodity price goes into the tank, just like what happened two seconds after Teck closed on the Fording Coal acquisition before the economic crisis).

It turned out my $10 billion dollar figure was nearly correct, but in the form of a 60% royalty on the first $7 billion of cash, coupled with $4 billion in 6.5% mandatorily redeemable preferred shares. Instead of doing a straight debt deal, this all just goes into Teck’s bank account.

The length of the payout period depends on met coal pricing being sufficiently high – something that I don’t think can be depended on for the majority of the rest of the decade.

Quite frankly, I think they screwed it up and hence the market reaction.

Since Teck is likely to make huge positive cash flows coming forward with their copper operations, they did not need to do a cash grab on the coal operation. If the spinoff was a simple one, I think much more market value would have been assigned to the joint entities.

Also, not being given enough attention is the give-away to the Class A shareholders. This is a very rare situation where you have a dual class structure and the voting shares get a huge payoff. (Looking at Rogers’ stock here!). I will be voting against this arrangement.

A few small observations

A mixed post.

Where I was mistaken

I made a claim earlier that I thought employment around January or February of this year would be shown to decline, presumably due to a slowdown in demand and companies cutting costs. Unless if you were one of the victims of a big tech company’s layoff, wow, was I ever wrong with this! Gross employment trends continue to exhibit strength, consistent with anecdotal reports of employers finding it difficult to source labour.

So where was I wrong here? Is there a demographic issue? Are companies out there finding additional vectors of demand to necessitate employment? Or am I just premature with my prognostication? I’m not sure.

There are some hints on the Fiscal Monitor – income tax collections and GST collections are up over comparative periods last year, and especially corporate income taxes. The government is likely to report an improved fiscal balance as well. This leads me to the second issue, which is…

The progression of QT

Members of Payments Canada (a.k.a. financial institutions parking reserves at the Bank of Canada and earning the short-term rate) continues to hover at the $190 billion level. The recent slab of government debt maturing off of the Bank of Canada’s balance sheet got directly subtracted from the Government of Canada’s bank account at the Bank of Canada, but the GoC is still sitting with $65 billion cash as of February 15, 2023.

What does this mean? The presumed pressure on liquidity is not happening – yet. Banks can still lend out capital, but you have to have an awfully good proposition since they’re not going to give it to you for cheap interest rates. Why should they lend it out to you at 6% when they can keep it perfectly safe at the Bank of Canada and skim their 4.5%?

While there’s liquidity, it’s definitely a lot more expensive. When you combine what I wrote about employment above, coupled with real estate finding its two legs again (helps that there is zero supply in the market), makes me think that the Bank of Canada was incredibly premature to call a pause on rates – March 8th they’ll be guaranteed to stand pat, but perhaps we might continue to see rate increases if CPI doesn’t drop quickly enough in the next couple months. Also, the US-Canada currency differential is also going to widen as the US Fed will be raising rates for longer.

A public market investor at this point is facing a crisis of sorts. Asset prices (unless if you owned garbage technology companies) haven’t deflated that much, so what is trading out there is really not the greatest competition for the risk-free rate. You have cash.to giving off a net 4.89%, and when you look at some average 20 P/E company, one has to ask yourself why you should be bothering to take the comparative risk. Just look at the debenture spreadsheet and the spreads over risk-free rates is minimal.

Commodities

In the middle of 2020, the trade was a no-brainer. Ever since then, it has become less and lesser so, to the point today where it is no longer about throwing capital into random companies and winning no matter what – discretion has been critical from about June of last year. The meltdown in the natural gas market is one example of where an investor could have turned into roadkill, especially with leverage. In general, you can lose less money by investing in low cost structure companies, ideally with as low debt as possible. The problem is if you have a whole bunch of industry participants in a good balance sheet situation – the race for the bottom becomes brutal since they can mostly survive low commodity price environments until some finally do get eliminated due to high cost structures and/or high debt service ratios.

Teck

They explicitly had to disclose they’re looking into strategic options for their met coal unit, which would be a cash machine of a spinoff if they went down that route. Seaborne met coal has rebounded as of late and it would be really interesting to see the price to cash flow ratio assigned to a pure met coal unit. A comparable would be Arch Resources, and they are trading at 4x 2023 earnings. Teck does have considerable competitive advantages, however – better access to the Pacific and a lower cost structure, in addition to being able to pump out more coal. Stripping out the coal business would leave the copper and zinc business in core Teck, and the residual copper business might get a 20x valuation (looking at Freeport McMoran as the comparable here). When you do the math on both sides of the business (especially as Teck’s QB2 project is ramping up this year and will produce gushing cash flows at US$4 copper), the combined entity would be worth well more than $30 billion today. So with a little bit of financial engineering, Teck can generate market value from nothing.

Let’s look at the first 9 months of the year (which is abnormally high for met coal, but just to play along).

I have (for met coal) their gross profit minus capital expenditures, minus taxes, at around $4.5 billion annualized. Give that a 4x multiple and you have $18 billion. On copper, with QB2 at full swing, it should be (very) roughly $1.5 billion total for their consolidated copper operations and at 20x you get $30 billion. Add that together and it’s well over the existing market cap.

What you also do to complete the financial wizardry is that you load the coal operation with debt, say around $10 billion. Give it to the parent company as a dividend, or perhaps give it to shareholders as a dividend in addition to the spun-off equity and the projected return on equity will skyrocket (until the met coal commodity price goes into the tank, just like what happened two seconds after Teck closed on the Fording Coal acquisition before the economic crisis).

Despite the above calculation, I’ve been taking a few chips off the table. My overall position has continued to be of increasing caution, one reason being that I don’t have a very firm footing on what is going on.