By Andrew Prochnow
The VIX has not risen above 40 since April 2020, almost four years ago. Before that, it hadn't gone above 40 since September 2011, and even then it was barely above that threshold. The last significant rise in the VIX, similar to The onset of the COVID-19 pandemic occurred during the 2008-2009 financial crisis.
This trend indicates that the VIX tends to cross the 40 mark only during times of extreme market distress. Under normal trading conditions, a VIX of 40 serves as a sort of ceiling for the index, as observed since April 2020.
Given recent history, what could potentially push the VIX above 40 in the near future? Contrary to expectations, it is unlikely to be a military conflict. Despite two major military conflicts occurring since the COVID pandemic, neither has allowed the VIX index to rise above 40.
It is likely that another financial crisis will be the catalyst that pushes the VIX above 40, similar to what happened during the 2008-2009 period. Sixteen years ago, the banking crisis, fueled by the real estate market, turned into a real financial collapse.
During this period, financial institutions overextended themselves into the real estate sector. Therefore, as property prices fell, so did the value of these investments. The severity of the housing crisis led to the collapse of the balance sheets of many financial institutions, forcing them into bankruptcy.
Currently, there does not appear to be the same degree of risk in the financial system as there was in 2008. Federal regulators regularly conduct “stress tests” to ensure that the nation's largest financial institutions are healthy. Additionally, rules have been put in place to ensure that banks do not take on too much risk.
Additionally, the US banking sector appears to have adopted a defensive posture following last year's regional banking shake-up. Currently, many of the country's banks have historically high liquidity levels. U.S. commercial banks have moved away, according to recent data collected by banking regulators 15% of their total assets in the form of cash. In 2019, this figure was closer to 10%.
The decision to hoard cash was likely driven by the turmoil seen in the financial system in early 2023, when several regional banks failed. This is partly due to rapidly rising interest rates, which have devalued the long-term bond holdings of many financial institutions.
Amid the turmoil, regulators stepped in to guarantee the deposits of struggling institutions. And this decisive action undoubtedly helped avoid a broader run on the country's banks, which would have triggered further destabilization of the financial system. After the sharp rise in stock markets that closed 2023, the banking crisis has been largely forgotten.
Everything changed on January 31, 2024, when the investment world was sternly reminded that significant risks remain in the system. That day, Community Bank of New York (NYCB) released its quarterly results, and the results weren't pretty. Unexpectedly, the bank reported a quarterly loss of $0.36/share, while pre-earnings expectations were for a profit of $0.27/share.
As many readers probably recall, New York Community Bancorp acquired the remains of Signature Bank when the latter filed for bankruptcy last year. And following the recent earnings report, one of the big concerns for New York Community Bancorp – as well as the industry as a whole – is an increase in loan losses, particularly those related to the lending sector. distressed commercial real estate. Net charge-offs, which are essentially loans that a bank deems uncollectible, increased from just $1 million in the fourth quarter of 2022 to $185 million in the fourth quarter of 2023 at New York Community Bancorp.
Due to these surprisingly poor results, the bank was forced to cut its quarterly dividend from $0.17/share to $0.05/share. NYCB shares have fallen about 48% so far this year. And the SPDR S&P Regional Bank ETF (KRE) also fell in sympathy with NYCB, down about 10% during the same period. But for now, this fear has not crept into the implied volatility of KRE options, as highlighted below.
Wider impact on the regional banking sector
From a glass-half-full perspective, some of New York Community Bancorp's fourth-quarter losses were attributable to increased regulatory spending. After acquiring Signature Bank, New York Community Bancorp now has more than $100 billion in assets, meaning the bank faces stricter compliance standards.
The big concern, however, is that loan losses associated with the commercial real estate sector will continue to increase. Not just for New York Community Bancorp, but for the entire regional banking industry. Research indicates that small and medium-sized regional banks hold approximately 70% of loans related to the commercial real estate sector.
So, if loan losses continue to grow, some of the country's regional banks will undoubtedly experience further erosion of their profits, as well as their overall financial position. In this scenario, more regional banks are virtually guaranteed to fail.
New York Community Bancorp isn't the only financial institution to report worse-than-expected fourth-quarter profits. Earlier in January, regional banks such as Citizens Financial Group (CFG), Comerica (CMA), KeyCorp (KEY), PNC Financial (PNC) and Zions Banking Company (ZION) all reported disappointing earnings compared to the same quarter last year. And just like New York Community Bancorp, Truist Financial (TFC) actually posted a quarterly loss.
Aozora bank loses
Aozora Bank, headquartered in Japan, also recently announced that it expects to record unexpected losses on loans related to the U.S. commercial real estate sector. Since the start of the year, shares of Tokyo-listed Aozora Bank have fallen more than 30%.
Commenting on the current situation, Chief Investment Officer of Guggenheim Partners Investment Management-Anne Walsh-said in mid-January that “the difficulties of commercial real estate in the office sector are only just beginning”. Given the regional banking sector's surprisingly poor quarterly results, these sentiments now seem even more worrying.
One advantage for regional banks is that the U.S. economy has held up better than expected, despite record-low interest rates. On February 2, the U.S. Department of Labor announced that 353,000 new jobs were created during the month of January, which was well above expectations. This level of hiring suggests that the economy remains robust and the risk of an impending recession remains low.
This means regional banks could continue to face headwinds from the commercial real estate sector, but are not facing the same level of pressure in other areas of their operations. As long as the economy continues to grow, robust revenues in the commercial and personal banking sectors could help offset credit losses in the commercial real estate sector.
On the other hand, this situation also illustrates how regional banks are currently on a difficult path. If another leg of the stool falters – corporate or consumer banks, for example – then regional banks could come under intense pressure. And if a crisis develops in regional banks, there is no guarantee that it will not spill over into other parts of the financial system.
Banking crises and black swans
Unfortunately, banking crises and black swans are birds of the same feather. Black swans, by definition, are sudden and unexpected events that catalyze severe and irregular corrections in the investment asset universe. Although black swans can appear unexpectedly, this is not always the case. Some experts correctly predicted the start of the 2008-2009 financial crisis, which was undoubtedly a black swan.
During the period 2008-2009, complications in the banking sector eventually escalated into a full-blown financial crisis, triggering corrections in many segments of the financial markets. The result was much the same in 1929, when an overextended banking system finally pushed the American economy into a deep depression.
Certainly, that doesn't seem likely today, with major market indexes trading at new all-time highs and the VIX trading around 10%. But by 2007, the VIX was also trading around 15% and the S&P 500 was hitting a new all-time high. The Great Recession arrived soon after.
Overall, this is an important reminder that significant risks remain in the system. And as Warren Buffett said, “be afraid when others are greedy and be greedy only when others are afraid.”