In The Trenches: Interview with Anthony Rodriguez and Conor Tidgwell (pt. 1)

9:03PM May 8, 2023

Speakers:

Steve Divitkos

Anthony Rodriguez

Conor Tidgwell

Keywords:

deposits

bank

loan

lending

institution

rates

banking

commercial real estate

question

impacted

interest rate risk

cash flow

terms

assets

steve

headline

months

accounts

issues

risk

Anthony and Conor, welcome to the show.

Thanks for having us here.

I did an episode about the state of the Debt Capital Markets, probably two or three months ago. But so much has changed since then that I thought it was really important to revisit the issue. And at the risk of indulging myself with our first question, if for no other reason than just personal curiosity, can you guys just take us behind the closed doors of a bank over the past two months or so. Because in a very short period of time, I mean, unless you've been living in a cave on Mars under a rock, you will know all of this. But in a very short period of time, we've seen SVB collapse, we've seen First Republic being rescued by JPMorgan, which I believe is the second largest bank failure in US history or something to that effect. And record rates of borrowing by commercial banks from the Fed. So I would just be very curious to be a fly on the wall, in your meeting rooms, in your offices. I mean, what is the internal communication been? What is the external communication been? And how is your day to day activity been impacted, if it has at all?

Sure, Steve, thanks for the question. I'll take a stab at that. It certainly was an interesting few weeks, you know, and on the banking side of the market, you know, internally, management has hosted several staff meetings to kind of talk through the headline issues facing banks that are in the headlines and answer questions from from the staff. So that has been, you know, probably a weekly occurrence at this point. And it's really driven by the employees wanting to know and management's goal to be transparent, and help guide us through this. Externally, the bulk of our time was spent communicating with, you know, all clients and prospects and presenting our position against some of those risk factors and the headlines that have come to light, you know, within the broader industry. Overall, I'd say the shakeup certainly demanded attention and cause a pause, in normal activities, at least out of the gate with the SVB issue. But management's been great to provide kind of necessary data and the narrative to settle the nerves, both internally and externally, which has been great. Conor, do you want to add anything to that?

Yeah, I would just add, you know, one of the biggest things that came out of this is just the heightened sense on insured deposits, right. And so we were pretty quick, I think a lot of banks were pretty quick to offer some solutions there. And one of ours was was insurify. So I think that was a big, kind of positive outcome of all this, that we quickly moved offer our clients, which ensures deposits and $250,000 increments across the 3000 FDIC insured institution. So I would just add that.

The FDIC insurance limit is an interesting one. Here in Canada, we have something called the CDIC, which is effectively the equivalent, but it's only for $100,000. And in the US, obviously, it's for 250,000. Both of those numbers struck me as abnormally low. And I don't know this to be the case. But my best guess was that these were numbers that were arrived at, I don't know, 5, 10, 15 years ago, and just haven't been revisited since. Am I onto something when I suggest that that's the case?

Yeah, I think that's spot on.

I think that's right, Steve. You know, I think the last time these were looked at, were coming out of the '08, you know, great recession. And they haven't moved since. And it's very curious, specifically, when it comes to, you know, commercial deposits, which, you know, some banks are 100%, commercially focused [inaudible] included. So I hope that those limits can be revisited here in the near term.

And there's no difference from the FDIC perspective between individual and corporate accounts. The max is 250k for either, is that correct?

That's right.

Yeah, I mean, it even just that, on its own appears to make very little sense to me. But anyways, maybe I'll have a banking regulator on as my next guest in case people want to use this pod class to help with their insomnia. Anyways, this is a bit more of a kind of like a meta question, and we'll get to specifics in short order here, but I mean, substantially, every bank obviously has to manage interest rate risk, that is a fundamental part of their business model. But the past, you know, six to 12 months or so feel like they have presented very acute challenges for banks with respect to managing interest rate risk.

I'm just, you know, for example, I'm thinking of a situation where a bank made a fixed rate loan to a company, let's say, three years ago, I'll just make up a number, let's say it was at 4%. But now those banks have to pay their creditors much higher rates. And again, I'll just make up a number, let's say it's 6%. So in situations like this, which substantially every bank is in the midst of I would imagine what what do banks actually do to mitigate the impacts of that negative spread?

Yeah, so this is quite topical, Steve, just in light of the First Republic fallout, you know, one of the biggest issues there came down to profitability. And you nailed it, they were, a lot of it came down to their heavy concentration on the mortgage side, and locked into these fixed rates, to your point a couple of years ago with a very low rate. So as those mature and as interest rates rise, and they have to pay their, you know, high net worth and large depositors, increasing rates, that's naturally just going to be squeezed profitability. So certainly a major issue there and felt to some other banks. Alongside that, the answer really comes down to diversification amongst the product set, I think that's just paramount.

I mean, you're going to have products that are more rate sensitive than others, meaning the market will dictate lower fixed rates, but other products, you have some more flex on the floating rate side, for example. Or you can fetch some higher rates and still win deals, if you will. So there's going to be a natural balance amongst the portfolio and diversification within a bank, that's why it's so key. Because you could have some that are, you know, locked in to some low rates, but others that are primarily floating rate based, and they're realizing the benefit as as you're paying deposit is depositors, more men, obviously, you know, every bank has a different borrowing capacity and cost of funds.

Obviously, deposits are the cheapest cost of funds. So different banks that don't have the deposits or access to those deposits, they're going to have a smaller spread on their loans. So they're probably gonna be less open to offering more aggressive rates, and so on and so forth. But I think the key takeaway is diversification amongst the products that which we've seen, can balance things out, regardless of the rate environment. And, again, keep things fairly stable.

So in our example, the fixed rate loan that a bank made to a company three years ago at a very low rate. Like on average, does that loan still sit on the banks books? Or is that been like securitized and is now held by some random third party Holder at this point?

No, that's on the books. yeah.

The SVB collapse was an interesting one, for many reasons, we could have several episodes about that, in and of itself, but I was a bit confused when I was reading the commentary that followed. And a lot of it was attributed to them basically borrowing in the short term, but lending across the long term. Like, unless I'm mistaken, isn't that the business model of every bank? Or am I thinking about that wrong?

No, essentially, I mean, you nailed it, you know, but there's a bit more than that meets the eye in banking. Of course, generally speaking, a bank takes in deposits, which is a short term funding source by nit by definition, and that's their primary funding source and then make loans to generate returns against those deposits. But more fundamentally, you know, a bank is in the asset and risk management business with a lot of irrelevant factors to account for and juggle simultaneously. So you got credit risk and regulatory risk, those are the kind of the two primary drivers for bank operations that most people see and understand. But interest rate risk is kind of Connor and Steve, you guys alluded to, it's just as important and maybe not as well understood.

And certainly one of the main underlying drivers of some of the issues in the headlines today. You know, balance sheets of banking institutions are regularly monitored and constantly shifting. You know, based on the loans deposits debt and investment securities, they structure and hold on. Nearly all of those instruments are impacted by market interest rates in one way or another. So a bank needs to understand kind of the net impact of interest rate fluctuations on their overall earnings and capital, which is usually done through a dedicated committee called Alko. Now, that committee is separate than credit, totally separate. So it's kind of less public facing, less customer facing. I think it's 100% internal.

So if the balance sheet is mismanaged, as certainly is the case with some of these headline institutions, their earnings capital, and ultimately, the liquidity are under immense pressure, which can lead to these bank rounds, if at the end of the day, the customer lose confidence, and pull their deposits. Not many banks, if any, can withstand the level of deposit outflow experienced in some of these current scenarios. Another important factor is, you know, that we touched on already is this deposit insurance by the feds, which is extremely relevant for these specific institution, given their customer bases, the higher the percentage of uninsured deposits, the harder it becomes to keep them on the balance sheet should those customers lose confidence. And we saw that with both SVB and FRB.

The thing that really jumped out to me was just how fragile this all is, you know what I mean? Like you think of a bank, any given bank, and at least in the mind's eye, it's as trustworthy and stable as it comes. But, you know, one of the things that this illustrated was just how perilous and how fragile the system is, and frankly, how it's less about your numbers on a spreadsheet, and more how it's about psychology, and specifically the psychology of individual depositors. And though me going to the bank to withdraw my deposits, because my neighbor did it, as well, is the thing that perpetuates the banking crisis. From my perspective, it's an inherently logical thing to do. So I don't know, like how that logic gets broken down. But I guess what, what this all showed me is just how fragile and how perilous this system is.

Yeah, that's interesting, Steve. And certainly, it's based on trust, at the end of the day. These non maturity deposits, you know, frankly, those can move around, mostly freely, right, especially for individual accounts. But some of these commercial deposits, particularly if they're tied to a loan, a lot of the times those credit agreements will require those borrowers to keep deposits parked at that institution. So that, in theory supposed to keep deposits a little bit more sticky. But you're absolutely right, you know, in today's world with the social media, and just 24 hour news cycles, all that all those things, you know, a contagion or that fear can spread like wildfire. And as we saw, I think with SVB, it was something to the tune of 40 billion of deposit withdrawal requests happen within a 36 or 48 hour period, which is unprecedented in terms of the velocity.

Yeah, that's just totally bonkers. Okay, so I'm going to ask you guys, let's get the unfair crystal ball question out of the way, because I'm sure you guys just love answering these these types of questions. So, you know, I'm not a banking expert by any stretch of the imagination. But in consuming some media on this, a lot of the commentators that I respect seem to generally agree there are exceptions, but generally speaking, they tend to agree like this is not 2008. And we shouldn't think of it as such. So the crystal ball question is, as best as you guys can tell, from your standpoint, are you expecting to see any further fallout within the banking sector over the coming six months or so?

Like, one of the big risks that's on the horizon, that makes perfect intuitive sense to me is the commercial real estate market, not just because of interest rates, but because of the paradigm shift visa vie work from home. That kind of was unexpectedly thrust upon us a couple of years ago. So that's kind of if there's going to be a next shoe to drop. That's the one I keep hearing. Like, what are you guys expecting over the next six months or so of course, respectful, the fact that none of us can predict the future?

Yeah, that will be my first answer as well, Steve, in terms of commercial real estate, that's what we're hearing. I mean, and like you said, just can't ignore how that landscape has changed. I think vacancy rates are at an all time high, a quarter of all cre is set to refinance this year at, you know, much higher rates, I think they're really hard to price. But that seems to be again, for the right reasons, that seems to be the area where there's going to be a lot of focus in these next six months, 12 months. So when you look at a bank or a lender that's heavily concentrated, they're certainly something to consider and keep your eye on. I think taking a step back from just a focused industry, you know, lenders and bankers are wary of the general macro environment, we're in the uncertainty ahead.

So, you know, these are unsettling times, you know, costs are way up, it's a tight labor market, there's interest rate risk, you know, just to name a few. So, as always, I mean, credit quality will be paramount, meaning active portfolio management and hopefully avoiding losses. Which these latest banking, fallouts, SVB, Signature, FRP, etcetera, kind of unique. I mean, the historical downfall of banks have been low losses. So those are always still going to be, you know, we got to protect our portfolio. And hopefully avoid kind of the big whales, if you will. I mean, another industry and we've already seen this, I think crypto, not so bullish on that. And we've already seen the negative impact on Signature Bank and others that that can have, but I think you got it, this commercial real estate, just you can ignore the stats, and how much that's changed in the last two to three years. A lot of exposure, there could be problematic.

So if a CEO is listening to this, and for whatever reason, they're worried about their current banking partner, right, like so as a for instance, let's say that the bank that they use, they know for a fact that they have large commercial real estate exposure. And as a result, they're worried if somebody is listening to this, and they're worried about their current banking partner for any number of reasons, what steps would you recommend that they take?

Yeah, good question, Steve. Ultimately, I think the most prudent step is to talk to your banker. They should be able to provide kind of insight into the institutional soundness and kind of near term outlook for that particular bank. But if you want to go deeper, there should be you know, to the extent available, any publicly published data on the balance sheet, you know, things like the interest rate, risk management and exposure, deposit trends, funding sources, and customer base are kind of all relevant. Another thing you might look at is the 2022 performance, you know, versus prior periods.

That's kind of you know, during 2022, market interest rates went up over 400 basis points. So that's a material shock to the system. How did that institution fare in 2022? You know, for instance, Avid Bank, we were asset sensitive institutions. So, rates up is good for us from just an earnings standpoint. So that's a useful data point to know. Another thing, it might also be good to know if there has been any turnover in kind of the C suite, or other senior management positions, like the risk officer, or anybody in finance. As we saw with some of these headline institutions that had issues, you know, there was some turnover, meaningful turnover in the C suite and senior management that might have created more questions.

So one of the things that I know some CEOs have done is they have net, like in response to all of this, they have spread their liquidity across several different accounts, within several different financial institutions. So you'll certainly have a million bucks, I don't have a million bucks with Bank A, I have $100,000 with 10 banks, or maybe $200,000, with five banks or whatever kind of permutation you want to mention. So in your view, does this strategy come closer to prudence or does it come closer to paranoia and why?

Yeah, I think there's certainly arguments for both. But here's what we know. The Fed did step in for what I think we can all agree was the near or the worst case scenario in terms of what transpired at SVB in terms of the run on deposits, etcetera. That was good to see obviously, you never want to get there but it good to see that you have that the Fed did step in and then an FRP that there was an M&A market there and those deposits are also stable and protected, if you will. So, through all of this, everyone has been protected and no one's deposits are at risk, in what we would say is a very unique and again, kind of worst case scenario.

There's also some really neat products out there, I alluded to Insurafy earlier in the pod. And, you know, that's that's where your deposits are still held at the institution. But they're insured and $250,000 increments across the different, you know, the, the FDIC insured institution. So I think it's very top of mind for banks right now that there is just a certain level of anxiousness around insured deposits. And, you know, the banks are trying to be as creative and flexible as possible on that front. But you know, and then doing your homework on your partner bank is always a prudent choice.

We've talked about this, but if there's concerns that come out of that, over some of the analysis that Anthony just talked about, it's certainly reasonable to diversify. I mean, and understandable. So I think that I think that's a prudent approach. And then I would caution that for loan and deposit relationships, that's a much more difficult equation. As you know, most institutions do require all deposits to be retained, if a loan relationship exists, otherwise as a default, so just be mindful of that. But, yeah, those would be my kind of the facts in what's transpired over the last couple of months, but certainly reasonable and arguments for both.

So I want to spend the next little while taking your temperature on what all of this means for banks willingness and ability to lend to small and medium sized businesses. You know, presumably, if a bank is lending to a fortune 500 type of company, that's one type of risk profile. But if we're lending to small founder owned businesses that have a million of EBITDA Well, that's, that's a very different risk profile. So I'll start with a general question. And then we'll get into very, very specific kind of consideration. So starting with a general question. I mean, how have the past two months changed, if they have at all, your view of lending to small and medium sized businesses? Is it different? Is it the same? And why?

Yeah, I'd say, you know, developments specific to banking have had not much impact to our lending activities overall. We did have, I mentioned, we had a strong 2022 In terms of growth and earnings. And we're on sound footing, you know, from a risk management perspective. So our growth goals this year have not changed. And we're still very active with lending to SMBs. You know, that that being said, the overall macro world, certainly has impacted our criteria, a bit, Conor will get into that in a second. But the specific, you know, headline banking issues, for us, at least so far this year haven't impacted us.

So let's get into some specifics, then. So the specific terms of loans, and maybe we'll start out with hard assets as collateral. When one lends to more, you know, industrial, more traditional, quote, old economy type businesses, there tends to be a lot of hard assets against which to collateralize the loan. But if you lend to a software company, for example, I mean, there's nothing other than people and computers. So there's not a lot of hard assets there. Has the importance of hard assets as collateral increased over the past couple of months. And I guess, question be, do lenders have an equal appetite for cash flow style loans relative to a few months ago?

So for our search and sponsor lending practice, we remain focused on cash flow generation as our primary repayment source. These businesses tend to be more asset light and less capital intensive, generally speaking, that being said, asset coverage is always a welcome enhancement for a deal and typically takes the form of accounts receivable, inventory equipment or real estate. So, you know, although not our primary factor to underwrite to, and structure to, it's always an enhancement to the deal to the extent that our term loan has direct collateral coverage, or any of our exposure for that matter. Whether it's a revolver or a term loan, collateral coverage and hard assets to enhance that profile.

As far as MRR loans go. Those can be structured, you know with a formula that governs the loan exposure, so it can be more palatable than a cash flow based facility on its own. That can also be a nice supplement to a cash flow loan and encourage the lender track leading indicators of future cash flow generation, you know, like churn and bookings, for instance. And tracking that stuff of course, this enhances the portfolio management for the credit overall.

So is it fair to say more similar than different with respect to how banks are viewing hard assets in this market?

I would say, it's probably nicer to have in today's world than it was, you know, six months ago, it's nicer to have that collateral support. But if you're a cash flow lender, that's still going to be your primary.