There’s Never Just One Cockroach

Why Jamie Dimon’s “Cockroach” Comment Matters

JP Morgan CEO Jamie Dimon said, “…when you see one cockroach, there are probably more.”  He likely didn’t really intend to liken banks to cockroaches.  But it was a colorful way to suggest that there may be more bad loans made by banks and investors should be prepared for more such news.  Of course, banks always make bad loans.  It is impossible for any bank to ensure 100% of all loans will be repaid.  That’s why banks maintain loan loss reserves and write off bad loans every single quarter, even in the very best of times.  What is really at issue is whether a weakening economy is about to launch a tidal wave of bad loans and trigger a recession.  We are confident that is not about to occur.

What’s Behind the Latest Loan Failures

Three loans failed within the past several days, by First Brands, Tricolor, and Cantor Group V, set off warning bells and depressed bank share prices, especially since investors remember the 2023 failures of Silicon Valley Bank and Signature Bank.  Those failures also precipitated major declines in the bank share prices, but both failures were highly idiosyncratic.  Silicon Valley borrowed short term money to finance the purchase of very long-term bonds, a blatant mistake taught in banking 101 classes.  They must have skipped that class.  (Even more remarkable, Fed banking supervisors were aware of the mismatch and incompetently failed to order the bank to correct it.)  Signature Bank was deeply involved in crypto and investors fled for the hills in response to this news, since no one had any experience with this new asset class and couldn’t judge whether the bank would remain solvent in a run.  The disruption in the bank market and regulators pushed banks to tighten lending standards sharply, which curtailed borrowing, but didn’t lead to a decline in economic activity.  But it did create some investor PTSD towards banks.  That’s a legacy we must live with for a while, but it also creates attractive investment opportunities.

How Past Bank Failures Shaped Today’s Market Fears

The three latest loan failures are also idiosyncratic.  The third of these, by Cantor, a firm I’d never heard of before, is an outright alleged fraud and its banker, Western Alliance Bank, remained profitable despite the loss.

First Brands was a sizable auto parts manufacturer that had borrowed vastly more than was understood by investors.  In fact, it was very deeply in debt and investors did not know.  As reported by WSJ, a reported $5.9 billion in outstanding debt suddenly mushroomed above $11.6 billion, which also raised questions as to whether the firm was suffering operating losses.  More than $2 billion of accounts receivable financing is unaccounted for, which is now being examined for whether these accounts were double or even triple pledged.  Its banker, Jeffries, claims fraud on the part of First Brands.

Tricolor made car loans to Hispanic immigrant families, but more than two-thirds of its borrowers lacked any credit score, and more than half lacked a driver’s license.  Who makes such loans?  Perhaps a company selling cars at close to a 50% premium over Kelley Blue Book.  But Tricolor didn’t care.  It packaged these loans and sold them off to “sophisticated” investors, who apparently didn’t bother to do any due diligence on what they were buying.

Understanding Non-Bank Financial Institutions (NBFIs)

A broader issue raised by these loan failures is that banks made loans to non-banks, who in turn loaned the money to assorted unqualified borrowers.  For example, banks loaned money to Tricolor, who made loans to those unqualified borrowers.  The case is made that banks are supervised by bank regulators, but non-banks aren’t, so they are freer to make questionable loans.  That’s true.  The business development company (BDC) business expanded dramatically after the government imposed greater capital requirements on banks, which cut off lending to a large segment of corporate borrowers, especially smaller or lower quality borrowers.  BDCs filled that void.  But nonbanks must also hold capital to be in business.  The typical BDC has about twice as much in loans as it has capital, so about 50% in equity capital.  In contrast, bank capital is commonly around 10%.  So, there is actually quite a bit of BDC capital at risk ahead of any bank capital.  Thus, the risk to bank capital is greatly reduced by interposing BDC capital between the banks and any borrowers, reducing risk, not enhancing it.

The Role of CDFIs and Regulatory Contradictions

But Tricolor wasn’t a BDC.  It was a Community Development Financial Institution, a CDFI.  Congress created this category to foster more lending to minority and lower-income households and banks could satisfy their Community Reinvestment Act obligations by making such loans.  Does this sound familiar?  This is precisely what pushed banks to make bad real estate loans that set off the housing crisis in 2007.  (One Congressman, Barney Frank, played a key role in all of this.  He pushed through the CRA to force banks to make those mortgages.  And he urged major fines for those banks for making those loans when defaults surged, arguing they made bad loans.  And to top it all off in a way no novelist would ever regard as plausible, Barney Frank was also on the Board of Signature Bank.)  Just as the CRA promoted riskier lending, so does the CDFI.  If you thought bank regulators were trying to make the financial system safer, this is a key example of how other priorities got in the way.

Lessons from the “London Whale” and Risk Management

You may also recall that in 2012, JP Morgan lost about $6 billion when the London Whale trade went bad.  Notwithstanding such a large loss, the bank remained profitable in the same quarter, which shows that its risk management worked to constrain the size of that loss well within the bank’s ability to absorb it.  (To rub some salt into that wound, JP Morgan was fined another $6 billion by regulators, even though government supervisors sat on JP Morgan’s trading room desk and were well aware of the activity to which they didn’t object.  And to borrow a line used elsewhere, no bank regulators were harmed (or lost their jobs) by their failure to supervise bank mistakes.)

Are We Headed Toward Another Banking Crisis?

The focus of concern this past week was with non-depository financial institutions, NDFIs, which include BDCs, hedge funds, private equity funds, and other such investors who don’t take deposits and, therefore, are not banks nor are they subject to bank regulations.  While some people worry that these firms may be taking undue risk, it seems they are typically taking well managed risk, since they are not obligated to lend to uncreditworthy borrowers.  They know their own capital is at risk and they (mostly) do a very good job of scaling their risks to their capital base.  With the exceptions of the frauds noted above, everyone else who reported losses as a result of these frauds still managed to report profits for the quarter!  All of them.

Bottom Line: Banks Aren’t Cockroaches

So, what do we expect now in the aftermath of the latest reported loan defaults?  Bank and BDC stocks have been hit hard, as investors sell first and ask questions later.  This is normal behavior and a classic mistake.  As described above, it appears the failures were idiosyncratic and due to fraud, not to a general weakening of the economy.  Since banks are not cockroaches, the case that there are many more failures imminent, because of three events, mostly if not entirely due to fraud, does not suggest a major surge in bank failures lies ahead.  And the Fed is likely to respond by reducing policy interest rates to prevent a general economic downturn.  Thus, we think the decline in financial stocks presents an attractive investment opportunity.

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