Updated: May 30
May 30, 2023 | A longtime reader of The Institutional Risk Analyst sent us a link to a post on Reuters from 2011, wherein we talked about the world of credit when the supposedly superior government credits are all insolvent or headed that way. Our relationship with Reuters ended not long after that post, when we suggested that Bank of America (BAC) should be restructured to rid it of the toxic mortgage liabilities of Countrywide Financial.
After a decade under CEO Brian Moynihan, BAC remains an example of why large banks need to be broken up -- to protect shareholders rather than just consumers. Since the 2012 National Mortgage Settlement that enabled Vice President Kamala Harris to buy a seat in the US Senate, large American banks have backed away from mortgage lending and investing in mortgage loans, especially government lending. But they continue to hold “AAA” rated agency and government mortgage backed securities (MBS), bonds that are arguably too dangerous to be suitable for most investors. Why?
Under Basel III, Ginnie Mae MBS have zero risk weighting and MBS issued by the GSEs is weighted 20%, even though both Fannie Mae and Freddie Mac remain in government conservatorship. Whole loans, on the other hand, have at least 50% risk weightings and infinite compliance and reputational risk, especially if the bank is facing a lower-income household with an above-average likelihood of default.
The message to banks from the 2012 Mortgage Settlement and related litigation, and Basel III, was simple: don’t lend to poor people. But as the $3 trillion asset BAC proves pretty conclusively, fleeing mortgage lending entirely is bad business. The bank's deposits are under-utilized and most of BAC's assets are invested in securities. And the bank owns lots of MBS.
After it purchased Countrywide in 2007, BAC destroyed tens of billions in shareholder value by withdrawing from correspondent lending. Under Moynihan, responsible growth means being number four or five in the top five largest US depositories. The chart below shows the gross spread on loans and leases for the top US banks and Peer Group 1 from the FFIEC.
Wells Fargo (WFC) is following BAC’s bad example and exiting correspondent lending in 1-4 family mortgages, leaving the $1.8 trillion bank few good alternatives for deploying liquidity into earning assets. This means that both BAC and WFC are only lending in footprint, via the banks’ branches, and cutting off wholesale warehouse liquidity to nonbank lenders and smaller banks that were once correspondents. Of note, the Federal Home Loan Banks only face one quarter of the US residential mortgage market because three quarters of 1-4 lending is now controlled by nonbank firms.
The net result of progressive, pro-consumer policies is to marginalize two of the largest banks in the country, including $5 trillion in assets, and decrease the availability of credit to the underserved. Since BAC and WFC now restrict their activities to internally originated loans and then only high quality loans that will be retained in portfolio, economic growth suffers along with shareholder returns. But as Silicon Valley Bank shows, the fact of a good credit portfolio does not mean low risk.
Since BAC and WFC don’t make enough loans to deploy the trillions in deposits the banks control, what do they do? They buy “AAA” MBS and other securities, in the process taking on huge market risk. The increase in interest rates by the Fed in 2022 wiped $7 trillion off of the global ledger, notes Gillian Tett in the FT. A good bit of this deficit came from the extension of maturities of MBS as interest rates rose, home mortgage volumes fell and bond prices sank accordingly.
In the event of a “balance sheet recession" Ms Tett describes, we are likely to wipe off a good bit more apparent equity from the books of banks and other credit investors that hold MBS. The irony of Silicon Valley Bank being rendered insolvent because of a bad bet on government-backed MBS speaks to the changes which have occurred in the markets since 2008. Federal debt has swelled, even as interest rates plummeted to the zero bound for two years during COVID. Volatility in the markets has also increased as interest rates fell, making it near-impossible to hedge the very low coupon securities created in 2020-2021.
What does a federal guarantee against credit loss on a Ginnie Mae 2% MBS matter when the Fed causes the markets to issue trillions in low-coupon mortgages, then raises market interest rates 6% in less than 18 months? The snapshot below shows mortgage TBAs at the close on Friday. Notice Fannie Mae 3s for delivery in June are trading at 87. Lenders were writing 7% home loans last week and selling the new loans into 6% MBS for June, which were trading just over 101 at the close on Friday.
Source: Bloomberg (05/26/23)
At the end of 2011, MBS equaled 11% of the $13.4 trillion in total banking assets in the US. By the end of 2021, the banking industry’s holdings of MBS rose to 15% of total assets. But what total assets? The total assets which almost doubled over a decade and then rose 20% in 2020-2021 thanks to QE and the Fed’s $9 trillion in bond purchases. You could not create a more perfect trap for killing banks. And we did.
The chart below shows MBS holdings by all banks vs deposits through year-end 2022 as a percentage. Deposit growth is generally how the Street thinks about MBS holdings. Banks’ mortgage backed securities holdings have been “dropping like rocks,” with Q1 2023 marking the fifth straight decline on depository balance sheets, according to Robert W. Baird & Co. “Banks lost almost $67 billion of MBS since the start of this year alone,” wrote portfolio strategist Kirill Krylov.
The one thing you can be pretty sure about is that bank holdings of MBS are likely to fall as balance sheets shrink in Q2 2023 and beyond. This will put selling pressure on MBS and push home mortgage rates even higher. Widening of the primary-secondary spread between loan coupons and MBS yields has yet to entice buyers enough to offset sales by banks and the FDIC. And the flood of banks looking to reduce market risk and raise cash is also adding to selling pressure.
One bank we hope to see reducing MBS holdings is Bank America, which was 50% above Peer Group 1 in terms of MBS exposure vs total assets over the past five years. BAC also retains a lot of whole loan exposures, one reason why the gross loan spread is so low vs other banks. The table below shows BAC MBS holdings as a percentage of total assets vs Peer Group 1. Note that BAC is in the 73rd percentile of Peer Group 1 in terms of MBS/Total Assets.
Bank of America | MBS/Total Assets (%)
As of Q1 2023, BAC held $229 billion in 1-4 family mortgage loans with a weighted average coupon (WAC) of just 2.9% and $851 billion in debt securities with a weighted average coupon of just 2.58%. Yikes. BAC's gross loan yield on the entire book was just 4.36% at Q1 2023 and has been in the bottom third of Peer Group 1 going back five years, according to the FFIEC. We know a wealth management client of BAC that has a 30-year, 2.25% mortgage from BAC. The 2021 loan is still owned by the bank. What is wrong with this picture?
Readers will be thrilled to hear that BAC was earning well-north of 4% on deposits with other banks at the end of Q1 2023. This tells you where funding costs for BAC and all banks are headed. You can see from the numbers above that we have a problem, yes? The rate of turnover for the $3 trillion total asset bank is very low, less than 10% per year, but funding costs are changing weekly. The snapshot below is from the Q1 2023 BAC earnings supplement.
For some time now we have been telling our readers that the threat to the US banking system posed by the policies of the Federal Open Market Committee is not limited to small banks. Some of the biggest holders of MBS and whole loans as a percentage of assets are among the largest banks. Banks like BAC, which originated and retained many low-coupon assets during the COVID ease by the FOMC, now face a funding mismatch of existential proportions.
When Zero Hedge wrote provocatively last week that the Fed Is "Foaming The Runway" For Big Bank Problems Ahead, the comments from noted monetary analyst Zoltan Pozsar reflected a degree of comfort with Fed actions that is way too optimistic. If you believe that the Fed is going to keep interest rates at or above current levels through to 2024, then we have a problem with several large banks led by BAC.
Foaming the runway is a great metaphor, but that assumes that the Fed actually understands the problem and is willing to act accordingly. We suspect that the general lack of focus and silliness that prevails in the world of finance and particularly in Washington may ultimately allow for a range of outcomes that are less than acceptable to the markets. Michael Hofman sums up the current state of things nicely in The New York Review of Books:
"Now that we’ve had it with uncomplicated greatness, just give us our supernatural machinery. What a poor, gaslighted, meme-riddled, spook-spooked species we are. We can no longer count to three, but by golly you should see our numerology. I don’t know what we should be more ashamed of: our stupid credulity or our oh-so-clever suspicion."
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