Don’t Wait for a ‘Plumber’ to Fix the Financial System – RealMoney

What happens when the plumbing of the financial system breaks down? Well, we are looking at it. Who is the plumber of last resort for the financial system? Well it would have to be the lender of last resort, which is, by definition, the Federal Reserve.

Every business everywhere, from a lemonade stand to JPMorgan (JPM) is based on constantly running transactions through a system. It's how fixed costs are amortized and how bankers make their bonuses. So, if that stops, then there is trouble for the U.S economy. Call it a credit crunch, call it fiscal tightening, call it what you will, but, make no mistake, it is visible everywhere.

Especially in the U.S. financial system, and specifically at regional banks. The Fed's disastrous decision to flood the economy with money in the depths of the Covid crash created inevitably a wave of inflation, which is still wracking the economy. As Powell and his clueless cronies at theFed only know one way to flood the economy with money -- dam-burst style -- similarly they are removing it with equal force.

Look at this chart from the St Louis Fed's FRED database:fred.stlouisfed.org/series/M2SL.

After rising steadily for the more than 80 years of data in the St. Louis Fed's data series, "M2 money supply" -- cash, checking accounts, CDs, and the like -- peaked in March 22 and has been trending downward since. So the U.S. economy is in its 14th month of monetary contraction and the casualties are forming. PacWest (PACW) looks likely to join First Republic, Signature, Silicon Valley Bank in the dustbin of history.

But why? I have never heard so many different answers to such a simple question from my friends that are Wall Street professionals. The answer to this medical condition is easy, though. The patient became addicted to a steady morphine-like drip of liquidity, and then the Federal Reserve -- to fixits own mistake -- removed that drip. Then things started to fall apart.

The classic bank business model is to borrow short (deposits are classified as liabilities for a bank) and to lend long. But what if it costs more to have funds available in the short-term than (deposit rate) than an institution can earn on a long-term loan (like a 10-year construction loan, for instance)?

The economics of your simple shoebox-style bank have just been totally upended. The yield curve has been inverted for 11 consecutive months now, a phenomenon that last occurred from 1980-1982. I just have no words for incompetently run this Fed and its ultimate backer, the Treasury Department -- run by Janet Yellen, a former Federal Open Market Committee Chair herself -- has been for the past three years.

So, I believe this credit crunch will eventually be resolved by having long rates gradually rise back through 4% -- making new loans profitable) not by the FOMC cutting the Fed Funds rate back to near-zero from the current 5.25% which would simply resuscitate the inflation monster. A yield curve re-steepening simply has to happen, and that was the genesis of my WYLD portfolio of currently-floating--rate preferreds. But, because preferred stock is counted as Tier 1 capital, the institutions that have the most incentive to issue them are ... you guessed it ... banks.

So, WYLD has paper issued by investment banks, insurance companies, NuStar Energy (NS-A) , which has been a terrific relative performer. Two WYLD names I have noted previously are Zions Bank's preferred (ZIONP) and Valley National Bank's (VLYPO) , and I am buying them both in size this week for Excelsior Capital, as we take advantage of their ridiculous yields. Those yields are based on three-monthLondon Inter-Bank Offered Rate plus an issuer-specific spread. Doing the simple math shows that VLYPO is yielding 14.69% currently, while ZIONP is "only" yielding 10.43% at today's price.

Those yields are crazy, and not reflective of the fundamentals at those banks. So, while I fully expect ZIONP and VLYPO will be just as volatile as their respective common stocks (VLYPO has had a particularly wild ride this week) I am committed to locking in those yields and then ... waiting. I don't think "this will all blow over" or any other such hoary cliche, but I believe the rewards we are reaping from these double-digit yields outweigh the risks. So, we wait.

At this point that is all we can do. I am not sure which is crazier, selling a security that one already owns that sports a nearly 15% yield that I judge to be safe, or buying that security in the first place. That ship has sailed. We are in these positions for the long haul.

When the plumbing is bad, I want to take advantage. That said, I don't like roulette, and I will not be looking to add any new names to my or my clients' portfolios for the foreseeable future. But the ones we have have gotten too cheap, and I am in there with bloody fingers from catching the falling knives and averaging down.

The famously conservative bankers at Zions navigated through 2008 (though ZIONP traded as low as 24 cents on the dollar then, which makes today's 56 cents on the dollar seem like a minimal reaction) and Valley National (VLY) has an ace in the hole, in the 14% ownership stake in VLY held by Israel's Bank Leumi. Valley bought Leumi's U.S. business last year, and, if thingsgo further, I would expect Leumi to consider returning the favor by buying the rest of Valley National.

The plumbing is broken now. Stick with names you own, andbe patient while collecting in love from those names, especially bonds and preferreds, and you will make it through this crisis without needing a bailout of your own.

(Please note that due to factors including low market capitalization and/or insufficient public float, we consider some of these stocks to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.)

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Don't Wait for a 'Plumber' to Fix the Financial System - RealMoney