by Christopher Whalen, Kroll Bond Rating Agency
Almost half a century ago, President John F. Kennedy borrowed the phrase “a rising tide lifts all the boats,” using it as a metaphor for how an expanding economy provides benefits to all. More recently, investors have convinced themselves that rising interest rates will generally and immediately be beneficial for all banks—this after almost eight years of artificially low interest rates.
In this research note, Kroll Bond Rating Agency (KBRA) juxtaposes the apparent benefit to bank earnings from higher rates against the less recognized risk of repricing of assets and imbedded duration optionality in bank balance sheets. Since even before the November election, equity market valuations for many financials have risen even as yields on debt obligations from these same issuers have risen sharply.
As we pointed out in our last note, The Return of the Bond Vigilantes, the recent sharp moves in the U.S. Treasury market imply significant losses for banks and other investors with unhedged exposures. While it is true that higher market rates will over time help banks to expand income from earning assets, net interest margins and earnings, this process will take months to see a significant increase in the asset returns and earnings.
KBRA believes that it is important for investors to temper rosy expectations regarding bank results in the near terms with a couple of facts. Chart 1 shows the components of net income for all FDIC insured banks through Q2 2016.
The chart above illustrates the huge degree of subsidies flowing through the U.S. banking system thanks to the low interest rate regime maintained by the Federal Open Market Committee (FOMC). Total interest expense for the entire industry was just $11.5 billion in Q3 2015 vs almost $100 billion at the start of 2008. Net interest income has been rising since that time to $113 billion in Q2 2016, following the increase in Treasury yields since June.
Rising interest rates do imply rising income for banks and non-banks, but not immediately. What investors need to consider, KBRA believes, is the large amount of duration risk being taken by U.S. banks in return for relatively paltry returns available on earning assets and particularly agency securities. Indeed, since the 1990s, as the FOMC has gradually pushed down the nominal yields on financial assets, the returns on earning assets for U.S. banks have also fallen even as the volatility of fixed income securities has increased along with the duration.
Duration is a measure of how long, in years, it takes for the price of a bond to be repaid by its internal cash flows. Bonds with higher durations (and lower or no coupons) obviously carry more risk and have higher price volatility than bonds with lower durations and higher coupons. U.S. banks are currently loaded with massive duration risk on government and agency securities in return for relatively small net-interest margins. Chart 2 below shows the return on earning assets for the U.S. banking industry since 1985.
Notice that the benefit from the low rate policy by the FOMC since 2008 is slowly dwindling as bank assets reprice to lower coupons, an illustration of the deleterious effect of low interest rates.
With average coupons for U.S. Treasury debt and agency securities at record lows, U.S. banks and non-bank financial institutions face record levels of market and duration risk on their fixed income exposures. In particular, as prepayments on mortgage-backed securities slow, the option-adjusted duration (OAD) of these securities can rise dramatically, increasing price volatility and rendering efforts to hedge these exposures ineffective. The relatively large move in yields on Treasury and agency securities observed since the end of October, for example, illustrates an environment where conventional hedging models may be unsuccessful and financial results for financials may be put at risk.
KBRA believes that, over the medium term, higher interest rates may indeed be good for the earnings of banks and non-bank financial institutions alike. In the near term, however, the impact of relative short-term movements in market interest rates is likely to have little positive effect and, indeed, may carry far more downside risk for financials and investors that hold mortgage-backed securities, callable securities and other interest rate exposures that are sensitive to changes in expected maturity.
In particular, OAD, which measures the convexity of a mortgage security, can cause the effective maturity of a mortgage bond to change rapidly and in ways that may exceed the short-term volatility expectations of investors.
With respect to RMBS, the measurement of duration is adjusted for the first prepayment option, usually a put to the investor when a home owner exercises the right to refinance or prepay. As interest rates rise and the likelihood of prepayment falls, the OAD of callable fixed income securities surges and with it the volatility of the security as well as the likelihood of default.
KBRA believes that some financial institutions may see lower income or even losses in Q4 2016 due to the volatility in the bond market starting at the end of October. In Chart 3 below, we show the 10-year Treasury bond yield minus the two-year Treasury note yield, which shows both the increase in yields over the past several weeks and also the expansion of spreads. While there is no credit risk for financials holding such exposures, there is considerable market and duration risk as market expectations regarding the maturity of RMBS as well as callable corporate securities change.
The examples of Long Term Capital Management and the companion class collateralized mortgage obligations (CMO) of the 1990s may have faded from the collective memory, but the potential for losses to financial institutions resulting from the unanticipated extension of durations on mortgage and other securities remains a significant threat to investors who fail to appreciate these risks.
When the FOMC raised interest rates in 1993 and 1994, the holders of companion class CMOs saw the effective duration of these securities extend from one year to more than 20 years in a matter of months. “For investors in traditional short-term government and agency debt, the impact was impossible to manage or understand. The hit to value made no mathematical sense except to those few people who understood the implications of a change in interest rates to the effective duration of companion class securities.”
KBRA believes that investors and financial institutions need to exercise increased caution in the weeks and months ahead with respect to market risk and, in particular, the potential for sudden changes in market expectations regarding prepayments of mortgage securities and thus effective duration.
In the longer term, rising interest rates will gradually result in an expansion of net interest margins for financial institutions, but this process will take months and years rather than weeks. KBRA believes that investors should adjust their strategies and expectations as to the benefit from higher interest rates to earnings for banks and other financials accordingly.
This is a Hedgeye Guest Contributor research note written by Christopher Whalen of Kroll Bond Rating Agency. Whalen is a Senior Managing Director in the Financial Institutions Ratings Group. Over the past three decades, he has worked for financial firms including Bear, Stearns & Co., Prudential Securities, Tangent Capital Partners and Carrington. This piece does not necessarily reflect the opinion of Hedgeye.