Measuring Powell's Bank Rate Shock
Updated: May 8
May 8, 2023 | A number of readers of The Institutional Risk Analyst have asked whether the banking crisis of 2023 is over. The short answer is no. The massive shift in interest rates, asset values and funding costs caused by the Fed's actions during and after the Wuhan Flu pandemic left many banks, pensions and other investors with significant capital deficits of unprecedented size. This party is just getting started.
In the next Premium Service issue of The Institutional Risk Analyst, we’ll be updating our readers on Rithm Capital (RITM) and its possible plans to spin off its residential mortgage lender.
With the 10-year Treasury note at 3.5% and SOFR at 5%, the mark-to-market picture is not as bad as Q3 2022. Yet the basic mismatch between cash flows, asset prices and funding costs remains. The chart below shows one-year T-bills vs the Reverse Repo rate paid by the FRBNY. Notice how yields on T-bills fell sharply in March and April.
Ponder the weight, emotionally and financially, of the market shock caused by three large bank failures since the first week of March, when brokered deposit rates were in the 3s. Today, teaser deposit rates from some of the largest banks are above 5% annualized, reflecting the fact that effective cost of funds is basically rising to meet yields on Treasury bills and the Fed's reverse repurchase facility.
Given that the gross yield on all loans and leases owned by large US banks was not quite 5% at the end of Q1 2023, you can see that we have a problem. The weighted average maturity of a large bank is generally measured in mid-single digits, meaning 20% or so of the average bank balance sheet may be repriced each year. Yet somehow Federal Reserve Chairman Jerome Powell is able to look into the TV camera and tell the public that US banks are safe and sound. Really?
One Year Deposit Rates
Last week was one of the worst weeks in the markets in awhile. We also got a strong jobs number Friday that largely let the air out of predictions of a Fed pivot on interest rates in the near term. The banks bounced Friday after a difficult week, with Western Alliance (WAL) closing at 0.58x book vs 0.71x a month before. PacWest Bancorp (PACW) finished the week below 0.3x book value. Generally speaking, banks trading below 0.5x of book are either state-supported zombies or for sale.
Our view is that the change in the market environment for banks since the collapse of SIVB is likely going to result in a reduction in credit availability for the US economy. Banks are looking to raise cash and the easy way to achieve this is to slow lending. Most of the better-managed banks we follow already have put their deposit rates in the 5% range or double the rate at the end of February. We look for some truly ugly earnings results in Q2 2023.
For example, the cost of wholesale bank financing for new commercial loans is now SOFR +3% or more (h/t J. Kohan). Needless to say, the volume of new commercial loans flowing through the system is down year-over-year. Of note, Wall Street banks have become comfortable with the idea that interest rates are unlikely to go much higher. By coincidence, the cost of interest rate caps on floating rate financing is suddenly falling. Go figure. But commercial loans with 8 or 9 handles is now the norm. Plug that into your DSGE model Chair Jay.
We expect that liquidity for banks and nonbanks will remain a serious issue in Q2, but the joke is that credit costs are also going to rise through the remainder of the year. So long as the 10-year Treasury remains at or below 3.5% (currently 3.41%), the situation is tolerable. If the 10s widen out to 4%, then the banks have a very ugly disclosure problem on M2M and the shorts sellers (who've been starving for a decade, to be fair) will feast.
Besides the ongoing, on-the-fly repricing of $19 trillion in bank deposit liabilities, the commercial lending sector also can look forward to sharply higher credit costs. Of course, this time it’s different. In 2008, we all fussed about residential mortgages, but this time commercial real estate exposures will lead the parade. Fact is, the loss given default (LGD) for $2.5 trillion in bank-owned residential mortgages is still negative, but the $500 billion in multi family and $1 trillion in commercial office exposures are already above the long-term average.
Source: FDIC/WGA LLC
If we combine the asset-liability mismatch facing the banks, with a sudden reduction in credit availability as lenders seek to raise cash, the end result could be a significant uptick in credit defaults later this year. Given the velocity of change we have already witnessed since the Fed began to tighten policy more than a year ago, we think that preparing for sharp upward moves in credit default rates at banks is probably a prudent move. But the real whammy that faces US banks and levered investors is what happens to net-interest margin when the rate of change in funding costs doubles or more in a single quarter.
Below we show the components of net interest income for all US banks. The rate of growth in interest costs has been galloping along at a multiple of interest income, part of the normalization process from the Fed’s QE program. Interest expense for US banks is up 10-fold since the near-zero lows of 2021. But while the rate of increase in funding costs for all US banks was decelerating gradually at the start of 2023, since the failure of Silicon Valley Bank in the first week of March the rate of increase in bank funding costs has jumped. The bank deposit rates we can all see online suggest that the US banking industry could see declining net interest margins in Q2 2023.
If we use U.S. Bancorp (USB) as a surrogate for the industry data that will be released by the FDIC at the end of May, Q1 2023 funding costs rose almost 40% and interest income rose 16% sequentially. The year-over-year comparisons are even more striking. But there are only three weeks of data post-SIVB in the USB results for Q1 2023. This begs the question as to what happens in Q2 2023 and beyond given the shock of three large bank failures in March and April. Our best guess about Q2 2023 for the whole US banking sector is shown below.
Source: FDIC/WGA LLC
Let’s say that banking industry interest income rises another 20% in Q2 2023, but bank interest expense surges higher and rises 100% vs the ~ 40% Q1 2023 baseline we take from U.S. Bancorp. The chart above shows the projected results for all US banks in Q2 2023, which will be released by FDIC at the end of August. Total interest expense exceeds net interest income by almost $14 billion, an unprecedented development in a year that promises to set more records. After all, it’s not even Memorial Day and we could easily see a couple more commercial banks fail in coming weeks.
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