This morning I was thinking about banks. I am putting my thoughts down in the hope others will offer criticism of my reasoning and conclusions.
Banks have a major profit stream from borrowing short-term and lending long-term and arbitraging the gap in rates over time, of an ordinary yield curve.
Currently the yield curve is inverted. Very much so; both in steepness of inversion, and also in terms of the time periods/terms over which the inversion holds.
Lending long-term and borrowing short-term now causes you to bleed money. This seems to be bad for banks.
There are essentially two ways the yield curve can un-invert. Either short-term rates go lower and stay low, or long-term rates go higher, and stay high.
This gives three possibilities in the coming 12 months. A) the yield curve remains persistently inverted B) the yield curve uninverts as short-term rates drop significantly. C) the yield curve uninverts as long-term rates rise significantly.
Looking at each in turn:
A) Banks may make money from other sources in future, but not from deposit/long term loans. This will reduce profits. A persistently inverted yield curve might also expose unforeseen weaknesses in credit markets, wherever participants have acted according to models that did not see it as possible.
B) A significant drop in short-term rates in 2023 will cause a reignition of inflation. Presumably, this will not be allowed by the Fed, and they have indicated along these lines.
C) A significant rise in long-term rates will cause bond-holdings of the banks to devalue (bad for book value / short-term earnings). It will increase funding costs for banks. It will trigger a deeper housing crash and defaults. It will trigger increased default on corporate lending by banks. This will be bad for banks and bank stocks will be carried down in the general malaise that ensues.
A&C are bad, and B is unlikely or perhaps impossible.
What is the bull case for banks? Why are people buying them? What am I missing here? Or is it even worse than I think?
Lastly, I should note that the outlook for banks in different countries is quite different. In the US & EU, banks make e.g. 20y housing loans, and in the US can offload to FM/FM. In the UK, Australia, Canada, NZ and other countries, banks hold home loans on their books as variable rate loans. In some countries banks are well prepared for problems e.g. reserves, in others, less so.
While this is true, I’d be interested in seeing the real-life cases. For example, if a bank lends money at 6.375% on a 30-year mortgage while getting the money to fund it by issuing 4.25% 3-year CDs, do they lose money? What happens if in 3 years from now that CD is only 3%?
Another example. If a bank has an online bank that garners lots of savings deposits at a 2.75% rate, and that same bank issues credit cards that charge 16.75% interest, and have a 2.93% default rate, does that bank lose money (at least on a run rate basis)?
The banks do not borrow much at the FF rate. That is not how the FED really works. It is marginal. The current FF rate is taking liquidity out of the market by drawing down lending as the banks wont borrow as much to beef up their reserves to lend at these rates against lower longer term rates for borrowing.
But all bets may be off very soon on the inverted yield curve. The selling of US paper may see the long end of the yield curve spiral out of control before the end of March.
I don’t think that quite an accurate representation.
Take mortgage rates. Banks can lend at 6%+ but borrow at much much less. Credit card rates are at record highs. Auto loan rates are at an 11 yr high. The cost to borrow from the public (savings interest rates) is still very low (national average is below 1%). CD rates are up dramatically but no where near the mortgage rates.
They rarely borrow much at two years and lend at 10 years. They tend to borrow and lend more toward the front, or short-term, end of the yield curve, which is steep. For example, the spread between the 3-month and 5-year, as shown on the Treasury curve, was about 190 basis points US3MUS5Y=RR on Tuesday.
For example, JPMorgan Chase & Co (JPM.N) funds more than half of its balance sheet with low-cost deposits, the cost of which tends to move up very slowly. The average rate for all of JPMorgan’s interest-bearing liabilities in the fourth quarter was only 0.22%. That is a long way from Tuesday’s 2.4% yield on 2-year Treasuries US2YT=RR.
The FED is not really doing much raising the FF to cut off borrowing.
The FED is forcing the US paper around the global to be sold. As yields rise generally other nations are losing money holding US paper. That is not just the moves by the FED. It is the nature of the entire period coming off of zero rates during Covid.
The curve is suddenly revert from inverted in the next couple of months.
For example, if a bank lends money at 6.375% on a 30-year mortgage while getting the money to fund it by issuing 4.25% 3-year CDs, do they lose money?
I was thinking about lending in the ongoing sense rather than lending initiated now.
i.e. if you lend out a mortgage for 30 years in 2021 at 2.5% fixed (or e.g. 2-5 year fix/discount), then have to match that with short-term borrowing, you end up with 2.5% coming in and 4% going out or whatever.
It likely depends on the balance of fixed/variable rate mortgages and the extent to which mortgages are offloaded to investors/government agencies in different countries.
The heart of it is the pace of the selling. It will steepen. Or could? I am not an expert on the future numbers. Yellen and Powell have put plans in place.
The bonds are up because the FED has slowed its rate hikes. The news of that, the perceptions of that and that business and the economy are good play a role.
The other matter in the wings, as JPY and EUR appreciate the need to sell US paper is reduced. Getting those currencies to appreciate was the issue. The trade is now on…how far will it go? Yellen really expects the long end of the yield curve to spiral upward.
Also in the US the economists are not expecting total hell next year. We have more visibility.
That leaves the swap market…need to sleep on it…as that data formulates I might see something in it.
The better-than-forecast results were due largely to JPMorgan seeing net interest income climb as a result of the Fed’s rapid rate-hiking path over the past year.
JPMorgan blew by analyst estimates, propelled by income from higher interest rates. The largest bank in the U.S. by assets reported a net income of $12.62 billion in the first quarter, compared with $8.28 billion a year ago.