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The Institutional Risk Analyst

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AOCI: The Winter of Quantitative Easing

Updated: Oct 24, 2022

October 24, 2022 | Equity investors have spent the past nine months watching as trillions in supposed paper wealth was destroyed. One of the weaker near-banks, Ally Financial (ALLY), just took its lumps on an ill-considered investment in Better.com. The loss is due to a $136 million impairment charge “on a nonmarketable equity investment” related to its mortgage business, Inside Mortgage Finance reports.


Some readers of The Institutional Risk Analyst may wonder if time is not running in reverse. Instead of creating wealth from the ether during 2020-2021, now the FOMC is destroying wealth with even larger effect on markets and companies. Is the damage being caused by the end of quantitative easing or QE over? Not even close.


The wealth destruction visible in the REIT sector, for example, is massive and continues each and every day. The negative mark on the trillions in mortgage-backed securities and loans on the books of all manner of REITs is mounting and is likely to put pressure on many of these issuers as they seek to replenish capital losses in the equity markets.


Consider the travails of the banks holding committed loans to Elon Musk for his alleged acquisition of Twitter (TWTR). The best thing that could happen to these banks is for the deal not to go through, in part because the lenders involved will be forced to retain the loans.


Musk at least locked in some of his financing costs for the $40 something billion acquisition, but the loans are now points under water and will probably need to be written down to fair value before being buried in a portfolio by the lenders. And what happens to the loans to buy Twitter if, for example, Musk is forced to retrench in China as communist dictator Xi Jinping doubles down on tyranny and wrecks the economy. Force majeure?


Of course the economists continue to focus on the “tough” job facing Jerome Powell and his colleagues on the Federal Open Market Committee. Little attention is being paid to the collateral damage being done by the FOMC to the debt capital markets and, by connection to the banking system, under the Fed’s tightening strategy.


Quantitative easing is a public policy disaster, yet the FOMC remains silent about its missteps over the past three years even as market losses grow. US banks had $4.2 trillion in unused loan commitments in Q2 2022 or 2x CET1 capital levels. How many of these commitments are now deep under water?


Source: FDIC


The chart below shows the accumulated negative "other comprehensive income" or AOCI for the US banking industry through Q2 2022 to the tune of -$250 billion or 10% of the CET1 equity of the entire industry. This chart illustrates the huge volatility injected into the financial markets by the FOMC.


Source: FDIC


Based upon Q3 2022 earnings, the mark-to-market deficits for the industry are likely going to increase significantly, but fortunately the top banks seem to have plateaued since Q2 2022. If you think of the downward skew in prices for the fixed income markets over 2022, the chart above begins to make sense.


Ponder, however, how much of the “pain” in terms of mark-to-market losses has been hidden by banks in held-to-maturity portfolios. Indeed, one big reason that JPMorgan (JPM) and Bank of America (BAC) are not showing big increases in AOCI in Q3 is that the losers on the available for sale book are being hidden in the held to maturity portfolio or sold.


JPM has almost cut its AFS securities book in half since March. BAC has also cut its AFS book by $50 billion but its held-to-maturity book is essentially unchanged. Our bet is that BAC CEO Brian Moynihan is burying his failure to manage interest rate risk deep in the bowels of the bank, with a commensurate negative impact on future earnings.


We expect the large banks to use hedging and transfers to held-to-maturity to shield themselves from further negative marks, but the banking and nonbanking sectors remain very vulnerable to additional losses as the FOMC continues its rate hikes. As we note in National Mortgage News this week, two more rate hikes of 75bp and we could see high-priced conventional loans above 10% by Q1 2023.


Just imagine the accumulated AOCI for all financial investors by the end of 2022. The negative mark-to-market on $9 trillion in government and agency MBS could exceed half a trillion dollars by Christmas. But the bigger risk lies ahead, when the FOMC finally drops interest rates and the margin calls on MBS and leveraged mortgage servicing assets crush those firms that managed to survive the Winter of 2023.



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