What Did Q2 Earnings Reports Tell Us About the Regional Banks: Slingshot Financial Podcast

Good morning everyone. Thanks for joining us on this summer Friday morning. My name’s Garrett Brooks with Slingshot Financial. Slingshot is a Colorado registered investment advisor and we serve as an institutional representative for specialized investment managers, including Gator Capital Management. Excited this morning to have Derek Pilecki. Derek is the managing member at Gator Capital Management, the firm that he founded back in 2008. He’s the portfolio manager for Gator Long/Short, which is the flagship portfolio there offered in a few different formats, including the original hedge fund, a mutual fund, as well as individual accounts. Derek, joining us here fresh out of earning season, so I’m sure it’s been a really busy time for you, but thanks for taking the time, Derek, and glad to have you with us.

Hey, good to be with you, Garrett.

Yeah, absolutely. So as we have done, this is our quarterly update, finding long and short opportunities in the financial sector. Derek is a financial specialist, has been for over 20 years. Like I said, founded Gator back in 2008. Before that was with Goldman Sachs Asset Management and a few other buy-side firms before that, but always focused on the financial sector. So we are certainly glad to hear what he has to say. Financials did a little bit better than expected coming out of earnings and would love to hear your key takeaways from this year or this quarter’s earnings season, Derek.

Hey Garrett. So I would say the story about this season was a relief rally in the banking sector. So regional banks, of course, had the bank crisis in March kicked off by Silicon Valley’s failure, and the regional bank index was down about 30% through mid-May. As we got through the end of the second quarter and the bank started reporting second quarter earnings in mid-July, the bank stocks really rallied. I wouldn’t say that the earnings reports were off the charts. I mean, they were pretty ugly earnings reports. I mean, deposits were down, net interest margins were crimped, but things just were not as bad as what investors were expecting. So there was some stability. I would say for the most part, deposit costs went higher, but maybe not as high as some of the most bearish expectations. Really, the regional banking sector was too cheap coming into earning season and investors did back up. So there was a nice rally in the regional banking sector during the earning season.

Yeah, we saw that coming out. The regional banking ETFs has actually been really on a run here coming out of earnings. To that end, what would you say overall is the health of the banks? It seems like a distant memory now, the banking crisis. Do you think this is something that’s largely in the rearview for us or something that could reemerge down the road, which was the fear I think at the time?

So I don’t think there’ll be additional failures. I think there was one transaction where Bank of California agreed to acquire a merge with PacWest, and I think that was done without any government assistance. So I think that really signals the end of the crisis. I mean, people were worried about PacWest. They had lost a bunch of deposits during the crisis. I think that’s really a signal that, okay, now we’re moving forward, if banks get into trouble, there’ll be deals done without government interference. I guess, another takeaway from this earning season was credit quality seems to be holding up just fine. The expectations were a recession coming, credit’s going to get worse, just a matter of time, higher rates. I think some of those things could still play out, like higher rates are definitely going to slow the economy. But I think it’s pushed out a few quarters and so investors are like, well, there wasn’t a necessarily a huge uptick in non-performing assets this quarter that people are expecting that those turn into charge offs in Q3 or and Q4.

So I think just pushing out the risk of credit losses a few quarters is another bullish sign for regional banks. Then I would say that there’s still a wide variety of interest rate positioning amongst the banks. So there’s a lot of banks with floating rate loans and pretty low cost transaction balance deposits. Then there’s other banks that have a lot of fixed rate loans and are funded with very hot money or high cost deposits. Those are the two ends of the spectrum on interest rate positioning. Not all banks are positioned the same. So to the extent that we have the long end of the yield curve go up and rates stay higher for longer, I think there could still be some banks that stumble through the next couple of years.

Yeah, that’s a great point. I’m curious, I know when we spoke back in May, I was really surprised to hear you say that you’re still finding some banks out there that haven’t done much in the way of interest rate hedging. I would’ve assumed at that point that everybody would’ve gotten their ducks in a row and gotten that taken care of. Is that something that you’re still seeing, you still have some banks out there that aren’t necessarily hedged out properly?

That’s definitely the case. It seems like they’re just taking the view of these low coupon residential mortgages that they own can’t extend further in duration, which may or may not be the case, but it seems like short-term rates are going to… The Fed’s not going to cut rates this fall, at least that’s what Chairman Powell said last week. So their costs of funds as they roll over are going to squeeze them. So yeah, there’s definitely banks that are exposed here with a lot of low coupon mortgages on their books.

Which is again, a good… It bodes well for you with the flexibility to both be both long and short, when you see those situations pop up, you’re able to seize those as well. One of the other things I think that we were talking about back in May, and then I’ve heard you talk about a few times since that leading up to this past few weeks, we’re looking for not only what the actual performance of particularly the bank’s would be, but also the market’s response to that. So thinking if we get some bad news and the market continues to push through, have we seen the lows? I’m wondering now, with having seen some of this play out and the market’s response, what are you thinking looking forward?

Yeah, in the absence of new information or new crisis points, I think that the mid-May lows in the regional bank index are the lows for the cycle. I think that unless there’s a big turn in credit quality or the economy drastically slows from some exogenous event that we’ve seen the lows.

Yeah, that’s good to hear. The other thing that I was curious about because you had mentioned it a few times leading up to this as well, was keeping a close look on loan volumes within the banks and keeping an eye for do we see a tightening credit that could possibly exacerbate any type of economic downturn that we see? I’m curious, most recently, what are the banks seeing in terms of credit and loan volumes?

Yeah, you’re right. So I was worried after the regional bank crisis started that we’d see a credit crunch where the banks would just be so worried about their own liquidity that they’d stop making loans and that would slow the economy. I guess, we’ve gotten some new data points on that front that evolved my thinking a little bit. First, it seems like that has happened to some extent, that loan growth has slowed considerably from last year. But it’s not clear that it’s all supply side, meaning it’s not all the banks restricting making new loans. Some of it is demand side. So to the extent that rates are… The prime rate is 8.5%, borrowers just don’t want to borrow money 8.5%. So you’re not seeing as much loan demand. So loan growth slowed, but it’s not all the banks restricting supply, it’s some loan demand constraints.

Then we have seen, not every bank has been deposit constrained. There have been bankers who have been well positioned for this cycle and they’re able to continue lending money. So it’s not like the whole industry’s just cut off the spigot, not making loans. There are banks that are making loans. They’re asking for better terms on the loans, which is natural in a cycle. They want wider spreads and better terms. They might ask for the personal guarantee more insistently this time around, but there are banks still making loans. Then we’ve also have the private credit funds out there that are chomping at the bid to dis-intermediate the banks. So they want to make loans, good loans, that the banks are constrained from making. So it doesn’t look like we’re going to have the worst case scenario where credit crunch causes economic recession.

We are having a slowdown, a natural slowdown, because of loan demands down and the banks are fixing their balance sheets. But it seems like the banks are pretty much through most of the right sizing on liquidity and deposits. So they’re still making loans to the extent that borrowers want them. They’re asking for higher spreads and better terms. Then you also, if the banks are held in check by these private credit funds, being willing to provide credit at the right price. So I don’t see the scenario where we get a bank credit induced recession, which is good news for all of us.

When you think through the recessions that we’ve had in the last 35 years, 1991 and 2008 were really bank credit recessions that were pretty deep recessions, whereas the recession from 01, 02 is more like capital markets, internet bubble, isolated recession. It wasn’t a economy wide where Main Street wasn’t getting funding. The Main Street economy got funded through 01, 02, whereas 90, 91 or 08, 09 Main Street had trouble getting funding. So it doesn’t look like we’re going to have one of those deep recession scenarios.

The Fed, have they nailed the soft landing, so to speak?

Yeah, we’ll see. There’s a lag effect to higher rates, and so we haven’t gotten the full lag effect, but it seems like the economy’s pretty strong still in spite of it, in spite of all the rate increases. We’ll see what the next six to 12 months bring. There’s isolated pockets that are really, really struggling. I mean, the office sector is tough. There’s not going to be new offices built, construction of new offices. Those construction crews are going to have to go to other property types. There’s going to be a lot of office buildings that are going to be owned by the bond holders or the mortgage holders instead of equity holders. So that will go through a cycle. But other than that, there’s not really an obvious thing that’s going to contract in the economy right now. Maybe the venture capital field, there’s not as much venture capital funding, but really that’s not a huge, huge part of the economy.

Yeah, that’s great news. I asked the question almost a little tongue in cheek because I think sometimes when things start to take on the grand narrative of the soft landing that it’s almost we lose sight of the real data points coming in and more focus on the story. So everything you’re saying certainly is encouraging, and this is real actual data that we can point to and give an indicator of what the economy is doing. It seems like things are working out, so let’s hope that we stay on that path. One other quick question for you, because it was so timely, what are your thoughts on the Fitch downgrading US credit rating?

Yeah, I mean, I am in the Jamie Dimon camp of the US is the strongest superpower in the world. We’re not going to default. I would say we’re running pretty big deficits. The demographics have gotten marginally worse with the lack of immigration over the last few years. So we have a lot of baby boomers retiring and Medicare costs are going to go up and social security costs. So I would say the finances that are driving that downgrade are worse at the margin, but I still think that we’re AAA, or the country’s a AAA credit. I do think that it doesn’t take into account the ability to print money and inflate our way out of our debts. So I think it’s a lot of noise and you shouldn’t change your investment perspective because of that.

Yeah, I’m glad you mentioned Jamie Dimon. I absolutely love it. I love that he says it doesn’t matter while he’s on his bus tour through the US, it was very like USA, USA.

I mean, he’s right about that. I mean, he’s a big fan and he’s right on a lot of those points. A lot of times we just get so focused on the pessimism and what’s going to happen bad from here. He’s pretty good about making us feel good about all the good stuff that’s going on. The economy’s pretty strong. We all are living, most everyone’s living better lives than they were 30 years ago. So he’s right about to be optimistic on a lot of those things. He’s in a good position to see it too. I mean, he runs the best bank in the country, the biggest bank in the country, so he sees a lot of the good stuff that’s going on.

Yeah, absolutely. So shifting gears a little bit here from the sector itself, I have to point out your performance has been stellar year to date. I mean, looking at, easiest I guess to point to is mutual fund performance. I mean, you are hanging right in there with the broad market. Impressive, considering we have big tech, a few big tech names driving that rally and the financials been somewhat of a laggard. To that end, you’re absolutely clobbering the long only financials index year to date and then looking on longer time periods as well. So I’m curious, with that in mind, where are you seeing opportunities now? How are you positioning yourself going forward?

Yeah, so I think within financials, it’s going back to our discussion earlier about interest rate positioning. So I think to the extent that I’m finding banks that are still benefiting from higher rates and then I’m shorting against them, the banks that have a lot of fixed rate loans on their books and weaker deposit franchises. So to pull out two examples, there’s a bank in suburban Chicago called Old Second Bancorp, and it’s in the far west Chicago suburbs. A couple of years ago they bought a bank called West Suburban, which is sitting between downtown and Old Second’s branch network. West Suburban was a franchise that had a lot of property locations that this previous CEO had bought in the fifties and sixties. These are just in good neighborhoods, middle-class neighborhoods. People used the branches for transactional banking. They weren’t rich people. They were just like middle-class people who had checking accounts and had a few thousand dollars in their checking accounts and aren’t rate sensitive. So it was a great acquisition by Old Second.

So they’ve also kept most of their balance sheet and floating rate loans. So during this rate cycle, they haven’t had to pay out for deposits. They’ve raised their rates a little bit, but really they’ve benefited from the repricing the loan book. So their net interest margins expanded and their ROE is above 20% now. So I think price to book value, it’s rallied recently, but it’s still under two times book. I think that’s a pretty interesting position from the long side. You contrast it to a bank like Hingham Institution for Savings, which is on the south shore in Boston. This is a traditional thrift. They make a lot of apartment loans. They have a very fixed rate loan book, heavy balance sheet, and it’s funded with a lot of high cost deposits.

There’s a lot of CD funding. Their loan to deposit ratio is well above 100%. Usually a commercial bank will run with an 85% or 90% loan to deposit ratio, but Hingham has a huge, huge loan to deposit ratio. So that means they have to fund a good portion of their balance sheet with wholesale borrowings. So their interest rate spread has just collapsed during this rate cycle. So it’s getting to the point where I don’t think the Fed’s going to keep raising rates. They might raise one more time. Maybe they’re done. But if they were to raise rates again or two more times, Hingham’s close to earning negative spread on their balance sheet. This stock still trades well above book value, so it trades for 1.25 times book value. So I just think given that they’re going to earn sub par ROE for the foreseeable future, this should trade below book value.

So those are the opportunities there. I think the opportunities persist in banks because a lot of people are expressing the view of banks through the ETFs. There’s a lot of banks out there and collectively there’s a lot of banks and a lot of market cap, but each individual bank’s relatively small, so it’s hard to get positions. The big investors use the KRE to express their view on banks, but the KRE buys or sells the entire system across all banks, where they’re not selecting individual banks of, I want to buy these ten banks that are asset sensitive and I want to short these banks that are liability sensitive. You just buy them all or short them all.

So, I think there’s nice opportunity for people like me who do the work on the individual banks and say, “Okay, this bank’s well positioned for this rate scenario and this bank’s not.” So that’s where I’m seeing the opportunities going forward. I think they’re still upside to the banking sector. I think valuations are still cheap, but I also like the opportunities within differentiating between the banks within the sector and that’s one of the benefits of having the flexibility of the long short fund.

Yeah, absolutely, that’s a great point. To that end, a lot of the people that we work with are even broader, more asset allocation oriented. So you take the very selective nature, your ability to be both long and short, and then you combine that with a much broader diversified portfolio and you have a really, really interesting and nice differentiated return stream in the portfolio. I know that current clients have really enjoyed that. Going back to my point earlier in terms of when you look at the broad market, just a few concentrated names pushing that, when you’re able to maintain the same type of returns but they’re much less correlation, it’s a really nice fit for an overall diversified portfolio.

Yes, definitely.

That is great news. How about outside of banks, what are you generally seeing or what are your thoughts?

Yeah, so I think that investors are recalibrating to a deferred recession. So we are really thinking about with inflation coming down and the Fed potentially being at the end of its rate height cycle, but maintaining rates at this level for a while, what does that mean for companies and the market? Generally it’s been pretty bullish for some of the higher beta names. So to the extent that people are deferring the pricing and the recession, that’s helped the sector. So I think some of the interesting names in the sector. There’s some asset managers that are trading for low valuations. There’s ongoing fair thesis in asset managers that we have the shift from active management to passive management. So the ETFs are taking share. So the active managers have had negative flows and the stock prices have gotten very inexpensive. So there’s some active managers that have neutral positive flows that are trading for five or six times EBITDA. So I think that’s an interesting play there.

Then there’s some, especially finance, especially insurance companies that are interesting. So the mortgage insurers have been doing well. We own Genworth, which owns a mortgage insurer called Enact. So that’s been a good area. I mean mortgage insurance is doing great because the housing market’s staying strong here, even in spite of higher interest rates. People just aren’t for sellers of their homes. They’re able to make the payments. They have 3% mortgages. Volumes are way down. If somebody does have to default on a home mortgage, insurers aren’t taking losses now because all the business they wrote in 2020 and 2021, there’s embedded gains there. So mortgage insurance is another good area. So between asset managers and especially insurance, those are the other areas that we like in the portfolio.

That’s great spots to be, makes a lot of sense. One other question that I had for you, I was actually talking with a investment officer at a wealth management firm, and within the context of Gator and a few other types of specialty funds, he was curious. He views the world very much within the smart beta, the factor type of analysis and uses that in constructing portfolios. Now I have heard you, in the past, talk a little bit about your views on how you incorporate and think about factors in managing your fund. But I thought it would be helpful for people on the call here today and anyone who joins later on to hear what your thoughts are on factors and constructing the portfolio around factors.

So I mean, I guess, I look at factors to make sure that we’re not taking the same bet on both sides of the portfolio. This goes back to a learning from 2014. I had the view that banks were cheap and REITs were expensive, and so I was long a lot of banks and short a lot of REITs. Then the embedded factor risk there was if rates went up both sides of the portfolio worked or if rates didn’t go up… It was an interest rate bet on both sides of the portfolio. So banks benefit from higher rates, REITs get hurt by higher rates. So in 2014 rates didn’t go up and so the banks muddled along and the REITs did great. So I had the same bet on both sides of the portfolio. So pay attention to the different factor models. We use Bloomberg. We load the portfolio into Bloomberg, look at what the factors our portfolio is expressing and make sure that we’re not out of bounds on having the same factor bet on both sides of the portfolio.

My factor friends will be excited to hear that. Well I think that those are all the questions that I had immediately. I’m going to go ahead and open up here for Q&A. So anybody on the call that would like to ask a question, go ahead and pop that into the chat. I will answer them as they come in. Well Derek will answer them. I will address them and Derek will answer them as they come in. Give it just a second.

Feel free to answer them, Garrett, that’s fine.

Looks like just one in the queue here and this is a slam dunk for you. What is the net long positioning of the portfolio? So I guess what is long versus short positioning?

Yeah, so right now the portfolio is 90% gross long and it’s 40% gross shorts, the nets plus 50. That’s a pretty comfortable spot for us. Usually the nets somewhere between 30 and 75 or 80, and so 50 is middle of the fairway. Part of that reflects, we’ve had a nice run up in July, so a couple of our positions hit their price targets and we reduced. So we don’t necessarily take the net and say, okay, we have to be at one point or another. It really flows from names we’re finding and we’re still finding a lot more longs than we are shorts and so we’re comfortable at plus 50.

Yeah, we always get that question, so thanks for asking. It looks like that’s it. It’s a quiet bunch. I wonder if people are taking the call from the beach, lakeside, whatever it might be here today, hopefully. Hopefully everybody’s enjoying their summer. I know you’re now sharing your time between Tampa and New York City, which is of interest, I know to some of the people I’m sure who are on the call here.

Yeah, so I mean I rent an apartment in New York in March. A couple drivers to that. A little bit more corporate access, so it seems like every financials conferences in New York and there’s a lot more companies coming through New York on a regular basis. So just meeting with more management teams while I’m up there. Then there’s getting access to more investors and so we’re meeting with more prospective investors by spending more time in New York. So those are the two benefits. Our families, were rapidly approaching empty nest stage, so my wife and I have spent 20 years in Florida and we’re just looking for the next adventure. So we’re starting to spend a little bit of time in New York and getting some business benefits out of it.

That’s awesome. That’s awesome. I know you’re also off on a huge golf trip coming up here.

Yeah, next week I’m going to Scotland for a few days with some buddies. So I’ve never been over there and I’m a big golfer and just love the game. So we’re going to eastern part of Scotland around St. Andrew’s, Muirfield and playing. I told the tour operator, I don’t want to play any modern courses over there. I want to play all the old Scottish courses. So looking forward to that and getting a few rounds in.

Yeah, enjoy. I am not really much of a golfer myself, but I know certainly a lot of people in the business are. I don’t want to speak for you, but is it fair to say you’re up for a round? Anybody in the New York area or certainly Tampa area, you want to get out on the course?

I’m always happy to play. This fall or winter, if somebody’s down in Florida and want to play, please send me an email or give me a call or get in touch with me through Garrett and we will get out in the links.

That sounds great. Well, we’re right up on time here. Appreciate it, Derek. Any final words from you?

Yeah, I think super interesting year as far as what’s been happening with the banks. So we’re in recovery mode here. Worst case scenario is not happening in regional banks. I think markets had a pretty good run, financials have lagged. I think there’s some catch up left within the financial sector, still some catch up left in the banks. I think the economy’s looking pretty good here, so I think I’m pretty constructive. We don’t have to chase the high valuation stocks within the financial sector. There’s a lot of cheap stocks, still reasonable valuations, and I think there’s pretty good fairway in front of us.

That’s great to hear. Like you said when we spoke earlier this year, with the bank and crisis, all eyes right there in your sector. I mean, if the economy, if the market, keeps tossing you those fat pitches, I know you’re just going to keep smacking them right out of the park. So keep it up.

Sounds good. Thanks a lot, Garrett.

Great, thanks Derek. Thank you everybody. Obviously any follow-up questions or requests for information, you can go ahead and pop that into the chat now. As always, feel free to reach out directly to me and we’ll make sure to get all of your questions and requests addressed. But with that, I hope everybody has a great afternoon, a great weekend, and enjoys the rest of this summer. Thank you.