Talking Banks Podcast - Episode 2

Transcript

Kevin Swanson (00:00)

Welcome and thanks for tuning into the Talking Banks podcast. I'm Kevin Swanson, Senior Analyst with GenOppp Capital Management. And joining me today is Joe Fenech, our Founder and Chief Investment Officer and our newest addition, Jeff Wallenius our Director of Business Development.

Kevin Swanson (00:12)

Before we start, a quick disclosure. Joe Fenech, Kevin Swanson, and Jeff Wallenius are employees of GenOpp Capital Management, an investment advisor that maintains exempt reporting status in the state of Indiana. This podcast represents the views, beliefs, and opinions of GenOpp members and does not assert to be complete. The information presented in this podcast is provided to you as the dates indicated and opinions presented may change. You should not rely on this podcast as a basis upon which to make an investment decision. This podcast is not intended to provide and should not be relied upon for tax, legal, accounting, or investment advice. GenOpp’s clients or its members may hold or recommend to GenOpp’s private fund clients the purchase or sale of securities of companies discussed in episodes of this podcast.

Kevin Swanson (00:55)

Needless to say, it's been a volatile start to the year across all sectors. It feels like the same story we've seen play out since the start of COVID, where you have an unstable market backdrop and things are happening that haven't been seen before. Banks are at the tip of the spear in a lot of ways due to the interplay with interest rates, growth and the overall economy. So maybe Joe, what are your thoughts on all that?

Joe Fenech (01:13)

Thanks Kevin, yeah, you mentioned the start of COVID in terms of the market instability, I would go back even further than that, and for banks it really stretches back to 2008.  So our view is that the banking industry bears a lot of responsibility for what happened in 2008, but that at the same time, the bank sector has been essentially fixed since 2010.  Underwriting standards are much higher today, there is a lot more capital in the system, I think sometimes there’s a lack of appreciation for just how much better capitalized the system is today than it was heading into 2008.  Service quality has improved.  Balance sheets are stronger.  And today, I would argue that the margin environment is better than at any time in the post-2008 period. We’ll get into that a bit later. 

But the economic and market-related distortions that started with the 2008 financial crisis have really created an unstable foundation that has been very challenging for banks to navigate.  So let’s start with the response to the 2008 crisis, the response to that was to take interest rates down to essentially zero, and hold them there for basically 14 years.  At the same time you had an anemic economic recovery post 2008.  So loan growth was slower but the much worse pain was felt in net interest margin.  It’s very difficult for banks to make money when rates are basically zero, so margins just drifted structurally lower for the better part of 15 years. 

Then in 2020, you get the COVID shock.  And so in response to that, the Fed and the Treasury issued $10 trillion of stimulus, through fiscal legislation and monetary policy.  So $5 trillion of that goes directly into the banking system, so you get this massive liquidity injection, bank deposits increase by 35% in 18 months, after growing on average about 2% a year for the prior 70 years.  So this liquidity comes on in the form of zero cost deposits.  Banks have nothing to do with this liquidity, they don’t go out and make a bunch of bad loans, they buy in many cases the safest asset in the world, US Treasuries. 

And then just as quickly as the liquidity in injected into the system, it starts to flow out when the Fed begins the quickest pace of rate increases we’ve ever seen, and at the same time, the switch gets flipped from massive Quantitative Easing to Quantitative Tightening.  So just to give some perspective on this, the Fed’s balance sheet heading into the ’08 crisis was less than a trillion dollars, at its peak in 2022, it was just under $9 trillion, so a 9 fold increase, primarily through QE. And today it’s about $6.7 trillion, so it’s down by 25%. That doesn’t get a lot of airtime in the financial press because it’s a very complex topic, and we could spend probably an entire podcast on the ways that that impacts banks. But for purposes of the discussion today in summary these massive injections and withdrawals of liquidity into and from the banking system are unprecedented, and they’re extraordinarily difficult to navigate for banks. Think about it as sort of this unseen force that is either providing a huge tailwind to deposit growth and lowering the cost of that growth, or it’s a massive headwind and increasing the cost of funding, and it has nothing to do with what’s going on in your underlying business as a bank, right? It’s not a reflection of the deposit growth characteristics of your market or how good of a job or how poorly of a job the bank is doing.

Also remember, rates had been near zero for the decade+ prior to the pandemic, so the way the balance sheets were structured heading into the pandemic, you had a lot of long duration, fixed rate assets at very low yields on the asset side of the balance sheet, and on the liability side you had funding costs that were basically near zero, and that was wholesale and core funding, there was no differentiation between banks that had a true core funding base and those that didn’t. Now you get this massive liquidity injection with the stimulus, so funds flow in at very low cost. So you have a too much liquidity. Now fast forward to March 2022, and the Fed flips the switch, and all in the same month, the Fed announces that they would start shrinking their balance sheet, so QT, and they also start raising rates as quickly and at a greater magnitude than they ever had in the past.

So bank balance sheets that had been built during the long period of near zero rates needed time to adjust but they didn’t have time to adjust. And that ultimately led to the liquidity panic in March 2023.

Kevin Swanson (05:51)

And maybe to interject here, is it fair to say that the distinction between 08 and 23 is that 08 was no question about it, a failure of risk management by the industry. But in every instance since then, 23 included, it was sort of unstable market foundation and the banks were simply caught up in it.

Joe Fenech (06:09)

That’s exactly what I’m saying, you said it a lot more concisely than I did. I think it’s really important to draw that distinction. And I put the events here at the start of 2025 into that bucket as well, of destabilizing outside events that ensnare an otherwise healthy and what we believe should be a thriving bank sector. Layered on top of all of that is the regulatory backdrop.

So since 2012, every four years, we’ve had turnover at the presidential level and it’s not just turnover like in the 90’s, where you go from George Bush to Bill Clinton. It used to be that when administrations turned over, in the banking regulatory agencies you’d get a change in say the head of the FDIC or the OCC where you move from someone a little left of center to a little right of center. Since 2012, though, banking industry regulation is a reflection of our overall politics, where you get these wild pendulum swings. You go from an environment where there seemed to be a deep-seated hostility to M&A to one where it now seems like acquirers can stack a couple of deals on top of each other and get them closed without much regulatory hassle. So again back to the point about an unstable foundation, how do make a 5-10 year business plan where the rules change drastically every 4 years?

So I know it might sound like I’m making excuses for the sector. But those that have known me a long time know that I call it like I see it, heading into 2008 as an analyst I had more sell ratings on stocks than all the other analysts at my firm combined, and I’ve said it before, I think the banking industry bears the brunt of the responsibility for what happened in 2008. But I’ve also been equally as vocal in my opinion that the banking industry’s issues have been fixed for a long time. And it’s sort of this instability all around the industry and banks sensitivity to that instability that has been the impediment to these stocks trading where they deserve to trade if we were able to look at the sector in a vacuum.

Kevin Swanson (08:06)

Yeah, that's an interesting point on the vacuum. So reality, of course, is that the sector doesn't trade in a vacuum and that instability seems unlikely to abate anytime soon. So do you think banks are just destined to trade with an inherent discount because they're so tied to these issues?

Joe Fenech (08:22)

I think that’s the biggest risk to a bullish thesis on the sector right now. So the flavor of the day today of course is tariffs and then the larger question around government debt and the potential that has to lead to distortions in interest rates. But again, this is just one in a series of unprecedented events that we’ve sort of seen in rapid succession since 2008. So the question is can we finally get to a place where we find some footing, that was the hope I think immediately after the election, and you saw how the stocks reacted. So I think that’s the key question and the key risk at this point.

Kevin Swanson (09:00)

So maybe drilling down to the sector level, let's assume for a second that we get stability we're looking for. What's the outlook for the sector in that vacuum, assuming all else stable and constant?

Joe Fenech (09:11)

Yeah, I don’t think it’s an exaggeration to say that the set-up and outlook for the industry today is as attractive as it’s been in over 2 decades. Let’s start with margin. I said earlier that in my opinion this is the best margin environment for banks in over 20 years. Remember, with near-zero interest rates, which we had from ’08 to 2022, what we had was margins just grinding lower and lower. That impacted everything from profitability to investor sentiment. Generalist investors left the bank sector in 2008 and never came back. So the events of 2008 destroyed the sector’s reputation as a safe and sound value play. And then the decade and a half of declining margins just gave those generalist investors a reason to continue to stay away.

That long-term margin decline bottomed out in the second quarter of 2024. So if you think about what happened, remember earlier I talked about that adjustment period that was required for bank balance sheets to adjust to higher rates. That positive inflection point occurred in the second quarter last year, where funding costs peaked, but those low fixed rate assets continued to mature and reprice higher and they will continue to reprice higher for the next several years. The big misperception from the liquidity panic in 2023 was that banks had an issue because the industry can’t handle interest rates at these levels. The reality though is once you got past that adjustment period, this interest rate environment today is a much healthier rate environment for the sector than any rate environment we’ve seen in the post-2008 period. If you think about it, if you have a true core funding base today that costs you less than say 3%, and let’s say you wipe away the entire legacy asset base and just backfill with loans and investment securities at today’s rates, you’re in basically a 4% net margin environment, and when’s the last time we saw that? We haven’t seen that in 20+ years which in our view is why the valuations haven’t returned to the level of 20 years ago. So that incremental 4% margin environment is being masked by the glut of legacy assets with low yields. But again, that has inflected as of the second quarter of last year.

And I don’t think it’s a coincidence that even though banks have taken it on the chin more than most through this whole tariff situation this year, the bank stock index has still outperformed the S&P 500 since the end of the second quarter last year, and just prior to the macro uncertainty this year, bank stocks were significantly outperforming the broader market. So there are a lot of factors driving that but I think the main reason for that outperformance is really tied to that structural bottoming and turn in the longer-term margin outlook for the sector.

Kevin Swanson (12:00)

So on that note, and again, through the lens of banks, stocks and a vacuum, what do you see as some of the other drivers behind that favorable outlook in banks?

Joe Fenech (12:09)

Well, so around the same time margins bottomed and then turned, you also had in September last year, the yield curve disinverted and has steepened pretty considerably. And that’s following the longest period of yield curve inversion in over 40 years. In terms of asset quality, look, I think the macro instability has hurt banks more than it’s helped banks for sure these last several years, but one area where it’s undoubtedly helped is with respect to credit. All of the stimulus money and liquidity pumped into the economy in response to the pandemic definitely had a cushioning effect with respect to credit as rates turned higher, and that’s been extremely beneficial to banks. Everyone has been waiting for the shoe to drop on credit, but the inverted yield curve and higher rates haven’t really prompted the typical credit downturn that we’re used to seeing in prior cycles, and I don’t think there’s really any question that the stimulus has helped on that front. So a steep yield curve is great for banks, but what people sometimes forget is that that steepening process where the yield curve goes from inverted to steep is usually a very painful period for banks, b/c the Fed is lowering rates to help solve for some sort of economic upheaval or credit dislocation, and we haven’t seen that this time, so we’ll see the benefits of a steeper yield curve without the associated cost.

Kevin Swanson (13:33)

And jump in, I think another factor would be the regulatory environment. We're hearing anecdotally, even without permanent agency heads in place yet, a significant shift. Some acquirers are even openly talking about stacking two or three deals on top of each other. I don't think they'd be talking like that publicly if they hadn't already at least teased the idea with the regulators. You and I have talked about how regulation moves in cycles, just like the economy does, and bank regulatory cycles also overshoot just like the business cycle does.

You had a deregulatory cycle through a repeal of Glass-Steagall most notably, that probably went a bit too far and contributed in part to the excess that culminated in the 08 recession. And then we entered into a new regulatory cycle, which was really highlighted by the Dodd-Frank legislation and stress testing.

In many ways that was needed, but then that overshot the mark in the 2020s. And now it seems like we're entering in another significant change in the regulatory cycle back towards deregulation with that pendulum swinging the other way.

Joe Fenech (14:31)

Yeah, well put. And that new regulatory cycle I think is lining up well with more pent-up demand for M&A than we’ve seen in a long time. Because of all the volatility these last few years, there just really hasn’t been a lot of activity, but in our view it’s just a matter of time. You have a friendlier regulatory environment, you have a need and a desire for M&A, we’ve made this point many times before, the average age of a bank CEO today is 62, one quarter of all bank CEO’s in the country are aged 65 or over. So M&A to us is a question of when, not if.

I would point you also to capital. The industry is as robustly capitalized as it’s ever been, so from a safety and soundness perspective, that makes us feel good, but then I like how Jamie Dimon has characterized this excess capital as potential earnings in store, that’s a really good way to frame it, you’re going to see capital return pick up as new capital rules and stress testing are finalized, you’re going to see capital put to use for balance sheet growth as loan growth eventually returns, for M&A, and for other reinvestments in the business.

And then valuation really completes the bullish picture here, we thought the stocks were attractive heading into this most recent sell-off, and now they are screamingly cheap, when you combine the fundamental outlook we just described with the valuation set-up, we think it’s going to be a really exciting time.

Kevin Swanson (16:13)

So maybe to sum this up, you have on one hand this extremely promising bullish setup for the stocks, but on the other side of that, you have the sort of unquantifiable macro risk that is a continuation and in a worst-case scenario builds on these economic and market structural imbalances. And banks are in orderly tied to those risks in a way that other sectors are not. And so your downside risk is that we continue to model through with a lot of volatility and your upside potential is that we get some semblance of stability. And then maybe the bullish thesis takes hold and you've got tremendous upside?

Joe Fenech (16:43)

I think that’s right. And look, when we started the fund in late 2020, the only thing we knew was that the stocks were cheap, it was a very good entry point, and that 5 years down the line, we thought the stocks would be materially higher, but we knew it wouldn’t be a straight line back to quote unquote normal, b/c of the unprecedented nature of some of the events we’ve described. So here we are having just completed year 4 since we launched the fund and that thesis, both in terms of the performance and the timeline we anticipated to get back to normal, I think it’s fair to say that that is roughly on track.

Before we close, I wanted to introduce to our audience the newest member of our team. Jeff Wallenius joined us late last year as our new Director of Business Development, a role we created specifically for him. I'll ask Jeff to speak for himself here in just a second, but just a quick word. You know, he's going to be actually, he already is a valuable member of our team. I've known him personally for a long time. I have a lot of respect for, well, first his friendship and then his career and really looking forward to what he brings to the team. And we look forward in future podcasts, which we hope to have more frequently going forward to having him involved in the discussion. So Jeff feels weird to say welcome when you've already been here for quite a few months, but welcome aboard!

Jeff Wallenius (18:09)

Thanks, Joe. Appreciate that intro. I'll jump into a quick introduction on myself and how I became involved with GenOpp and then I'll hand it back to you guys here. I was born and raised in Oregon and began my career as a third generation professional firefighter in 2003. I'd always wanted to invest in real estate, seen my dad and grandfather do that. Fortunately in 2005, I had the opportunity and started buying single family homes to rehab and sell. 24 hour shift at the fire department and two days pulling nasty carpet from a fixer.

I really wanted to retain more assets. So after some drawn out due diligence, homework, mentorships, I created two SEC investment funds and began purchasing homes in about nine different states. In 2018, I was able to retire early from the fire department at the age of 39 and move out to the Indy area to oversee the portfolio. And subsequently that's where I met Joe, who was a neighbor where he just moved in.

So late 2018 into 2019, I began work on two large apartment developments. Those were about 580 units total and also one 650 unit self-storage development in Oregon. As those developments were nearing fruition, Joe and I began having additional conversations. With my background in real estate, syndication, capital raises. Joe and I both agreed that there was some synergy with our skill sets.

I started with GenOpp here in last November. It's definitely been an exciting five months. I can say that we continue to meet new institutions, which has been great and really look forward to future conversations with more and more of you as GenOpp continues into 2025 here. So with that, I'll hand it back to you guys.

Kevin Swanson (19:54)

Thanks, Jeff, and welcome aboard. On that note, we're gonna wrap up. Thanks to everyone for listening in. We'll have more to say on these topics and others impacting the banking industry in the coming months. Hope everybody has a great day.