Variable Rate World, Part 3: 'This Horror Show Is Just the Beginning'
It's easy to assert that big banks and other holders of long-term bonds will be crushed by rising interest rates, but it's tough to calculate just how bad the carnage will be and how quickly it will come. Tough but not impossible. A couple of recent Zero Hedge articles provide some data - and it's brutal.
First, this from July 8:
Wondering how the blow out in interest rates is impacting commercial banks, which just happen to have substantial duration exposure in the form of various Treasury and MBS securities, not to mention loans, structured products and of course, trillions in IR swap, derivatives and futures? Wonder no more: the Fed's weekly H.8 statement, and specifically the "Net unrealized gains (losses) on available-for-sale securities" of commercial banks in the US gives a glimpse into the pounding that banks are currently experiencing. In short: a bloodbath.
After crashing from $15 billion to just $6 billion, the reported balance of net unrealized gains is barely positive for just the first time since April 2011. And to think this number had topped out at over $43 billion in December 2012. But the worst is that monthly drop in "gains" of $24 billion is the biggest by a wide margin since the Lehman collapse.
Note the crash in the long-term chart:
The skeptics will say: $6 billion? Big deal. The Fed did almost that much in its POMO last Wednesday. The issue, however, is that the AFS line, which runs through the Accumulated Other Comprehensive Income line as the last thing banks want is for MTM to crush their reported bottom line is merely a proxy for how rising rates impact on a snapshot basis the consolidated bank balance sheet of US banks, which at last check had $7.3 trillion in loans and leases (still below pre-Lehman levels) not to mention countless other undisclosed instruments that represent their "London Whale" equivalent prop positions, funded with customer deposits.
In other words, the shorthand is to look at the massacre that is going on in the AFS line and extrapolate it to all other levered commercial bank (and hedge fund) rate exposure. Expect math PhD-programmed GETCO algos that determine the marginal momentum of the S&P to figure this out some time over the next 2-3 weeks once banks begin reporting results that are not quite in line with expectations.
And on the 11th, highly-respected bank analyst Chrisopher Whalen added some detail. Here's an excerpt:
So let's look at some of the top banks - JPMorgan Chase, Bank America, Wells Fargo, and Citigroup - and make some educated guesses about the degree of gross AFS [securities available for sale] losses, before hedges and other mitigating factors that we may see in Q2 2013 earnings next week. This horror show is just the beginning of the fun, however, because the non-cash mark-to-market losses in the near term begin to suggest what will happen to these banks as rates rise and many of these positions are dragged underwater vs. funding costs. Like home owners with mortgages that are worth more than their homes, banks too will have investments in fixed income securities that will be underwater in terms of both price and spreads over funding.
Last quarter, for example, WFC had a total cost of funds of about 3/8ths of a point. But many of the Treasury and agency securities issued over the past year have even lower yields. As the hundreds of billions of dollars' worth of recent vintage securities held in portfolio and AFS buckets by banks and all fixed income investors are refunded at progressively higher rates, many of these positions will be generating cash losses for banks and other leveraged investors.
By pursuing QE too long, the FOMC has engineered a repeat of the periods of market losses and negative accrual that nearly crushed the banking industry in the 1970s and 1980s, only worse. And the G-4 central banks actually plan to keep short rates low through 2015.
The extraordinary gains taken by banks on older, higher coupon securities in 2012 and before during the period of QE will not be available to support earnings in future thanks to QE. Or to put it another way, the period of "recovery" for bank earnings is nearing an end. To paraphrase my pal Joanie McCullough at East Shore Partners, "get used to it."
For JPM, the cost basis for the AFS portfolio was $360 billion at the end of Q1 2013. Unrealized gains net of losses were about $10 billion or 3%. If you figure that the Bernanke shock was good for an average loss of about 7% across the portfolio, then JPM is looking at an unrealized loss of about $12 billion going into Q2 earnings.
Keep in mind that half of the JPM AFS book is agency securities which have moved down in price 2x vs. comparable duration Treasury securities, so the gross losses could be higher than our speculation above. Going back to the issue of duration, the average life of agency paper has been lengthening. Combine long duration with extremely low coupons and widening spread relationships and these securities become very dangerous during times of market turmoil.
The AFS book for C was about $280 billion at the end of Q1 2013, including about $60 billion in MBS, $90 billion in Treasury and agency securities and $80 billion in foreign government securities. C reported net gains of about $2.5 billion or less than 1% of the total, so figure that the Bernanke Shock wiped out the gains in the portfolio and pushed it into loss to the tune of about $12-15 billion. Keep in mind that hedges and derivatives may mitigate some of these losses, but don't look for gains on AFS positions to bolster C's earnings due to Q2 2013 losses.
At WFC, the AFS book totaled about $240 billion at the end of Q1 2013, including about $130 billion in MBS. WFC reported net unrealized gains of about $13 billion or about 5% of the total at the end of Q1 2013. Figure that the Bernanke Shock wiped out these gains and generated gross unrealized, non-cash losses of a further $10-12 billion because of the large proportion of MBS and agency paper.
At the end of Q1 2013, BAC actually reported a net loss on its AFS book of $9 million. BAC has been aggressively selling higher coupons to augment earnings. In the Q1 2013 10-Q, BAC talked about how "a decrease in unrealized gains in accumulated other comprehensive income (OCI) on available-for-sale (AFS) debt securities" had negatively affected earnings. Look for more of the same in Q2 2013.
At the end of Q1 2013, total AFS securities held by BAC was $350 billion. The bank reported net unrealized gains of $8.8 billion or about 2.5% of the total AFS book. As with WFC, more than half of AFS securities at BAC were in MBS. Since these securities have been moving at a multiple to the moves seen in comparable maturity US Treasuries, it seems safe to assume that the AFS will show a fair value loss in Q2 2013. Call it a minus $16 billion gross, non-cash loss before any hedges or other offsetting factors.
While the mark-to-market losses at BAC and other banks in Q2 2013 will get a lot of media attention, the real problem lies down the road as rates rise and bank cost of funds normalizes. Indeed, if we see a rally during Q3 2013, many of the paper losses on AFS positions could be reversed. But in terms of cash flow, the picture is very different. As in the 1970s and 1980s, in a couple of years BAC and other banks face the prospect of being in a negative cash flow position with respect to many of the securities issued by the US government and agencies during the period of QE. Then the next Fed Chairman will need to explain why the benefits of QE were worth the trouble affecting the nation's banks. Stay tuned.
The above is a bit technical, but the gist is pretty simple: The big banks own a ton of securities that will plunge in value if interest rates rise. Accounting rules require the banks to tell us when it happens, which means huge losses, plunging share prices and some outright failures. The latter might threaten the survival of other banks on the hook for various kinds of derivatives, taking us back to 2009, where $10 trillion of taxpayer money is all that's standing between us and marshal law.
This explains Fed chairman Bernanke's quick retraction of his "tapering" comments and his renewed promise of low interest rates and debt monetization for as far as they eye can see. He knows now what will happen to bank balance sheets and earnings if rates rise even a little from here. The problem is that low rates created the imbalance in the first place, and the longer they're in place the bigger the imbalance will become. So as with so most policy decisions that follow a debt binge, the choice is unacceptable pain today or even greater pain tomorrow.
Because "tomorrow" will be experienced by other people, today's politicians and bureaucrats will always choose pain then over pain now. Ben Bernanke, for instance, is due to shuffle off to high-prestige retirement within the year, leaving his successor to oversee the implosion of the banking system.