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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.