R. Christopher Whalen
Apr 19, 20237 min
April 19, 2023 | Premium Service | In this issue of The Institutional Risk Analyst, we review the latest earnings for banks and think about the next shoe to drop. One reader asked why JPMorgan (JPM) is paying 5% for one year deposits. The short answer is that JPM and Bank of America (BAC) are competing for funding in a shrinking market. The funding crisis affecting US banks is not over and very definitely not limited to smaller banks.
CNBC World Wide Exchange (04/17/23)
Every time a Treasury bond matures in the Fed’s portfolio, the Treasury refinances that piece of debt (since the US is running a massive deficit) and an investor buys that bond. A bank deposit disappears and an asset is acquired. And given the growing crowd of investors dumping commercial real estate exposures, the demand for risk free collateral is brisk.
The same math does not apply to mortgage-backed securities (MBS), sadly. Since the mortgage finance industry is barely producing $400 billion in new loans each quarter in 2023, the Fed would need to sell $50-$100 billion per month just to compensate for all redemptions globally. Net, net, the mortgage ice cube is melting. The MBA estimates only $1.8 trillion in production in 2023.
By not selling MBS from its portfolio, the Fed is causing distortions in the Treasury yield curve and arguably is forcing down mortgage rates and long-term yields generally. As new MBS production dwindles and the Fed sits on its growing pile of duration represented by the MBS in the system open market account (SOMA), the net effect is to make MBS scarce and drive down yields. Even with banks backing away from 1-4s, the net effect is still to make MBS collateral ever more scarce.
As liquidity runs out of the system, the FOMC ought to be providing risk-free collateral to enable private counterparties to raise cash. One of the little market details that seems to always evade economists is the link between liquidity and risk-free collateral like Treasury bonds and Ginnie Mae MBS. If collateral is tight, then raising cash is also more difficult and expensive. After December 2018, you’d think that the Fed understands this connection by now.
The BlackRock (BLK) sale of mortgage bonds for the FDIC could reach up to $2 billion in MBS pools and $500 million in collateralized mortgage obligations per week, close to expected levels of $10 billion a month, this according to analysts at Citigroup (C). But since the primary market for new agency and government MBS will be lucky to produce $400 billion in Q1 2023, the obvious answer is for the Fed to join the banks as net sellers of older mortgages. This may be obvious to investors, but nothing seems to be obvious to members of the FOMC when it comes to finance and economics.
The same pressures that are building on banks are also impacting all manner of buyers of assets, from insurance companies to REITs. Reports that the insurance sector is stepping back from the commercial office market is bad news that could not come at a worse time. Indeed, we perceive a run on commercial real estate that carries profound risks for the credit markets. Just because commercial real estate is a mostly private market without public prices for entirely large, disparate exposures does not mean that there is no pain.
Earnings Roundup
So far the earnings reported by the banks largely confirm several basic points we have discussed over the past year. Points:
First is volatility. The rate of change in just about every metric is off of the scale compared with past experience. Looking at the rate of change in funding costs for JPM and BAC, for example, we see confirmation of the trend visible in the regulatory data, namely that funding costs are surging. Our estimates put C’s interest expense north of 2.5% of average assets in Q1 2023 or basically 2x Q4 2022. Again, why is JPM paying over 5% for 12-month deposits? Because they need liquidity. Note too that Citi reported that cash fell 14% sequentially and 6% YOY.
One of our portfolio holdings, Western Alliance Bancorp (WAL), saw net interest income jump 35% in Q1 2023, but funding costs rose 10x in line with JPM. Of note, WAL reported fair value loss adjustments of $147.8 million related to the transfer of $6.0 billion of loans from held-to-maturity to available for sale. Run rate revenue was over $700 million before the fair value adjustment. Meanwhile, the 43% efficiency ratio gives WAL a lot of flexibility to deal with future losses. The stronger banks are those with sufficient earnings to sell underwater assets.
The fact that WAL was able to increase net-interest margin by 14% in Q1 2023 vs the year before speaks to the focus of management. With the management changes at PennyMac Financial (PFSI), WAL’s Amerihome mortgage unit has the world of conventional correspondent largely to itself. At the end of March, Vandad Fartaj ceased serving as PFSI’s Chief Investment Officer, causing PSFI to subsequently become less aggressive in the secondary market for conventional loans.
The table below shows some of the changes to the WAL balance sheet over the past year. Notice that the bank has moved 10% of assets into available-for-sale and raised cash and total assets, even while pushing down deposits.
Second is the broad-based flight away from risk assets such as commercial real estate exposures. This change in lender appetite comes at a time when banks are already lightening up on commercial loans and also 1-4s, and looking to maximize liquidity. One way to immediately increase liquidity is to decrease lending. We see a flight from risk building among banks and nonbanks as concerns about the economy grow, particularly in areas such as legacy urban commercial real estate.
Banks like Citi are reducing corporate exposures even as they coast temporarily in terms of allowance for future losses. Citi is also running off legacy exposures in Asia and Mexico at a 20% annual rate and putting cash into trading accounts and securities. We look for all large banks to step back from high-risk markets and maximize cash over the balance of 2023.
Third and looming large for the rest of 2023 is credit costs. The fact that JPM boosted provisions 56% YOY is more significant than the fact that the bank basically made no additions to the ALLL in Q1 2023. The industry is pausing before a significant credit build – because it can.
For most banks, Q1 earnings are likely to be the best of 2023 for a number of reasons, chief among them are strong top-line revenue from the banking side of the ledger and low current credit expenses. Will JPM pull another bunny from the hat in Q2 2023 in terms of a 72% surge in principal transactions? See yellow highlight below.
Looking at the $470 million loss realized by GS on the sale of Marcus loans, our earlier view about the inferior credit performance of the Goldman credit book seems to be confirmed. We agree with the decision to cut the loss at Marcus, but we continue to believe that GS needs to merge with a larger player to address funding costs. In the post QE world, the shrinkage in available liquidity as the SOMA runs off will put growing pressure on high-cost depositories.
Interest expense at GS was up 850% YOY and 27% in Q1 2023 vs Q4 2022. Interest income was up 365% YOY and 20% sequentially, again illustrating the vast change underway in terms of funding costs. If we replicate the calculation from the FFIEC, annualized interest expense/average assets for GS was 342bp in Q1 2023 vs 138bp in Q4 or a 150% increase in a single quarter.
Notice in the table below that GS saw net interest income fall in Q1 2023, even as non-interest income provided most of the profitability. Banks large and small are feeling the withdrawal of liquidity from the markets. Again, the liquidity run on US banks is not over and it is very definitely not limited to smaller depositories.
With Morgan Stanley (MS), for example, interest expense soared 1,750% YOY, from $434 million in Q1 2022 to $8,033 million in Q1 2023. Credit expenses also increased triple digits, albeit from a small absolute amount. MS reported 1bp of net loss in Q4 2022, an excellent performance that puts them in the bottom quartile of all large banks. While the headline assets is $1.1 trillion, risk weighted assets is less than $450 million.
MS got a nice surprise from the investment bank, but net interest income was flat, up 1% sequentially and 6% YOY. This again shows how hard it is for relatively short-duration businesses like MS or GS, which are still predominantly broker dealers, to generate net interest margin.
Like Charles Schwab (SCHW), MS is a large investment firm that owns a large, liquid banking business. Net interest income at MS was $2.3 billion vs over $12 billion from fees and other non-interest income generated by investment activities. The 48% increase in trading activity at MS in Q1 2023 is unlikely to be repeated in Q2 2023.
The key takeaway from Q1 2023 earnings so far: Volatility on the balance sheet and in the income statement are to be expected in 2023. We look for better managed banks to get smaller and more liquid over the next several quarters. Banks that do not get the hint and wait to make adjustments when change is forced upon them will pay accordingly. The changes we see occurring at some of the largest US banks suggests to us that the tightening of credit conditions by the FOMC is affecting all banks differently and to a degree that is not well-understood by markets or policy makers.
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