“The investor will achieve a fully compounded yield equal to the bond’s stated yield to maturity at the time of purchase only if he can reinvest all coupons at his purchase yield.”
Sidney Homer, Martin L. Leibowitz
On July 8th, ZH published an important article (Chart Of The Day: Taper Fears Lead To Biggest Monthly Loss In Bank Securities Portfolios Since Lehman) describing the possible mark-to-market losses that many banks and other investors in fixed income securities may face as a result of the market rout that occurred last month. For those of you have just awoken from cryogenic freeze, the fun began when Fed Chairman Ben Bernanke held a press conference last month and suggested that the Fed’s purchases of Treasury and agency securities was nearing an end. ZH:
“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.”
Over the past few years, Bernanke and the other inhabitants of the fantasy world we refer to as the Federal Open Market Committee have convinced themselves that taking hundreds of billions of dollars per month worth of duration out of the financial markets has no consequence for the economy or the banking system. There is also a large body of opinion among economists that ending the purchase of tens of billions of dollars’ worth of securities each month via QE does not represent a change in policy so long as short-term rates remain low.
For those of you unfamiliar with the term, think of duration as the time value of money, a way to measure the “weight” of securities on the financial markets. In terms of bonds, it measures how long, in months and years, it takes for a bond to be repaid by its internal cash flows. It is an important for our discussion about QE because bonds with higher durations (and lower cash flow) carry more price volatility than bonds with lower durations. For a zero coupon security, for example, the duration is the stated maturity.
For the past few years, the Fed has taken most of the weight of securities issuance by the Treasury and housing agency off of the markets in an effort to keep interest rates artificially low. By suggesting that quantitative easing or QE would end, Bernanke caused the bond and stock markets to sell off dramatically. Why? Because the decimated US fixed income dealer community realized that they would soon be asked to again support the full weight of debt issuance by the Treasury and GSEs – even if rates remain low through 2015. The chart below shows the movement in the one-the-run agency market.
The market rout following the relatively benign comments by Chairman Bernanke has both short-term and longer term consequences. In the near term, the impact of the “tapering” of QE is likely to be significant mark-to-market losses on the available-for-sale or AFS portfolios of many financial institutions in Q2 2013. The fact of both extending durations and widening spreads between Treasuries and MBS created a double-whammy for the banks. The timing of Bernanke’s remarks just before the end of the quarter was very poorly chosen and reflects an almost childlike naiveté on the part of the Fed staff. This is one of the negative aspects of packing the Fed board with academic economists who have no significant market experience. Duh, right?
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 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. Bob Eisenbeis at Cumberland Advisors puts it well:
"The market turmoil that followed the last FOMC meeting suggests it may be time for a primer on the relationships among the Federal Reserve’s asset purchase program, its Federal Funds rate target policy, and its unconventional policy at the zero bound. What are these programs and how do they fit together? It turns out that they are more closely intertwined than the discussions so far have suggested."
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.