EDITOR'S NOTE:At the peak of a heating economy, financials typically do well as banks benefit directly from higher interest rates. But that only lasts as long as consumer demand sustains itself. We’re past the peak stage and entering contraction. Interest rates are still dominating the financial news but in a manner that reflects the downside of an economic cycle. And the negative effects of high rates are concentrated in the mortgage market. Banks have lost $17 billion in paper losses. The irony is that yesterday's Housing Starts and Permits came in hotter than expected. No developer starts new homes unless they’re certain they can sell them. But who’s buying? It’s a confusing landscape, yet it’s one that hovers over the economy like a dark cloud. Here’s how experts are weighing in on this seemingly contradictory market environment.
(Bloomberg) -- Higher interest rates helped Wells Fargo & Co. land more than $3 billion in profit in the third quarter. From a capital perspective, they also wiped out nearly three-quarters of that.
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While rising rates buoy revenue for the country’s largest banks, in the short term they also force them to write down the value of assets they hold on their balance sheet, exacerbating a capital squeeze that’s prompted most of them to halt buybacks. At Wells Fargo, it was an additional $2.4 billion in unrealized losses on mortgage-backed securities and other bonds that weighed on shareholder equity in the third quarter.
Wells Fargo’s three biggest rivals took a similar hit. On mortgage-backed securities alone, the four banks’ unrealized losses have climbed to $17 billion, based on company filings.
“When it comes to managing capital, we should be extremely conscious of what the risks are that are around us,” Wells Fargo Chief Executive Officer Charlie Scharf warned last month, citing swings in the value of the bank’s investment portfolio as well as geopolitical risks. “Those are all reasons, given where we sit today, to be more conservative on capital rather than less conservative.”
The unrealized losses don’t appear on the firms’ income statement, but under accounting rules they still end up hitting the banks’ balance sheets, affecting so-called accumulated other comprehensive income, or AOCI. There, the country’s four largest banks -- JPMorgan Chase & Co., Citigroup Inc., Bank of America Corp. and Wells Fargo -- reported a $16 billion drop in AOCI for the third quarter, to negative $102 billion, company filings show. Because swings in AOCI affect shareholder equity, the drop in AOCI has weighed on key capital ratios.
The writedowns come at a tough time for banks, which are trying to hoard capital to meet new, higher regulatory requirements. They’re just one of a bevy of headwinds weighing on capital ratios. Others include new accounting rules that say banks must set aside even more in reserves as a result of rising inflation that’s threatening the overall economic outlook. And with markets on edge over the Federal Reserve’s rate hikes, banks have also been battling back an increase in risk-weighted assets, which are used to determine minimum capital levels.
“The banks, in general, are taking the necessary actions to maintain sound financial profiles amid a deteriorating economic backdrop despite these headwinds,” Julie Solar, who tracks North American financial institutions at Fitch Ratings, said in an interview. Still, she said, it’s likely “share repurchases will be curtailed or continue to be suspended as the banks meet their capital requirements.”
Capital ratios at Wells Fargo not only exceed regulatory minimums, they’re also higher than buffers set by the bank’s management. Still, the company and its rivals looked to their portfolios of mortgage-backed securities as they prepared for the shift in interest rates.
Many firms moved billions of dollars of those assets into their so-called held-to-maturity portfolios in order to boost capital. The value of such securities has surged to $802 billion from $495 billion at the start of the pandemic at the country’s four largest banks, according to company filings. For bonds in that pile, the recent softening of the mortgage and broader markets won’t affect capital ratios.
“What’s a little bit different is how quickly this has occurred, how quickly you’ve seen banks react to it and the utilization of held-to-maturity much more actively,” said Greg Hertrich, head of US depository strategies at Nomura. “They were prepared for it, and when the market moved as quickly as it has, they were able to pivot.”
Still, the country’s four biggest banks are sitting on $157 billion of mortgage-backed securities they’ve marked as available for sale. Paper losses on those assets have soared in recent quarters, hindering efforts to boost capital.
Take Citigroup: The company has said it’s hoping to increase its CET1 ratio to 13% by the middle of next year, up from 12.3% in the third quarter. In June, the Wall Street giant transferred $21.5 billion of agency residential mortgage-backed securities to its held-to-maturity portfolio. That’s helped cut unrealized losses on such securities almost in half.
At JPMorgan, unrealized losses on mortgage-backed securities in the available-for-sale portfolio reached $7.4 billion in the most recent quarter. That’s after the firm transferred $73.2 billion of investment securities from available-for-sale to held-to-maturity in the second quarter, citing capital management as the reason.
Chief Executive Officer Jamie Dimon has long preferred keeping investment securities available for sale, rather than holding them to maturity, because it provides greater flexibility to buy and sell securities when the bank wants to, according to people familiar with his thinking.
In the third-quarter, investors got a taste of what that preference might cost them when JPMorgan reported a $959 million loss from selling some of its available-for-sale US Treasuries and mortgage-backed securities. Even so, the CEO said he still expects his firm to reach a Common Equity Tier 1 ratio of 13% in the first quarter. The firm ended the most recent period with a ratio of 12.5%.
“We don’t want to be locked into something we think will get worse and not take a chance to buy something that we think will get better,” Dimon said.
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Originally published on Yahoo Finance.