Submitted by Chris Whalen, Chairman of Whalen Global Advisors LLC in New York and publishes The Institutional Risk Analyst blog.
It is axiomatic among investors that rising interest rates are good for banks in terms of enhancing earnings. But this is not necessarily true. In fact, banks make money on widening interest rate and credit spreads, namely the different between the cost of money and the return on loans and investments. Rising rates can be a mixed blessing.
In the 1980s, sharply higher interest rates during the term of Federal Reserve Chairman Paul Volcker essentially destroyed the housing finance sector in the US. Fixed rate mortgages and rising interest expenses led to widespread insolvencies in the savings & loan sector that cost US taxpayers hundreds of billions in losses. Today the situation facing banks in the US is equally dire yet is largely unrecognized by the financial markets and policy makers.
Since the 2008 financial crisis, the Fed, ECB and Bank of Japan have suppressed the cost of funds, providing an enormous subsidy to bank equity holders and debtors at the expense of individual savers and bond investors. In 2015, for example, the cost of funds for the $15 trillion in US bank assets fell to just $11 billion per quarter. Prior to 2008, that number for quarterly interest expense was close to $100 billion. In Q2 ’18, the US banking industry reported net interest income of $161 billion vs a cost of funds of just $27 billion. The latter figure showing interest expense is almost doubling every 12 months.
With the Fed now tightening policy, both by raising the target for short-term interest rates and by allowing its balance sheet to shrink, US banks are facing the prospect of rising interest expense and shrinking net interest margins. At the end of the second quarter of 2018, the larger US banks saw their cost of funds rising by more than 55% year-over-year while interest earnings were increasing by about 1/10th that amount. By Q4 ’18, interest expense will be around $40 billion per quarter and rising faster in dollar terms than interest earnings for all US banks.
Based upon projections by Whalen Global Advisors, net interest income for all US banks will cease growing by year end and will be visibly declining in Q1’19. In the event, the superficial narrative parroted by Wall Street pundits that rising interest rates are good for banks and other leveraged investors will be shown to be a complete nonsense. Bank profits since 2008 have been supported by cheap funding, not robust asset returns, a situation that is rapidly changing. Will Chairman Powell wake up before we run the good ship Lollipop aground?
Indeed, one reason that the ECB is reluctant to follow the example of their counterparts in the US by raising interest rates is because EU banks could never withstand such a change in funding costs. As one ECB official told this writer in June, “we intend to reinvest the proceeds of quantitative easing indefinitely.” BTW, the decision by Chinese conglomerate HNA to exit its incredible equity stake in Deutsche Bank now begs the question with respect to DB and the broader question of prudential supervision in Europe.
Adding to the dilemma facing Fed Chairman Jerome Powell and his colleagues on the Federal Open Market Committee is the fact that the trillions of dollars worth of securities purchased by the Fed, ECB, BOJ and other central banks since 2008 has effectively capped asset returns. Central bank action to lower interest rates drove the return on earning assets for US banks down from well over 1% to just 70bp last year. The gross spread, before funding costs, of the top 100 US banks is just 4%. Margins for loans and securities are brutally tight.
As interest expenses for banks rise at double-digit rates, asset returns are barely moving, as illustrated by the sluggish response of the benchmark 10-year Treasury to Fed rate moves. For the largest US banks, gross yields on their loan portfolios are below 3%, a reflection of the still tight credit spreads visible in the bond and debt markets. Competition for assets is intense, effectively making it impossible for banks to grow their profit margins on loans even as short-term rates rise.
So long as the Fed and other central banks retain their nearly $9 trillion in securities, the effective return on loans and securities will be muted. Central banks do not hedge their positions or even trade regularly, thus there is no selling pressure on long-dated securities. While the FOMC under Chair Janet Yellen was perfectly content to manipulate long-term interest rates downward via “Operation Twist,” when the Fed purchased long-term securities and sold shorter duration bonds, now the Fed sits by and does nothing as the Treasury yield curve threatens to invert.
The strange asymmetry in Fed interest rate policy threatens the soundness of the US banking industry and, with it, the growth prospects of the US economy. Just as a mismatch between rising interest rates and fixed-rate mortgages destroyed the S&L industry in the 1980s, US banks today face a market environment where funding costs are rising, but the returns on loans, securities and other assets are not increasing commensurately. Indeed, the dearth of duration in the market continues to put downward pressure on spreads.
Simply stated, banks in the US are about to get caught in an interest rate squeeze of gigantic proportions. In order to avoid this approaching calamity, the Fed needs to start outright sales of longer term securities, essentially the reverse of Operation Twist. They might also have a chat with the Treasury about issuing longer dated paper, as we recently discussed in The Institutional Risk Analyst.
Even sales of long-dated swaps and futures would be helpful to manage the transition back to “normal” that Chairman Powell has professed to be the goal of the US central bank. Given Powell’s previous statements in 2012 about the duration of the Fed’s bond portfolio, one wonders what he is waiting for when it comes to managing this dangerous situation.
By law the Fed is responsible for managing interest rates and employment, but in fact the yardsticks used by the American political class to measure the job performance of Chairman Powell and his colleagues on the FOMC are the debt and equity markets. Should the Fed continue its “do nothing” approach to monetary policy normalization, then we are likely to see an inverted yield curve, then a selloff in global equity markets led by financials and finally shrinking profits in the US banking system early next year. These three eventualities may very well ensure that 2019 is a recession year in the US.