October 4, 2023 | In this issue of The Institutional Risk Analyst, we provide a setup for top five bank earnings in Q3 2023. The big issue facing the industry is rising interest rates, which are causing a squeeze on net income and rising losses. Look for flat to down net income for US banks in Q3 2023 and a 10-20% increase in unrealized losses vs Q2 2023.
Did we mention that rising interest rates are causing margin calls on Treasury and mortgage-backed securities (MBS) owned by REITs and dealers. And rising mark-to-market losses on securities and, yes, loans too? Apparently we're not even going to do $1 trillion in new 1-4 family mortgages in 2023. Just imagine how things will be in credit with the 10-year Treasury at 5%.
There are many ways to measure the impact of rising interest rates on banks, but suffice to say that in Q3 2023 the negative mark-to-market on all securities owned by banks could exceed Q3 2022 and approach -$1 trillion. Our mark-to-market for the industry follows below.
Mark-to-Market | All Banks
Source: FDIC (RIS), WGA LLC
The good news about mark-to-market losses is that the average coupon for all ~ $18 trillion or so in securities, loans and leases owned by banks is above 3% and slowly climbing. Slowly. The bad news is that securities with 3% coupons are trading in the low 80s and high 70s as of the end of Q3 2023. With the 10-year Treasury note trading above 4.7% yield at quarter end, we'd probably look for a 20-22% mark-to-market adjust in Q3 '23. The 10-year was at 3.8% at the end of Q2 2023.
Of note, in terms of equity valuations U.S. Bancorp (USB) is the worst performer in the top-five banks, followed by Bank of America (BAC), Citigroup (C), Wells Fargo (WFC) and JPMorgan (JPM) leading the pack. USB continues to work through the December 2022 acquisition of MUFG Union Bank’s core regional banking franchise from Mitsubishi UFJ Financial Group (NYSE: MUFG). JPM is leading the rest of the group by a significant margin and is the only stock in the top five that still is up for the year.
Source: Google Finance (10/02/23)
The reason for our negative comments about Citi, USB and BAC is that they are spotting 10 points or more of operating leverage to JPM. Ten points explains a lot of the public equity market valuation gap, period. Notice that Peer Group 1 is at 59% efficiency (Overhead expenses / Net Interest Income + non-interest income). WFC is at least heading in the right direction at 64%, but needs to drop five more points to be credible. Also note, in this regard, how stable is the simple average of efficiency for the 140 banks in Peer Group 1.
Even allowing for the positive effects of the First Republic transaction, JPM is still setting a blistering pace for the other banks to follow. Notice that near-banks Morgan Stanley (MS) and Goldman Sachs (GS) are not even in the big bank game with efficiency ratios in the 70s, but Charles Schwab (SCHW) is right behind JPM at 61%.
At 65.7% in Q2 2023, Citi is way out of line in terms of expenses and thus the urgency of CEO Jane Fraser in launching the latest restructuring. But of course with net interest income slumping the first half of 2023, the higher efficiency ratios seen at large banks is not really a surprise. Less efficiency ratio means more net income, if you have the income vs overhead.
Source: FDIC | *Six months
The analyst pack has JPM earnings ~ $16 per share this year, but then falling to just $14 in 2024 because of a bad landing? Or maybe net asset shrinkage in the bank. This is remarkable because the curve is meant only to be upward sloping on Wall Street, right? The Sell Side's downbeat view of JPM certainly aligns with the public comments of CEO Jaime Dimon, who has been a vocal seller of current Treasury yields and soft landings.
For those who missed it, Dimon told Bloomberg TV it’s possible the central bank will continue hiking short-term rates by another 1.5 percentage points, to 7%, a level that would assure more bank failures. In a rising rate environment, finding buyers for the assets of failed banks is problematic. Seven percent would be the highest federal funds rate since December 1990. In March 2022, when the current hiking cycle began, rates were at 0.25%-0.50%.
Another down quarter in terms of net income will press many Sell Side analysts to back off their equity recommendations. Of concern, the growth rate for bank interest earnings continues to slow. The rate of increase in funding costs is also slowing to a lesser degree, but basically we are giving back the supranormal asset and equity returns of 2022 in 2023.
As we noted earlier, JPM is now the largest servicer of residential mortgages in the US, surpassing WFC at the end of last year. JPM is also the largest warehouse lender to other mortgage shops. But is JPM going to be able to stay in the residential mortgage business under the new Basel III proposal?
Meanwhile, Rithm Capital Corp (RITM) entered into a definitive agreement with Computershare Limited (CPU) to acquire Computershare Mortgage Services Inc. and Specialized Loan Servicing LLC, for a purchase price of approximately $720 million. Even if the Basel III proposal is watered down, nonbanks will continue to take share in residential mortgage lending and servicing.
The folks at Bank Policy Institute have done a comprehensive look at how the new Basel III proposal will impact mortgages. Answer: Badly. If adopted, this draconian proposal will double the risk-weight on 1-4 family loans and impose large market risk adjustments for MBS.
Just for the record, we think ALL MBS and Treasury debt ought to have 100% risk weights because of the market volatility, a dash of convexity and potential for employing double digit leverage under the assets. Loans? Not so much. Sane people really only put 1x leverage under a residential loan and then only if it has an agency or government credit guarantee.
We think risk weights for 1-4s ought to start at 50% and move higher, faster with LTV regardless of the guarantee. That is the part of the Basel III proposal we think is long overdue. Private label loans ought to start at 100% depending on LTV. But the big ask ought to be raising Treasury and MBS risk weights to the same level as corporate exposures. Silicon Valley Bank could never have run 40% of total assets in MBS unless those securities had low or zero Basel capital risk weights.
The chart above tells the story of top-five bank earnings in 2023. JPM is running about 40% above the group and Peer Group 1 in terms of earnings since the acquisition of First Republic. JPM was over 1.4% ROA vs BAC, WFC and Peer Group 1, which are clustered around 1% ROA. And Citi is at the bottom of the group at 0.6% ROA, a decidedly unacceptable position driven by poor operating leverage. Citi needs to cut expenses until efficiency starts with a "5."
If Jane Fraser cannot get Citi's expenses down so it can at least meet peer levels of asset and equity returns, then she should break up the bank. The value of the pieces may indeed be greater than the current equity market value of C. Ponder the value of the Citi payments platform and the subprime consumer loan book in a sale. The only thing that prevents Citi from being broken up via a hostile takeover is federal banking laws.
Notice in the chart below that the rate of increase in asset returns has slowed dramatically over the past two quarters. How is it that JPM and BAC are tied for last place among the top five banks and Peer Group 1 in terms of asset returns? Meanwhile, Citi's high yield loan book enhances asset returns, but the poor operating efficiency prevents this income from reaching the bottom line. The key battleground for US banks in 2023 and beyond is at least maintaining operating efficiency.
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