The banking sector crisis cast a wide net of influence over the municipal market this week, stirring pricing volatility, upending monetary policy predictions and raising questions among participants over how deep the troubles run and whether the potential contagion will roil economic prospects.
Silvergate Bank’s March 8th announcement it was closing up shop led the wave followed by California-based Silicon Valley Bank’s March 10th collapse and regulatory takeover. Similar steps followed March 12th with Signature Bank in New York, with the latter two marking the second and third largest bank failures in U.S. history.
While the Federal Reserve guaranteed uninsured deposits in a move to stabilize investment and consumer confidence, worries grew over First Republic Bank and Swiss-based Credit Suisse Group AG’s fiscal health.
On Thursday, nerves were calmed when it was announced the Swiss National Bank will come to Credit Suisse’s aid and 11 banks stepped up with a $30 billion rescue for First Republic.
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“The failure of Silicon Valley Bank along with Silvergate Bank and the Signature Bank of New York has created what is possibly an inflection point in the bond markets,” John Mousseau, president and director of fixed income at Cumberland Advisors, wrote in a commentary Wednesday noting the flight to quality. ”The effect on the fixed-income markets has been nothing short of astonishing.”
The crisis cut a wide swath across the market with pre-pay gas bonds feeling the pressure and daily shifts in tax-exempt movement sometimes aligned with Treasury fluctuations and sometimes against. Some believe regional banks could face intensified scrutiny that stands to impact their role in the municipal market, but that remains to be seen.
Public pensions have already suffered some wounds from their holdings, but losses would be contained if the crisis is limited. Fallout still looms with the potential for regulatory actions that impact banks with municipal divisions or that provide direct lending and liquidity support.
While federal intervention has managed to tamp down worries and the crisis doesn’t bear striking resemblances to the 2008 financial crisis — that took down Wall Street investment banking behemoths Lehman Brothers and Bear Stearns — it has stirred up painful memories.
“Everyone has PTSD from the 2008 financial crisis, but we have a very different market today,” said Lisa Washburn, a managing director at Municipal Market Analytics.
Unlike 2008, the muni market has limited exposure to banks in the form of letters of credit or liquidity support, and investment-grade issuers that do have ties to struggling regional banks should be able to replace the products “pretty readily,” Washburn said.
“Right now I don’t think the comparison is there,” because it’s smaller regional banks involved so far compared to major broker-dealers in 2008. “The question is does this metastasize to other institutions and get larger over time?” said John Hallacy, founder of John Hallacy Consulting LLC. “I don’t think it’s a high risk but that risk is there.”
Bear Stearns was sold to JPMorgan in January 2008 in a Federal Reserve-assisted deal, a casualty of the subprime mortgage crisis. In mid-September that year, Bank of America purchased Merrill Lynch as it struggled with a funding crisis. Lehman Brothers tried to find a buyer as it struggled with losses over its mortgage-backed securities and collateral debt obligations, but negotiations failed and it filed for bankruptcy.
For regional banks, jitters over the strength of firms’ balance sheets could spur more consolidation with banks looking for partners, Hallacy said.
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Market impact
Munis saw a turbulent week as buyers digested the daily ups and downs.
Monday’s panic-driven rally swept muni yields lower along with USTs. Municipal bond yields fell as traders assessed the effects of SVB’s failure and federal intervention. “Fixed income is certainly enjoying a flight to quality,” said Jeff Lipton, managing director of credit research at Oppenheimer Inc. “And, the municipal bond market is happy to hang on the Treasury coattails.”
On Tuesday, municipals were little changed even as U.S. Treasuries reversed course and sold off on inflation data.
By Wednesday worries over Credit Suisse’s health drove bond yields down in choppy trading with municipals continuing to follow U.S. Treasuries in a flight to quality as volatility persisted. UST yields initially fell, then recovered and fell again, but didn’t reach the lows of Wednesday morning.
An evolving picture emerged Thursday as munis largely ignored a U.S. Treasury sell-off as reports circulated on the Credit Suisse and First Republic Bank developments, which helped calm investors’ concerns about a global banking crisis.
Pre-pay gas bonds have faced pressure driven by financial sector volatility in recent days, “which makes sense given that banks tend to be among the main guarantors of gas supply in the deals; hence, prepay gas bonds are highly correlated with financials,” Barclays said in a report this week. “However, we still see value in the sector. Barclays’ equity bank analysts continue to have a positive view of U.S. large cap banks for 2023.”
Pre-pay gas bonds trade cheap to similar-rated municipals because of their structural complexity. Strong supply of late could slow due to the current market environment and overall expectations of lower bank supply, according to a report from Barclays strategists Mikhail Foux, Clare Pickering and Mayur Patel.
With recent deals geared toward short-duration structures, Barclays sees mandatory put deals as a good way to gain exposure to the sector. “In our view, the belly of the curve and certain non-call bonds offer attractive spread pickup. We liked this muni subsector going into the current market turbulence and continue seeing value there, especially if the credit spreads of pre-pay gas bonds widen further in sympathy with corporates,” they wrote.
Regulators
Commenting on the First Republic Bank lifeline, the “show of support by a group of large banks is most welcome, and demonstrates the resilience of the banking system,” Treasury Secretary Janet L. Yellen, Federal Reserve Board Chair Jerome H. Powell, Federal Deposit Insurance Corp. Chair Martin J. Gruenberg and Acting Comptroller of the Currency Michael J. Hsu announced in a joint show of force Thursday.
Earlier in the week, the Federal Reserve, Treasury and FDIC worried that an aggressive response was needed to deal with the “systemic threat” and invoked post financial-crisis reforms that paved the way for their guarantee to all depositors in the failed banks. “This should allay depositors’ fears about getting their money and end any bank runs,” Moody’s Analytics said in its weekly outlook.
The Federal Reserve also established a one-year $25 billion credit facility —the Bank Term Funding Program — that allows banks to leverage qualified assets for advances.
“I can reassure the members of the committee that our banking system remains sound, and that Americans can feel confident that their deposits will be there when they need them,” Yellen said in testimony to the Senate Finance Committee Thursday. “This week’s actions demonstrate our resolute commitment to ensure that depositors’ savings remain safe.”
The fall of Silicon Valley Bank and Signature Bank will likely force regulators to take a closer look at depository institutions and their related affiliates and is prompting a Dodd-Frank like scenario where muni leaders may be called to testify in front of Congress to provide critical information about public finance.
While emergency measures taken by the FDIC prompted markets to stabilize and have so far largely avoided causing any major damage to the muni market, investigations by the Securities and Exchange Commission and Department of Justice are already underway as regulators look to get a clearer picture of the situation.
“They’re going to have to re-look at asset structures and structural integrity of depository institutions,” said Emily Brock, director of the federal liaison center at the Government Finance Officers Association. “I think that there are a lot of questions about issuers of securities because those provide the integrity of the depository.”
One piece of legislation currently under the spotlight is President Trump’s 2018 Economic Growth, Regulatory Relief and Consumer Protection Act, which relaxed regulations put up by Dodd-Frank and exempted from certain regulations dozens of banks under the $250 billion asset threshold.
Muni holdings and lending
The Bank Term Funding Program has so far shored up struggling banks and appeared to limit immediate contagion. “I don’t see where there’s any real systemic risk for the marketplace,” Washburn said.
On the portfolio side, a review of balance sheets show that Signature, SVB and First Republic all carry muni bonds. SVB held $7.4 billion of municipal bond and notes as of Dec. 31, 2022, which were marked as having a fair value of $6.15 billion, according to its 10-K filing with the SEC. The paper carried ratings of A1 and above.
Signature Bank — which in 2015 launched a public finance business — held $247 million of state and municipal securities in 2022, up from $7 million in 2018, according to its recent 10-K.
First Republic Bank carries $19.4 billion of state and municipal securities, up from $8.19 billion in 2018. But with the feds and large banks coming to the rescue to the banks, a “fire sale” of their muni portfolios into the market appears unlikely, Washburn said.
Hallacy, too, said he expects new owners to hold on to those portfolios for the most part.
Signature Public Funding Corp. — a subsidiary of Signature Bank and affiliate of Signature Financial — “offers tax-exempt financing for government, and not-for-profit organizations throughout the United States.” The municipal finance arm operates under Signature Financial, the bank’s specialty finance unit, and launched in 2015.
Donald Keough, senior managing director-public funding, leads the group. ”The creation of Signature Public Funding complements the specialty finance business lines offered through Signature Financial,” the bank said in a statement when the specialty arm launched.
One source said, “things are in flux” but the unit remains open for business, with press releases proclaiming “business as usual.”
The unit’s website said the business provides tax-exempt private placement loan, lease, and bond financings to a wide variety of organizations and entities. “Additionally, SPFC offers flexible structuring of loan, lease, and private placement bond transactions to meet the borrower’s specific requirements,” according to the website.
The lending business focuses on essential-purpose and essential-use capital equipment needs, such as computer hardware and software, emergency vehicles, heavy-duty and lightweight trucks, school buses, solar and other green projects, medical equipment and other healthcare and higher education financing needs. The lists of qualifying organizations covers local and state governments, agencies, schools, special districts, utility systems, and not-for-profit higher education institutions and hospitals.
Monetary policy
All eyes will turn to the Federal Reserve’s Open Market Committee meeting Tuesday and Wednesday as it weighs efforts to tamp down inflation against worries over the banking crisis’ toll.
The Federal Reserve has lifted interest rates by 4.5 percentage points over the last year and, ahead of the SVB collapse, analysts believed a strong employment report had upped the odds of a 50-basis point rate hike.
With the failures, the market is now expecting a 25 basis point hike or a pause.
After SVB’s failure, “the 50-basis point probability plunged and now the market is pricing in a 25-basis point hike as more likely,” said Tony Welch, chief investment officer at SignatureFD. “Also, the chances for a June/July hike fell.”
“There is no question that the Fed wants to see the current turmoil in the market calm down before resuming any hiking program. Whether the Fed does raise rates will be data dependent, but all of the above amount to a brew of statistics signaling lower economic activity,” Cumberland’s Mousseau wrote Wednesday.
“Obviously given the market turbulence over the past week, it is no surprise that expectations for the FOMC meeting on March 22nd are all over the place,” said Edward Moya, senior market analyst for the Americas at OANDA.
“Despite optimism that fallout on the financial system will be contained, they likely will impact monetary policy. The Fed will be under pressure to pause its rate hikes, and it is likely they will not raise rates at their March meeting,” Moody’s Analytics said Thursday its weekly market outlook/capital market research entitled “Shaken, Not Rattled.”
“We had previously expected a quarter-point rate hike. So-called financial conditions are one of the factors used in Fed monetary policy decisions, and the current turmoil in the system will likely lead to a tightening in underwriting standards and less credit availability,” Moody’s said. “We now expect two more quarter-percentage-point rate hikes, 25 basis points each time, at the May and June meetings of the Federal Open Market Committee.”
“The expected recession is now more likely and will probably occur sooner” perhaps by mid-year and the downturn “may be more severe than previously expected, given the stresses in the banking system,” said David Berson, chief U.S. economist at Cumberland.
“Given this outlook, the Fed is likely to tighten only one more time, at the March 21-22 FOMC meeting. It is certainly possible that there will be no tightening at that meeting, but given still rapid inflation and continued economic growth, a 25 basis point move is more likely,” Berson wrote Thursday.
Economy
Washburn said she’s most concerned about the impact on the U.S. economy and in turn, on state and local government revenues. Sectors like health care already face tight margins, she said. “The conditions are getting more difficult,” she said. “It moves the dial in favor of a harder landing relative to where we were two weeks ago.”
On the positive side, if the central bank next week opts to pause or scale back an interest-rate hike, that could spur more issuance after a year of anemic volume. “If there’s a flight to quality and muni rates benefit from that, maybe we’ll see some pick up in issuance,” Washburn said.
“The collapse of Silicon Valley Bank will make it harder for the U.S. economy to have the ‘soft landing’ that the Federal Reserve hopes will result from its anti-inflationary interest-rate hikes,” said Michael Bright, chief executive officer of the Structured Finance Association.
“At the same time, a banking crisis is deflationary by its nature, which will help the Fed’s cause. But this is certainly a suboptimal way to get inflation under control. No doubt it will take a while for the markets to sort out these major crosscurrents,” Bright said.
Most of the uncertainty as to whether the state and nation are headed for a recession lies in tracking what the Fed will do and how that will impact the economy, UCLA Anderson Forecast Senior Economist Leo Fehler said.
“We are presenting two scenarios,” Fehler said. “One scenario is no recession, where economic growth slows, but remains positive, inflation ebbs, labor markets remain robust and the Federal Reserve takes a less aggressive approach to monetary tightening policy tightening.”
In the second scenario, the Fed forces a mild recession and accepts an economic contraction and higher unemployment to combat inflation, he said.
Trying to guess what the Fed will do when Powell has said they “will continue to make decisions meeting by meeting,” is challenging, Fehler said.
The Anderson Forecast’s no recession scenario has the Fed stopping to wait for a lot more data to come in to before making another move, so it has a lot more certainty, he said.
Economists and others weighed in on how they think the tech industry is doing, given the raft of layoffs that have been announced. The banks’ collapse marks another pain point for local, tech-dependent economies that have already been struggling, said Washburn.
California economists, including UCLA Anderson Director Jerry Nickelsburg and Christopher Thornberg, founder of Beacon Economics, said the state’s tech industry continues to show strength despite layoffs announced at Twitter, Google, Salesforce and Meta. ”The ballooning tech layoffs are not the canary in the coal mine, Nickelsburg said. “If you look at technology in California, tech employment is going up.”
New Jersey Gov. Phil Murphy was quick to announce $35 million in support for businesses in New Jersey affected by the collapse of Silicon Valley Bank. Two programs managed by the New Jersey Economic Development Authority will provide businesses in the state with critical short-term support and ensure investments “continue to flow” to emerging industries.
“By offering a suite of programs for New Jersey entrepreneurs impacted by the SVB collapse, we will continue to keep residents employed and support companies that are vital to our innovation ecosystem,” Murphy said in press release.
Pensions
Some public pension funds are also digesting losses.
The California Public Employees’ Retirement System has $67 million of exposure to Silicon Valley Bank and $11 million of exposure to Signature Bank, CIO Nicole Musicco said during the CalPERS board’s Investment Committee meeting on Monday.
“Those will be the assets at risk, likely at a loss, but in the grand scheme of things a small percentage of our overall portfolio,” Musicco said. “We’ll continue to monitor the situation in the upcoming days and weeks and continue to be strategic, agile and patient as a long-term investor.”
As of last week, the Ohio State Teachers Retirement System held shares of SVB worth $27.2 million or 0.03% of STRS Ohio’s total fund. STRS Ohio did not own shares of Signature or Silvergate.
“The collective actions taken by the Treasury Department, Federal Reserve and Federal Deposit Insurance Corp. to insure and backstop deposits have helped to mitigate the situation facing the banking industry. STRS Ohio continues to monitor and assess the impact of these developments,” the fund said in statement.
The Ohio Public Employees Retirement System held shares in SVB worth $3.2 million and shares in Signature worth $2.2 million or a combined 0.0058% of OPERS’ portfolio.
“Pension funds have exposure but the holding in any one name are usually pretty small,” which should limit the impact, Hallacy said.
While exposure might be limited, the worry is the crisis broadens and leads to the failure of other banks whose stock pension funds hold, because as losses mount, pension funding costs rise.
Refundings?
Market participants don’t expect to see volume rise later this year if the Federal Reserve Board pauses or slows its rate hikes.
“While the SVB collapse added significant volatility into the financial markets, I don’t believe it will materially change the thinking of the Federal Reserve,” said Roberto Roffo, managing director and portfolio manager at SWBC Investment Company.
It’s difficult now to predict if the banking collapse foreshadows a deeper problem in the financial markets over the longer term, he said, but he doesn’t believe it will make enough of an impact to change the Fed’s decision-making process or lead to a substantial increase in refunding supply — even if interest rates decrease.
“Powell has made it clear that they will continue to raise short-term rates as long as it takes to tame inflation,” he explained. “SVB just served as a reminder that they need to be careful.”
While a significant drop in long-term interest rates could potentially increase refunding volume, Roffo and other market sources don’t believe a volume spike would be substantial — if one occurs.
Here are links to The Bond Buyer’s coverage of the banking sector crisis:
Muni bond market stirred, not shaken as Silicon Valley Bank collapses
Munis follow USTs in flight to quality as Credit Suisse imperiled
Silicon Valley Bank failure adds to California’s economic uncertainties
Munis largely ignore UST movement as concern about banks ease
Experts don’t expect banks’ collapse to spur bond refunding
Silicon Valley Bank failure may prompt closer look at munis
New Jersey directs $35 million to businesses hit by Silicon Valley Bank failure
Silicon Valley Bank collapse adds wrinkle to FOMC meeting