“They keel over like canaries in coal mines filled with poison gas, long before more robust types realize that any danger is there.” – Kurt Vonnegut, American writer and satirist
Welcome to the supplement – this week’s quote is somewhat out of context, but feels like a useful analogy. I’m going to kick off with a whistle stop summary of the past few years of events, in an effort to put the news that broke late Thursday about Silicon Valley Bank (SVB) and a resulting 60% drop in the share price into some useful context – before I touch on the subject that has gripped the attention of the media, the airwaves and the people for this week, GaryGate (or whatever we will end up calling it).
We all know we had a pandemic. We noticed. As I said many times during the meat of the event, the after-effects would last for many years – at the very least, the whole of the next decade. Quite a few commentators disagreed – instead citing Brexit as the event that would have far longer ramifications. Whilst there is an inevitability about the length of time Brexit takes to work through the entire system, I did feel people were vastly underestimating the effects (economically) of the stimulus, as well as (psychologically) on the population, as well as (politically) on the system as a whole. To say there were some dangerous precedents set would be an understatement of the ground that was ploughed, worldwide, in some supposedly forward-thinking liberal democracies. The UK didn’t actually measure up too badly, as I commented throughout, for a change, although we have been left with significant concerns and our lack of a decent energy strategy, or a backbone to embrace nuclear power if you prefer, alongside what’s happened in energy markets since has shown just how vulnerable we are as a nation to pricing of commodities that we simply do not control enough of.
We can fast-forward to the election of a lettuce as our prime minister. Except a lettuce would actually have been less damaging, because it wouldn’t have made as many cock-ups as LT did. We had the most profitable budget for hedge funds for many years, which royally shafted everyone else one way or another, directly or indirectly (let’s face it, neither are pleasant). Interest rates shot through the roof in terms of UK government bonds, which sent shockwaves around other markets of course, and forced the Bank of England into a bond-buying spree which, frankly, any idiot could have embarked upon – one which made them £4 billion which is fantastic, but also represents a tax on the pension funds (primarily), which is unlikely to be helpful in the long run. Hardly redistributes it from the super-rich – but considering we have a long track record of losing money when we get involved in bailout-style situations, this has to at least be considered some progress!
I wrote at the time of unseen bombs in the train tracks that the economy is wobbling along at the moment – as did other sensible commentaries. We didn’t know where they were. There’s a fairly simple next chapter that is emerging – some banks have been overexposed to certain sectors or events that have undergone a massive change as part of the pandemic picture and resultant huge and speedy interest rate hikes.
The first such bank is (both are California-based) Silvergate – who had massive exposure to Crypto and counted the much-discussed FTX (crypto exchange and hedge fund) amongst its client list. Fairly typical contagion-style situation – Bitcoin has recovered a little (20% or so from its low following the revelations about FTX), but not enough to keep the music going at Silvergate. Silvergate announced on Wednesday this week that it would liquidate, having seen deposits drop from around $12bn before the FTX scenario, to $10bn, down to under $4bn by the end of 2022. The news has of course in turn not helped the Bitcoin price, losing around 10% of its value this week – although in crypto, that hardly qualifies as news.
The second, and more significant (because what’s significant about a relatively small bank, despite worldwide reach and a public listing, that was focused on crypto – going into liquidation, particularly after the bubble burst) bank to be in trouble this week is Silicon Valley Bank. This is much, much bigger and is the second largest bank failure in US history – only behind Washington Mutual in 2008 (which failed after a 9-day bank run, which is always the chief fear here). The FDIC (similar to our FSCS scheme) was appointed on Friday. The UK arm (yes, there is an SVB UK) will be placed into insolvency by the Bank of England – this looks a relatively small concern compared to the $208bn US exposure, of course.
It might be timely to explain exactly what happens in such situations! Does that mean $208bn is lost? No, not at all. What is likely to happen is that any profitable parts of the Bank are sold off (almost always to another bank), and any losses up to the limits ($250k in the US, our £85k guarantee under the FSCS – for individuals, please note! – are covered). This doesn’t at all mean there is necessary loss for depositors, although in this situation that will remain to be seen. The parallel with Northern Rock – for example – that was in trouble when it was obvious they had lent on properties at false valuations, offered too much leverage in LTV terms, and then the loans stopped performing because of the Great Recession – is that they were split into two, UKAR was created (some will, I’m sure, have some fabulous stories of dealing with UKAR) and Virgin Money was the purchaser of the banking assets of Northern Rock for nearly £1bn all-told.
One thing to remember here is that confidence is everything. Remember we use a fractional reserve banking system – and even with much higher capital requirements, deposit money is multiplied and lent out thanks to some fancy accounting and the settlements with the Bank of England and the Real Time Gross Settlement system as required. Thus, a bank run is a very damaging thing – because all of that money is simply not there, if everyone wants to withdraw it at the same time.
Indeed, some of the more minor players in the sector have been reporting increased deposits as concerned savers move money around where they have a personal exposure above £85,000 in the UK. Revolut, Wise and other fintech firms have reported massive transaction increases – mostly because from a UK perspective a number of tech startups who do (did!) use SVB were facing the real prospect of not being able to get their money out in an orderly fashion.
You can see the pattern I’m sure – Northern Rock was overexposed to mortgages, which went south in 2008. Washington Mutual was the same. Silvergate was overexposed to crypto. SVB was overexposed to tech firms, and of course after the pandemic-inspired 2021 bubble which saw Elon 10x his net worth with not a lot more runway than he had before the pandemic (but arguably several years of growth within a few months of course – but was it sustainable? Never), tech popped and we have seen major league share price adjustments in the sector throughout the whole of 2022.
This is what it looks like when the music stops somewhere. An event FORCES a repricing of assets, because no-one is willing to do it on their own – or when they are, they do it very, very slowly. This is where it gets really interesting, as well, of course – as I attempt to get now to the “so what” for us in property.
Commercial property investments have always been volatile. Since the pandemic, there has been a very lightweight repricing of these assets, even though the risk free rate of return has gone from nearly nothing to around 4%, and certainly above 3.5%. There has been a huge margin compression as no-one wants to talk about this – this can be very damaging chat. There are plenty of businesses with masses of corporate bonds out there at very low rates, that upon maturity (which is typically 5 years – very similar to our refinancing cycles), will cause a problem. They cannot roll the debt at the same cost – if they had borrowed £200m at 2%, the price for that is now 6% (or so) – and so the interest payments treble. Bonds only pay the capital at the end of the term remember – so these are interest-only payments.
That 6% coupon takes 3 times as much cash to service. This IS instant repricing, because the bond markets are so thick with liquidity that they reflect the real risks and prices, as the entire market sees them, in real time (it doesn’t make them right, but it does make them fast – and in a time of tightropes and crises, it makes them volatile). Property investors do not have the same magnitude of problem – instead, mortgages have moved from a lightly-available 3% (although really, the number since 2016 has been more like 4-4.5%) to a hard-fought 5.5% or 6%. Nowhere near the trebling – instead, perhaps fair to call it more like a 50% increase, on average (if you built a portfolio from scratch VERY quickly during the pandemic and loaded up on sub-3% debt you would be looking at more like a doubling, but that will be a very small number of people).
This serviceability is a risk, of course. Lenders look at this in a similar way as to the way that they look at debt service coverage. 125% (the regulatory recommendation) is, frankly, laughably low. Sensible banks have used 150%+ for years – I very much try to aim for 200% coverage personally, but am looking at investments that cashflow as a general rule (and percentages can be deceptive, especially with low rents – so please bear that in mind). My idea of investment grade, however, is something that is going to use less than 50% of its gross revenue to service its debt. I’d be a very cautious mortgage lender!
If 5% of revenues were being used to service debts, and that jumps to 15% (let us say) – and bear in mind, these nominal borrowings will have depreciated thanks to inflation on fixed coupons, so this definitely overstates the problem – inflation will take care of a good slug of it, even without growth – but if a mature company which is attractive for investors grows revenues at a massive 10% per year for those 5 years, then if we start with a revenue of £1bn let us say, that was £50m in debt payments – when those bonds get refinanced, 5 years down the track, revenues are £1.6bn or so but then debt payments have moved to £150m – so then we need to understand the margin of the operation to understand the magnitude of the interest rate effect. Low margin with small debt payments becomes particularly problematic, of course, unless they can outgrow the increased debt burden.
That’s if they CAN refinance. If the serviceability is not there on a property – we hope we can sell it. Indeed – if we did take advantage of the low rates and have a spread of debt, there has been a 15%+ adjustment upwards in any of the pricing since before June 2020. That is coming down a little (that’s why I’ve only said 15%) – although Halifax tell us that prices went up 1.1% in February, contrary to the Nationwide viewpoint – although both have the market similar numbers off its pre-lettuce peak, 2.9% for Halifax. Those houses can be sold – they are income producing assets. Businesses do not have that same luxury – sure, they can sell off profitable parts of their business, but are unlikely to realise the full market value for them, and if income and serviceability is an issue, then selling off the bits that throw off the cash will not solve the problem – it will exacerbate it.
So, my belief is that the yields out there at the moment are nonsense. Most are simply too low on property assets, particularly commercial. Some rentals do not stack up – there are still many amateurs in the market, and property moves slowly, so they are unlikely to liquidate for this reason. If they are losing money every month and cannot refinance – just as in the example above – they will likely sell, of course – and that will lessen the stock available in the sector. That one wrinkle still exists – that MASSIVE piece of protection that makes vanilla BTL so nice and boring, but yet profitable in general – and that is that the retail housing market sets the price of the sale of most assets (aside from the quirky ones, which are likely only priced by the investment market – and this is where there is money to be made, of course). This is why individual houses have always been great – individuals can and do want to buy them. They set the price – in no real expectation of a discount – based on what they can borrow. Whilst their mortgage pay rates stay below 5.5%, the affordability calculations are NO DIFFERENT to they have been for the past decade or so – and as such, the availability and price of credit – the big driver of the market – is stable.
Does the collapse of SVB change that? No, not really. Before this week, 99% of people would not have heard of SVB – just as 99% of people did not understand LLDI (leveraged liability driven investment) before the long-dated gilts crisis triggered by Truss and Kwarteng. What might it do to rates, however – and what are the possible concerns and outcomes?
Firstly – a liquidity crisis. $208bn, ridiculously, is relatively pocket change. It was the 16th largest bank in the US, and the vast majority of the exposure is indeed in the home state of California (which, you should always remember, if it were to secede from the rest of the US, would on its own be the 4th largest economy in the world. Yes, California alone is a bigger economy than the UK, and France). Money is being shuffled around, at the moment – but not withdrawn from the system altogether. When people get really worried and there’s a genuine bank run – they are queuing to get physical cash (some will remember the Northern Rock queues from the financial crisis – they made a huge impact on the news and the sentiments of the country). As soon as someone is at it, everyone is at it – the pandemic “toilet roll” effect. Internet banking makes those queues invisible, of course, but the reporting has been fairly transparent in terms of the sorts of sums that have been moved from SVB in the past few days.
We aren’t in anywhere near that sort of position at the moment. Of course, it is concerning – because the entire financial system is built on confidence (and arguably smoke and mirrors) – so a major hit to confidence is a problem. Remember, however, Bear Stearns went down and there was still another 6 months before the stuff really hit the fan.
Secondly – how will the Bank of England react? How will the Federal Reserve react? Banks are likely to suffer (they already are) when interest rates go up quickly. They have to increase rates to attract depositors, and cut margins to remain competitive and attractive. They have had the very easiest 12 or 13 years you can imagine, once the sweeping up from 2008 was complete. This is “all change” and stresses the sector – and the values wiped off the shares on Friday are justified and perhaps need to go further, on this basis. The landscape looks poor, if you believe as I do that inflation is going to remain persistent and problematic.
Are rates LESS likely to go up – potentially, yes. A banking crisis of any sorts must be avoided at all costs. Inflation is problematic, but a systemic issue in the banking system will create even more problems than inflation. We know we’ve likely seen the peak (although bear in mind that in April, some massive rises in minimum wage and benefits will kick in, and pretty much 100% of this uplift is guaranteed to be immediately spent in the economy as the recipients struggle with the cost of living – so that’s some guaranteed inflation in the numbers right there) and that the main driver of the original inflation is back under control (for the moment…..).
I’m also cynical and have pointed out several times that the government would love a sustained period of inflation that is under semi-control – an average of 4-5%, for a couple of years, would be a great tonic to the swollen national debt thanks to Covid stimulus and recovery schemes. Tax take up, wage rises more controllable, thank you very much. Eat away at those gilts! The Central Bank sets the interest rates of course, but Andrew Bailey had already hinted that the rises “might be enough” before all of this – observing financial stability of the system for the next 6 months, closely, as we go through what is dangerously close to a stress-test event, will make sense to quite a few members of the monetary policy committee, I am sure.
This also had an impact on the bond markets, which regular readers know that I’ve been following very closely in the past 15 months or so. The 5-year dropped back under 3.5% on Friday, which is welcomed, and 0.15% came off the Sonia 5-year swap rate. That’s reflective of the likely impact, as it is currently seen and known, of the receivers stepping in at the federal level to sweep up this mess.
So – think about contagion. This is like your entire portfolio being in Sunderland and Nissan leaving, or going bankrupt – it is a massive, massive risk to the area. This is exactly why we diversify generally – take out some of the individual property risk, or the geographical area risk, and get exposure to a little bit of quite a lot nationwide. Don’t take risks you don’t get paid for!
More to consider on this? There will be, and the next week will be very interesting. We do have the aforementioned budget, of course, as well, but for space reasons that will be analysed post-hoc and last week’s supplement will be all there is on ifs, whats and maybes. My view is that Evergrande looked more dangerous globally – and whilst that’s not over yet – indeed, the next winding-up court hearing is in 8 days time – there’s always a lot of blood and thunder here but not too much to do in terms of taking actions outside of the checklist outlined last week.
So – that leaves a little room – and I do mean a little, for those still with me – for a bit of Salt and Lineker. I was absolutely distraught this week, although I did find a positive in it – I agreed with Richard Madeley on question time. I haven’t spent extensive time ever watching Richard and Judy (although I may have partaken occasionally at university……) – but I have always considered RM to be a bit of a melon. Or a lot of one. However, he did make what I really believe should be the central point here. This should be firstly and foremostly about free speech, and Gary’s right to it (and EVERYONE’S right to it!).
Whether you agree with Gary or not – and, for what it is worth, I think the same standards should be held to the left and the right, and whilst I understand the emotion he stirs when he uses the emotive language he does, and also think that Braverman’s language in particular is mean-spirited at best and laughably inaccurate at worst, let alone its potential to incite hatred – two wrongs don’t make a right. He went too far, and by all means hold the government to account effectively, but just because you say something in a clever way doesn’t mean you didn’t say it.
I don’t think he sees that side of the argument at all – and that’s understandable, because he occupies an ideological position. There’s been plenty of fact in what he has said – and no-one wants this discussion based on the facts, because as has always been said since before Brexit, the UK setup is now massively dependent on immigration, and since the populace are otherwise distracted by cost of living crises, and wars and defence, this issue is down the agenda – despite the >500k net migrants last year. That tells you that people don’t care about numbers and facts in this debate as a rule (and they rarely do) – it is more emotion and ideology. Both are so often a waste of time, frankly – particularly in issues that we do not control.
To put some context around that – 71% of those polled in September 2015 named immigration as the number one issue facing the UK. The economy was mentioned by 35%, health 28% and housing 19%. Today, that looks like 60% economy, 45% health, Immigration 30%, and housing 17%. (These never add up to 100 because the respondents can tick up to 3). Immigration reached a low of 14% in this survey in March of 2020, where health was number one, of course.
It’s great to see that the other commentators have rallied around him, and will make it genuinely interesting to see how this plays out with the BBC. There’s a lot of noise around Lord Sugar, who in a similar situation DID delete a tweet and apologise – the BBC needs to try and remain impartial as an organisation whilst accepting that social media exists, and it cannot gag its employees. Lineker looks likely to be branded difficult to work with, on the back of this, rightly or wrongly, and when the dust settles, he would be replaceable – just like everyone on television (or in business) ever is, to be honest. It might not be the same without him – but change is inevitable, just as it is in the private rental sector at the moment! And, with that extremely tenuous link – I will sign off for this week, with that one final catchphrase – keep calm, and carry on!