The guest commentary below was written by Christopher Whalen. It was originally posted on The Institutional Risk Analyst.
This week The Institutional Risk Analyst is participating in the Information Exchange sponsored by Black Knight, Inc. (BKI), the premier provider of integrated technology, data and analytics for mortgage lenders. We'll be joining Laurie Goodman of Urban Institute, Chris Flanagan of Bank of America, Sam Khater of Freddie Mac and Ed Pinto of American Enterprise Institute for a Super Session on the housing economy.
With long-term interest rates falling, the mood in the mortgage industry is much improved and lending volumes are rising. Will profitability return in the yield spread famine created by the central bankers? Maybe. Sadly short-term interest rates remain elevated, held up by the errant policies of the Federal Open Market Committee. Significantly, even as the 10 year Treasury note sits at 2.5%, short-term interest rates are fundamentally linked to funding costs for banks and other leveraged investors.
Last week Wells Fargo & Co (WFC) and JPMorgan Chase (JPM) reported earnings, in both cases exceeding Street expectations. But the results from both WFC and JPM confirm our expectations with respect to rising funding costs, which continue to grow by mid- to high-double digit rates or roughly 4x the rate of increase in bank asset returns.
In the case of JPM, interest expense rose 70% year-over-year from $4.4 billion in Q1 2018 to almost $7.5 billion in Q1 2019. By Q1 2020, we expect to see quarterly interest expense for JPM over $12 billion. To give you some context, JPM’s net interest income was $14.5 billion in Q1 2019. While JPM is guiding investors to higher earnings, nobody expects the House of Morgan to grow asset returns by $5 billion in the next three quarters.
For WFC, total interest expense rose 50% from $3.1 billion in Q1 2018 to $4.7 billion in Q1 2019. By Q1 2020, we expect to see WFC’s funding costs rise to something over $7 billion. To compare, WFC’s net interest income was $12.3 billion in Q1 2019. WFC has provided guidance to the Street for declining earnings and revenue through the end of 2019.
Even were interest rates to remain unchanged over the next year, the cost of funds for the US banking industry is likely to continue increasing as bank deposit and debt costs normalize. Whereas in the period between 2008 and 2014 funding costs fell faster than bank asset returns, now the opposite is the case as we discussed on BNN last week.
Bank funding costs are rising 3-4x asset returns as interest expense normalizes back to the $70-80 billion range. At Q4 2018, total funding costs for the banking industry were just shy of $40 billion. As noted in a previous comment, we expect quarterly bank funding costs to be over $60 billion by year-end 2019. To provide some perspective, the net income of the entire US banking industry was $59 billion in Q4 2018. Since 2014 when bank funding costs troughed at $11 billion per quarter, interest expense has grown four fold and at an accelerating rate.
Since much of the growth in bank interest income is due to balance sheet growth, the cost of funds for the industry is likely to stabilize well above $100 billion per quarter vs the pre-2008 levels of $80 billion. Total assets of the banking industry was $13.8 trillion at the end of 2008 vs $17.9 trillion at the end of 2018, a 30% increase. This is one reason why we believe that net interest income is likely to flatten and start to decline this year and beyond, as shown in the chart below.
James Grant writes in Barron’s this week:
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“Radical monetary policy, and the interest rates that go with it, advantage some, punish others. Speculators gain, savers lose. The rich do better than the poor. On balance, has the decadelong experiment in interest-rate suppression yielded the expected net benefit? The answer—'no’ — is best explained by the first economist who uttered the five wise words. ‘There ain’t no free lunch.’” |
Between 2008 and 2014, the FOMC subsidized the US banking sector to the tune of tens of billions per quarter in incremental income. Now as the financial markets slowly claw their way back to normal, banks and leveraged investors are entering a dangerous period of falling margins over funding and uncertainty about the future direction of interest rates.
Without a complete capitulation by the FOMC and short-term rate cuts, we see no avenue for bank's to avoid a squeeze on net interest income in coming quarters. Yes, President Trump and Larry Kudlow are right about the Fed and interest rates.
This novel and ultimately deflationary situation facing investors is entirely the fault of the FOMC and other central banks, which persist in thinking that negative interest rates are somehow helpful in terms of encouraging economic growth. But in fact savers, bond holders and now financial institutions are paying a very high price for the speculative fancy of global central bankers.
As Warren Buffett told Yahoo Finance’s editor-in-chief, Andy Serwer: “I think, now, there’s still $11 trillion, at least, of government debt around the world that’s at a negative rate. So we’ve never seen it before.” No indeed.
EDITOR'S NOTE
This Hedgeye Guest Contributor piece was written by Christopher Whalen, author of the book Ford Men and chairman of Whalen Global Advisors. 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.
