NYCB won’t be the last rates accident

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NYCB gets worse

It is a sign of our times that a pretty big US bank is in deep crisis and nobody much cares. New York Community Bancorp, with $115bn or so in assets, is having serious problems, and the broad market (here represented by the S&P 1500) indifferent: 

Admittedly the regional bank index is underperforming pretty badly, in part because of commercial real estate, which is one aspect of NYCB’s problem. But unlike the meltdown of Silicon Valley, First Republic and Signature a year ago, NYCB is not dragging a club of similar bank stocks down with it. Since late January, NYCB is down almost 70 per cent. The next worst performer, Valley National, is down 25 per cent. NYCB is alone.

So are we all whistling past the graveyard? When I last wrote about NYCB, a month ago, I argued that its problems are largely company-specific and non-contagious. The bank, born of two mergers (one of them with Signature!), sped across the $100bn asset threshold, triggering a change in rules. Supervisors insisted it improve liquidity and increase reserves, creating a big drag on profits and requiring a dividend cut. The bank also took a loss on a loan to a rent-controlled New York City multifamily building — an asset type that was NYCB’s speciality before its recent mergers. That writedown stemmed from a 2019 change in New York rent control regulations paired with a big increase in interest rates. Unless there are other banks that have passed the $100bn threshold and also specialise in NYC regulated multifamily buildings, all of this looks non-transferable. 

Back then, I argued that NYCB investors had to contemplate two unsavoury possibilities. First that the higher provisions for losses reflected not just a new regulatory classification but a loan portfolio headed south and, second that “management simply failed to anticipate how much added capital and liquidity the mergers would require. In other words, it seems possible that the management team is just not very good.”

Well, since then, the chief executive has been replaced, a board member resigned, a new chief risk officer and audit chief have been hired, Moody’s has downgraded the bank’s debt to junk, and the bank has disclosed “material weaknesses in the company’s internal controls related to internal loan review, resulting from ineffective oversight, risk assessment and monitoring”, causing a delay in the release of its 10-K financial report.

The second unsavoury possibility is less pressing now that the management team looks very different. The first possibility looms larger, though. What might the review of the financials reveal? What unsettling news about credit quality is in store?

The company has said that it has plenty of liquidity to more than make good on its uninsured deposits, leaving little room for a run on deposits. It has also said that it does not “currently anticipate” changes to the income statement it published at year-end — implying that reserves will not go up further. These points are good to hear, but have evidently failed to reassure investors.

What next? Opinions vary. Chris Marinac of Janney Montgomery Scott argues that the bank’s problems are “solvable”, though it will take time. Confidence is the crucial problem, he says, but if the bank gets the 10-K out and raises some capital — just to prove that it can — it will be profitable enough to build up the additional reserves it needs, and reposition itself away from New York regulated multifamily buildings. Steven Kelly of the Yale Program on Financial Stability thinks a sale is the best solution. A new owner solves the problem of the junk credit rating instantly and, Kelly believes, the mark-to-market losses on the loan portfolio are unlikely to be so large as to make a sale impossible.

Charles Peabody of Portales Partners disagrees with Kelly. He thinks the big increase in rates makes selling any bank hard, because mark-to-market loan losses have ballooned, and NYCB has its troubled multifamily portfolio on top of that. The most likely scenario, he says, is that the bank will now face funding costs in excess of its return on assets — eroding capital slowly and zombifying the bank.

Whatever happens, the NYCB story is loaded with painful ironies. The bank, everyone agrees, has three basic problems: it grew too fast; it had too high concentration in New York City regulated multifamily, an asset class in trouble; and it got whacked by higher rates. But, as Ebrahim Poonawala of Bank of America pointed out to me, the cause of the first problem, very fast growth, was acquisitions explicitly designed to solve the second problem, the concentration in regulated multifamily. One of those acquisitions, Signature, was a deal the regulators brokered. Yet the bank’s crisis may have been set off by overeager regulators, who were trying to prevent higher rates from destabilising the merged bank the way rates had destabilised fast-growing Silicon Valley, First Republic and Signature. You can’t, as they say, make this stuff up.

Kelly argues that the regulators should not have asked NYCB to cut the dividend, because that hit the stock price hard, and set off a chain reaction: 

There is this idea, which is true to a degree but not all true, that the stock prices don’t matter to bank stability. It’s true when the price goes from $100 to $90, but when a stock goes to $3, you have to worry. First you worry about the stock, and then the bank supervisors get in the door, which is costly even if they find nothing, but supervisors will always find something. The rating agencies will then downgrade based on stock price, because they are worried about the tradable debt. And once the debt gets downgraded, depositors are next in line.

Should anyone care about all this, if they do not own the shares or debt of NYCB? Bank regulators probably should, as there is a good case that they have been clumsy here.

More than that, however, I think Kelly’s point about the importance of stock prices is generalisable. The reason we had a mini banking crisis last March is a sudden and sharp increase in rates after years of them hovering near zero. The NYCB mess shows that the change in the rate environment can still act as a catalyst for big problems at unexpected moments.

Why haven’t we seen more crises like NYCB’s, not just in banking but the corporate world generally? Partly because many corporates (and households) termed out their debt when rates were low. Higher rates have not yet touched those that did. Another reason is very strong stock prices, which relieve pressure on the whole capital structure, and form a comfortable basis for solving any form of corporate distress. All debt has to be refinanced eventually, though, and equity rallies don’t last for ever. At Unhedged, we’re betting that NYCB is not the last rate-driven market accident we are going to see in this cycle.

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