NEW YORK, April 3, 2023: Last year Guggenheim CIO Scott Minerd said in his analysis of the Federal Reserve: “They are going to push until something breaks”. During March we saw both Silicon Valley Bank and Signature Bank “break.” In this report, we will explore whether the crisis of confidence in the banking sector was driven by the Fed’s actions or other factors.
Money flowed into U.S. money market funds for a third straight week as $59.31 billion moved this week bringing total inflows in March to $273.3 billion. Fed lending to banks slowed, and its balance sheet shrank slightly. The Fed’s key inflation rate was better than expected in February, but still above the target. The S&P 500 ended the quarter up 7%, with the NASDAQ up 17% and the Dow Jones Industrial Average up 0.4%. The market movements were certainly not linear, as uncertainty continues to reign.
Contemporaneous credit conditions accelerated their decline in March, and the Kamakura Troubled Company Index closed the month at 9.08%, up 1.45% from the prior month. The index measures the percentage of 41,500 public firms worldwide with an annualized one-month default probability of over 1%. An increase in the index reflects declining credit quality, while a decrease reflects improving credit quality.
At the end of March, the percentage of companies with a default probability between 1% and 5% was 6.62%. The percentage with a default probability between 5% and 10% was 1.23%. Those with a default probability between 10% and 20% amounted to 0.80% of the total; those with a default probability of over 20% amounted to 0.43%. Short-term default probabilities ranged from a low of 7.34% on March 3 to a high of 9.17% on March 23 as volatility in the index also increased.
Figure 1: Troubled Company Index — March 31, 2023
At the end of March, the riskiest 1% of rated public firms within the coverage universe included 11 companies in the U.S. and one in the UK. The riskiest rated firm was Cyxtera Technologies, Inc (NASDAQ:CYXT), with a one-month KDP of 45.92%, up 39.31% from the previous month. There were 15 defaults in the KRIS coverage universe in March, with eight in the U.S., two in Australia and one each in Belgium, France, Israel, Switzerland and the UK.
Table 1: Riskiest Rated Companies based on 1-month KDP – March 31, 2023
The three-year default probability provides a more forward-looking view than the one-month probability. As we look further out on the curve, the impact of higher interest rates, the reduction in market liquidity and the rollover risk of existing debt have greater impacts on credit quality. This can be seen in Figure 2.
Figure 2: 3-Year term Default Probabilities – U.S. Market, March 31, 2023
Table 2 below shows the riskiest companies, based on the three-year default probability. The table measures the likelihood of default over a longer time horizon, which we think is an appropriate view in the current environment. The ability to examine the term structure of default is a key advantage of using KRIS data.
Table 2: Riskiest 1% of Rated Companies Based on 3-Year KDP – March 31, 2023
The Kamakura Expected Cumulative Default Rate, the only daily index of credit quality of rated firms worldwide, shows the one-year rate up 0.38% at 0.95% with the 10-year rate was up 2.39% at 12.63%. The three-year expected cumulative default rate rose by 1.46% to 4.84% which implies an increasing rate of defaults over the next few years.
Figure 3: Expected Cumulative Default Rate — March 31, 2023
Commentary
Stas Melnikov and Martin Zorn
SAS Institute Inc.
The failure of Silicon Valley Bank (SIVB) was triggered by a 21st century run on the bank followed by emergency actions to stem a systemic spread. Some analysts pointed towards actions by the Fed, while others pointed to weak regulations or the failure of regulators to take more definitive action sooner. The fact is, the failure was a result of poor risk management, resulting in a mismatch of assets and liabilities. The bank attempted to game the accounting system by holding assets to maturity without doing adequate stress testing or considering the ramifications for depositors. At the end of the day, it was a failure to use basic risk management tools and build appropriate guardrails. Regulations are the minimum floor for rules banks should adhere to. Managers must remember that they work for the shareholders. In this case, management receives a failing grade from all concerned.
Though markets seem to have calmed in recent weeks, based on money market flows, we continue to see a lack of confidence in the safety of uninsured deposits. Fund flows reflect the growing gap in deposit rates at the banks compared to the funds. Also, the market is focusing on unrealized losses and evaluating whether banks using held-to-maturity accounting in fact have the ability to hold these assets to maturity. There will be above-average interest in bank call reports when they are released later in the month. The industry has become more reliant on deposit funding in recent years, and unless bank managers can show investors that they have a better understanding of interest rate risk and deposit behavior than was evident at SIVB, banks are likely to trade at lower multiples for some time. The banks with the greatest unrealized losses (noted by JP Morgan Asset Management in Figure 4 below) saw significant movement in their stock prices.
Figure 4: JP Morgan Asset Management Analysis of Unrealized Securities Losses
As the banking sector shores up its liquidity, lending will slow. This is especially true for regional banks, for which the government may not backstop deposits. A slowdown will adversely impact small business and other sectors highly dependent on bank funding. As a result, the default risk for these sectors will rise.
In Europe, the actions taken around Credit Suisse resulted in a wipeout of the bank’s AT1 or “contingent convertible” bonds. That will make it harder for banks to tap the capital markets for liquidity; however, it should also make the banks focus more on the fundamentals of risk management–their basic job. As calls go out for more regulation, one positive outcome could be a more level the playing field, so that deposits do not continue to move to largest banks.
The markets are largely moving based on their assessment of how the events in March will impact future rate increases. We have been “six months away” from a recession for quite some time now. Companies keep announcing layoffs, yet most firms are still having trouble hiring, especially for critical positions. The Federal Reserve’s models missed persistent inflation, and most models cannot explain current employment behavior. It’s a matter of signal versus noise: How do we interpret the rapidly moving, often contradictory data?
Risk management in this environment requires robust data and dynamic models that can recognize changes in interdependencies and measure behavioral changes as they happen, not after they happen. It also requires a return to fundamentals, which means follow the cash—or phrased another way, improve the measurement of your liquidity and the liquidity of your counterparties.
SAS is well-positioned to provide all the analytics necessary to answer the myriad of questions today’s challenges pose.
About the Troubled Company Index
The Kamakura Troubled Company Index® measures the percentage of 41,500 public firms in 76 countries that have an annualized one-month default risk of over one percent. The average index value since January 1990 is 14.32%. Since July 2022, the Kamakura index has used the annualized one-month default probability produced by the KRIS version 7.0 Jarrow-Chava reduced form default probability model, a formula that bases default predictions on a sophisticated combination of financial ratios, stock price history, and macro-economic factors.
The KRIS version 7.0 models were developed using a data base of more than 4 million observations and more than 4,000 corporate failures. A complete technical guide, including full model test results and key parameters, is provided to subscribers. The KRIS service also includes a wide array of other default probability models that can be seamlessly loaded into Kamakura’s state-of-the-art enterprise risk management software engine, Kamakura Risk Manager. Available models include the non-public-firm default model, the U.S. bank model, and the sovereign model. Related data includes market-implied credit spreads and prices on all traded corporate bonds traded in the U.S. market. Macro factor parameter subscriptions include Heath, Jarrow, and Morton term structure models for government securities yields in Australia, Canada, France, Germany, Italy, Japan, Russia, Singapore, Spain, Sweden, Thailand, the United Kingdom, and the United States, plus a 13-country “World” model. All parameters are derived in a no-arbitrage manner consistent with seminal papers by Heath, Jarrow, and Morton, as well as Amin and Jarrow.
The version 7.0 model was estimated over the period from 1990, through the Great Recession and ending in February 2022. The 76 countries currently covered by the index are Argentina, Australia, Austria, Bahrain, Bangladesh, Belgium, Belize, Botswana, Brazil, Bulgaria, Canada, Chile, China, Colombia, Croatia, Cyprus, Czech Republic, Denmark, Egypt, Estonia, Finland, France, Germany, Ghana, Greece, Hungary, Hong Kong, Iceland, India, Indonesia, Ireland, Israel, Italy, Japan, Jordan, Kenya, Kuwait, Luxembourg, Malaysia, Malta, Mauritius, Mexico, Nigeria, the Netherlands, New Zealand, Norway, Oman, Pakistan, Peru, the Philippines, Poland, Portugal, Qatar, Romania, Russia, Saudi Arabia, Serbia, Singapore, Slovakia, Slovenia, South Africa, South Korea, Spain, Sri Lanka, Sweden, Switzerland, Tanzania, Taiwan, Thailand, Turkey, the United Arab Emirates, Uganda, the UK, the U.S., Vietnam and Zimbabwe.
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Editorial contacts:
- Martin Zorn – Martin.Zorn@sas.com
- Stas Melnikov – Stas.Melnikov@sas.com
