Authored by Peter Tchir via Academy Securities,

We are hearing a lot about Liquidity and Solvency right now. Often people talk about them as though they are two different things. That can be true at times, but in many cases, there is a complex relationship between the two. That is particularly true for financial companies and banks, which is where this discussion is centered.

Let’s start with extreme and obvious examples.

The real world is never so simple. Enough liquidity can mitigate solvency issues, over time. 

Liquidity, over time, can help with a solvency issue, but it depends on:

I think the Long-Term Refinancing Operations (LTRO ) were an interesting example.

Which brings us to where we are today.

In the U.S. we had Sunday night sessions to deal most directly with Silicon Valley Bank and Signature Bank. The solutions provided were meant to help the entire banking sector, especially regional banks that were feeling the pressure as attention turned from SIVB to other banks that some people thought might be vulnerable. We covered some of this on Saturday in I Like Mid Banks, I Cannot Lie, and What We Know Post Intervention and on Bloomberg TV Monday Morning.

Yesterday CS dominated the headlines, ending the day with a plan announced by the Swiss National Bank that we will analyze as well.

The analysis tries to balance the solvency and liquidity issues and with the solutions provided so far.

I’m sticking to a B+ sort of score. They acted boldly and quickly which is good. But the core problem “unrealized bond losses” hasn’t been sufficiently addressed. At least not in my view of where we are on the continuum of solvency and liquidity.

This is the liquidity solution provided for banks. For up to 1 year, banks can post a high quality bond as collateral and receive a loan based on the par value of the bonds.

Let’s say a bank owned $100 of a Treasury against a $100 deposit they had received. That bond is currently at 80 cents on the dollar. If the depositor withdrew, the bank had to sell that bond to pay back the depositor (super simplified, but good enough for what we are trying to illustrate).

The bank would only raise $80 by selling the bond, so would have to sell other assets or effectively take money out of their equity capital to pay the other $20. There are issues with bonds in available for sale, versus held to maturity accounting etc. but the crux of the matter was the assets earmarked for depositors aren’t currently valued high enough to pay back depositors.

One “good” thing is that the bonds in question are liquid and are at virtually no risk of not getting paid back fully according to their original terms. That is very different than in 2007 and 2008 when the assets were of dubious and deteriorating quality.

So, with the new facility, when the depositor requests $100, the bank doesn’t have to sell the bond at a loss. They can pledge it to the facility and receive $100 for that bond and now, instead of paying interest to the depositor the bank pays interest to the facility for a year.

This helps the “liquidity” issue:

This compounds the NIM (and solvency) issue:

Let’s use one of my “favorite” bonds – the 0.75% Treasury maturing 3/31/26 that was issued on 3/31/21. I like this bond because I could see an institution getting deposits in March of 2021, buying a 5-year treasury with those proceeds (still seems aggressive to me, but at least I’m not embarrassed with that as a scenario, unlike 10-year treasuries which just makes me wonder why they stopped teaching the S&L crisis in business school). But let’s look at this bond.

One question that I asked myself, hoping to bolster my case for banks, was if the recent rebound in treasury prices “solved” the problem of unrealized losses on bond portfolios. The answer, is, sadly, as a bull, no. It has done very little. This bond which now only has 3 years to maturity is still wroth only 91 cents on the dollar. Up from recent lows of 89 and well up from the lows of last September when it was only worth 88. (I did, out of curiosity check out the 1.125% Treasury of 2/15/31 (issues 2021) and it is at 84 today, up from 81 earlier in the month, but saw its lows as 79 last October. Why was no one talking about unrealized bond losses in September last year, when in all likelihood they were worse? There may have been people writing about it, but it wasn’t on my radar screen and I don’t remember seeing it as a discussion topic. Maybe deposits weren’t declining back then, but they were (just check out the SIVB deposit charts in Saturday’s report).

There will be time for questioning how this wasn’t a problem and then became a problem another day.

According to the terms of the program, here’s what would happen.

The lending program buys some time, but does absolutely nothing for the bank’s capital, and if anything, banks will be worse off having to use this program versus retaining deposits.

The key to any level of success will be if banks can retain deposits. Keeping deposits reduces the negative carry (versus using the facility) and over time, the pull to par effect helps (if they can keep the net interest margin losses to a minimum), but even that is only really helpful for portfolios that didn’t go way out the maturity spectrum.

I think it buys the weakest banks time to shore up their capital – either through a capital raise or a merger.

If that can occur, then the banks the next wrung up will be fine. As the “fire break” works, you don’t need further protection.

The question are:

If those questions get answered “correctly”, we should be off to the races.

If those questions don’t get answered “correctly” expect more pressure on the weakest banks and for the vortex of weakness to suck more banks into it.

I think we have a few weeks (not months, but weeks) before the patience of the markets and the reprieve the Fed/FDIC/Treasury bought us starts to fade.

I’m optimistic that we see capital issues addressed, via the private sector and that paves the way for a rebound, but sooner than later is a key, even for me as an outspoken bull.

I’ve run out of time and energy, so will be brief here.

I give a C- to the Swiss efforts so far as it is too localized, does nothing for capital, and starts to hint at intervention in ways that your rights as a certain type of investor, might not be given their due course.

While I give the U.S. a few weeks before markets will demand action, I expect by early next week, the luster of the Swiss solution will be gone, without something more substantive.

The solutions in the U.S. and in Europe bought time. How much time is yet to be determined, but only some time and it is up to various institutions to use that time to fix the problem – capital concerns.

I’m optimistic we get good resolution on that front, but that is what is needed from here!