Will the FOMC Break the Financials?

October 17, 2022 | Premium Service | A number of readers asked about the reference in our last comment to banks being rendered "insolvent" on a mark-to-market basis as a result of rising interest rates. Will quantitative tightening (QT) tip over a large bank or nonbank financial firm that has not hedged its market risk? Is hedging even possible in the volatile post-QE markets?

The huge shift in funding costs engineered by the Federal Open Market Committee caused an equally large downward move in bond and loan prices. Every loan or security created during 2020-2021 was mispriced, with a resulting negative “accumulated other comprehensive income” or AOCI. Remember those four letters if you invest in or have risk exposures to banks and other financial intermediaries. Note too that banks own a lot more variable duration mortgage-backed securities (MBS) than Treasury bonds.

Source: FDIC

As interest rates increase, changes in the fair value of debt securities that are available for sale (AFS) may negatively affect accumulated other comprehensive income (AOCI), which lowers the bank's based capital. AOCI also includes unrealized gains or losses related to the transfer of debt securities from AFS to held to maturity (HTM), which are subsequently amortized into earnings over the life of the security with no further impact to capital.

So how big is the mark-to-market hit facing US banks? At the end of Q2 2022, US banks held $6.1 trillion in securities, including $3.4 trillion in AFS and $2.7 trillion HTM. These totals include $1.5 trillion in Treasury paper, $3.38 trillion in MBS and another half trillion in municipals. Depending on your assumptions about the fair value of the MBS, the unrealized loss figure stretches into the tens of billions of dollars. Keep in mind that the weighted average coupon (WAC) on bank-owned MBS probably averages around 3.5% vs today's yields of 6.5% to 7% on new issue MBS. The low-coupon MBS owned by banks and the Federal Reserve itself are trading in the 80s and 70s today.

During the earnings call for Wells Fargo (WFC) last week, Morgan Stanley (MS) veteran analyst Betsy Graseck asked management how long it would take for underwater securities to accrete back to par.

Betsy Graseck -- Morgan Stanley - Analyst

The underwater AFS book, right? Like if rates were flat with quarter end 3Q, you

got--

Mike Santomassimo -- Chief Financial Officer

When do you start to accrete back the AOCI?

Betsy Graseck -- Morgan Stanley - Analyst

Yeah. Yeah. How long does it take to accrete back the AOCI?

Wells Fargo CFO Santomassimo then explained why it will take a while for that to happen, especially if you recall that many of these securities have below-market coupons – like 400bp below current market. And many bank-owned MBS were purchased significantly above par. As Graseck notes: “it's meaningful to the capital outlook.” The chart below shows the accumulated AOCI at WFC through Q3 2022.

Source: EDGAR

Meaningful indeed. Declines in accumulated other comprehensive income for WFC, driven by higher interest rates and wider agency mortgage-backed securities spreads, resulted in declines in the Common Equity Tier 1 (“CET1”) ratio of 96 bps from 3Q21 and 21 bps from 2Q22. In other words, mark-to-market losses have wiped out 10% of WFC's capital in the past year. At the end of Q3 2022, JPMorgan Chase (JPM) had negative $19.1 billion in AOCI. Now you understand why the Fed, OCC et al are pressing JPM and the other large banks to raise new capital immediately.

The chart below shows the CET1 capital for Well Fargo. Over the period of quantitative tightening or QT, we estimate that bank capital levels could fall 30% from the 2021 high water mark due to market risk and without any uptick in actual credit costs.

Source: Edgar

Due to the sharp increase in interest rates, many banks have been moving low-yielding securities from AFS to HTM, a process that normally cannot be reversed. If an institution changes its intent or no longer has the ability to hold one or more securities held to maturity, it will usually have to reclassify the entire portfolio as available for sale and mark the assets to market immediately.

The migration of securities from AFS to HTM illustrated in the chart below suggests that a number of banks have been caught off base by the Fed’s interest rate hikes over the past year. While moving these securities to HTM will avoid future loss recognition and reduce hedging costs, these low yielding securities may hurt bank asset returns over time.

Source: FDIC

Many institutions also consider reclassification because of the Current Expected Credit Loss (CECL) rule. CECL applies to securities held to maturity but will not affect securities available for sale. As a result, some financial institutions consider reclassifying securities so they do not have to worry about applying CECL to their securities portfolio.

Banks like WFC and JPM have a choice. Keep the securities in available-for-sale and risk further price deterioration or move the securities to held-to-maturity and take the hit now. The latter choice stops the accounting for additional declines in market value, but imbeds a low-yielding asset in the bank’s portfolio at a loss. Thus the question about accreting the asset’s fair value back up to break even.

Now you may be wondering: What about loans? Both mortgage and nonmortgage loans classified as held for sale should be carried at the lower of amortized cost basis or fair value. If the amortized cost basis of a loan exceeds fair value, a valuation allowance should be established for the difference. However, if the loan is hedged using an active portfolio method, the loan’s fair value is not adjusted.

One big area of concern for both banks and nonbanks is delinquent loans, an area that was very profitable for issuers in 2020-2021 but has now become a source of significant risk. At the end of 2020, banks held nearly $30 billion in early buyouts (EBOs) from Ginnie Mae MBS, but the number has come down since that time as the economics of buying delinquent loans has sharply deteriorated with rising mortgage rates.

Source: FDIC

GNMA EBOs are loans that were sold into an MBS pool by an issuer and subsequently repurchased due to delinquency. In the wake of QE, volatility in loan prices has exploded. Billions in low coupon delinquent government loans bought out of pools are now trading in the low 80s, choking both investors and lenders alike. Many of these EBOs were purchased above par, say 103, when the TBA was a 2% MBS trading at 106. But no more.

At the end of September, nonbank issuers operating in the GNMA market faced billions in EBOs and far more delinquent government loans are still sitting in MBS with WACs below 4% and in some cases below 3%. These low-coupon loans created by the FOMC during QE represent a substantial burden to these issuers, both in terms of the cost of loss mitigation and the eventual loss on the loan when it is modified and sold into a new MBS. Again, the on-the-run MBS for delivery in November is a 6.5% coupon today. The table below shows the largest government issuers, the total AUM of their servicing book, the weighted average coupon (WAC) and the level of delinquency.

Source: MIAC

The sharp markdown of EBOs illustrates the problematic aspect of market volatility and how it impacts the value of the assets of commercial and mortgage banks in times of rising interest rates and growing illiquidity. Upward movement in benchmark interest rates during Q3 further increased the value of mortgage servicing rights (MSRs) but pushed MBS and loan valuations lower. Those Ginnie Mae 1.5s and 2s are now effectively orphaned securities that trade at distressed bids despite the government credit wrap. As interest rates have risen, the rate of purchases of EBOs has plummeted.

GNMA EBOs ($)

Bottom line: We have noted before that the Fed has created an embedded short-put position for investors in MBS and whole mortgage loans that could prove problematic for banks and markets in the months ahead. The huge volatility in asset values observed over the course of 2022 is clearly an enormous negative effect of QE and its aftermath. The cause is artificial low-coupon Treasury securities and MBS.

We expect to see considerable pain evident in the financial results for banks and nonbanks alike due to the sharp increase in interest rates in 2022. Mark-to-market losses on the $4 trillion in MBS owned by banks could easily exceed 10-15% of face value, forcing many banks to transfer these assets to HTM in order to conceal the lapse in risk management. But can you really criticize a bank for failing to anticipate the ravages of QE and now its reverse?

But burying a toxic MBS with a 2% or lower coupon in HTM does not end the problems for the bank, REIT or nonbank owner. If interest rates remain at or above current levels, negative carry on low-coupon securities could eventually damage banks and nonbanks badly enough to force a fire-sale to raise liquidity. In the event, the entire portfolio category may then be considered "available for sale" and the resulting mark-to-market could cause the failure of the bank or nonbank investor all thanks to the FOMC.

The Institutional Risk Analyst is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.