Thesis

We are yet again witnessing momentous times – yesterday, March 10th, SVB Financial Group (SIVB) became the largest bank to fail since the 2008 financial crisis. Based in California, the lender was ranked as the 16th largest in the US at the end of 2022, with about $209 billion in assets. What is shocking is not the bank failure in itself, but the speed with which it developed:

Just two days prior to March 10, the bank was trading at $265/share! A monumental market capitalization wipe-out triggered by a number of factors, including its corporate uninsured depositor base, its decision to liquidate the AFS portfolio and advertise it, and a lack of banking management acumen in matching its assets and liabilities. When banks fail these days, they fail fast!

Do not think we are done here – the market tends to be perverse in the sense that participants always look to make money from the next weakest cohort member. It is akin to a pack of lions attacking a herd – the weakest ones are to be culled:

We saw massive moves in some banks’ common equity on Friday, moves that resulted in some names like Signature Bank (SBNY) triggering stops. The issue we are facing nowadays is that people pull the trigger first and ask questions later.

And this is due to the business that bankers are in – a business that requires depositors’ faith. I have been asking myself in the past few days how is this possible? How can you have zombie companies like Carvana (CVNA) that are just burning cash still around, and investment grade banks that manage to raise new capital go bankrupt two business days later? The answer lies in the asset / liability origins for a bank.

A bank is solvent as long as its depositors think it is. If all depositors were to withdraw funds tomorrow, ANY bank in the US would be insolvent. And that is a fact. Banks will always exist because they are a cornerstone of societies, but bank management makes a massive difference. How you position your balance sheet, your customers and your liquidity are keys to success and survival.

Do not think this is over by any means. The effects of this sudden bankruptcy are just getting started:

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Think about this for a second. Sellers on Etsy are suddenly not getting paid because of the SVB default! There are numerous stories of start-ups that will not be able to make payroll next because of the SVB issues.

What does this mean? It means that regional banks are going to be savagely attacked by the market and some of its depositors are going to move swiftly to large ‘fortress’ banks such as JPMorgan (JPM), Bank of America (BAC) and Citi (C). Moreover, preferred shares issues by regionals are going to switch from being a pure rates play to being credit risky securities. In SVB’s case we are assuming zero recovery on the preferred shares, given where the senior unsecured bonds are trading:

Flaherty&Crumrine Preferred Income Opportunity Fund (NYSE:PFO) is a CEF backed by preferred equity, mostly bank preferred equity. While the fund is overweight large bank preferred stock, it does contain regionals such as New York Community Bancorp, Fifth Third Bancorp and Regions Financial Corporation. We already had a massive move yesterday with PFO down more than -4%, but if the ‘party’ is to continue in regionals we feel there is more pain to be had.

In our minds we are not done yet with bank failures – this weekend is probably going to see a frantic action in liquidity raising by some of the banks which are under the gun. We are pretty sure of that. Nothing of this magnitude goes without reverberations or other dominoes falling. Until things clean themselves out, a retail investor is best served to reduce exposure to the space. While in the long run (ie 2 years and more) PFO should be fine, short term you have to ask yourself if you are ok with another -10% to -15% drop from here.

PFO Holdings

PFO is composed of preferred equities:

The CEF is overweight bank preferred securities, while insurance companies are second. From an individual name perspective banks are the largest components:

The fund is very granular, so we do not expect any one default to have an outsized impact here. Spreads can widen though (and are widening as we speak). Widening spreads can have an outsized impact on preferred equity prices:

This is how the First Republic (FRC) preferred Series I performed on Friday. The market is quickly pricing in the fact that in a bank run, preferred equity is basically the same as common equity. That is the unfortunate result of a bank run – all prior rules go out the window:

Above we can see the debentures from SVB. They went from par to 50 cents/$ in a matter of 2 business days. An investment grade bank with investment grade bonds. Bank runs are binary events. The results? Complete wipe-out of common and preferred equity and partial or complete wipe-outs of debentures.

Premium/Discount to NAV

The fund is already trading at a deep discount to NAV given its historic range:

From a discount perspective the CEF is at the bottom of the range, so statistically there might not be more here. However, history has taught us that when everybody dumps an asset class, discounts can get bigger. Do not underestimate this fund going at 2020 Covid discounts if the run on banks continues.

Conclusion

PFO is a closed end fund composed of preferred equity. The CEF is overweight banks and insurance companies, with the largest exposures being made up by banks. Although it has a granular build and can withstand a few defaults, the fund is susceptible to spread widening in the space, as we have seen via its -4% gap-down on Friday. We believe the market is not done yet in ravaging regional banks, and before the move is over we are going to have one or two more ‘restructurings’. Expect continued pressure on the space and weakness in the names. If you are not comfortable with a -10% drawdown here it is time to reduce some risk. Long term PFO is a robust name, but as a leveraged take on financial services preferred equity it is set to gap down even further as the storm continues.