Chief Investment Officer
BirdsEye Viewinterest rate risk
Regulatory risk has been the number one risk in our industry, replacing credit risk at the top of the charts for the past couple of years. But interest rate risk isn't far behind. Previous indications suggest that easing will cease once unemployment hits 6% (which is likely to happen in 2014, not necessarily due to job growth but more due to the decline in the size of the workforce, with more women and older people exiting the working ranks).
Yet valuations and margin expectations for asset-sensitive midsize banks aren't meaningfully different from other banks. High profitability banks have experienced the greatest stock price appreciation YTD in the KBW universe (44%), a reflection of the shift from the TCE and asset quality focus to EPS and revenue growth. Credit recovery stories and sellers have outpaced the asset-sensitive banks in terms of stock performance, and high capital banks bring around the rear (2.9%). The world certainly has changed.
Banks are now being rewarded for revenue growth and transformational deals rather than for a fortress balance sheet and strong capital positions. Loan growth and more aggressive investment portfolio strategies seem to be at the forefront of many bank executives' minds. KBW has revised 12014 upward for 2/3 of their SMID cap bank universe, and the revisions are largely due to revenue growth through margin expansion (expected to reach 3.59% next quarter, still a far cry from the historical 4.41%). Performance is further burdened by rising efficiency ratios (211bp 2013E vs. an 18 year median), and capital levels nearly 2% higher during the same time frame. In addition, overcapacity makes it difficult to get paid for credit risk, and deposit pricing can't go below zero.
So the pressure on improving asset yields by going longer and/or relaxing credit standards is acute. Does the yield pickup justify the incremental risk? And, more importantly, can we measure that risk, especially when it comes to interest rate risk?
We are at a point in time where the past is not a good indication of the future. Many mortgage holders, whether outright or as securities, still assume pre-crisis durations in their models, while the extreme low rate environment we live in implied durations extending beyond past expectations. Are old duration models breaking?
As Jefferson Harrelson pointed out to me the other day, in recent weeks mortgage REITs such as Two Harbors decided it is too risky to lever capital into mortgages. Instead, they de-levered their balance sheet at the near-term cost of 30% EPS decline. US global banks have also reduced their mortgage balance sheet holdings at a dramatic rate ($20B in the week of 7/24/13). The message: mortgage balance sheet portfolio might be too risky in today's rate environment and with respect to newly forming customer behaviors.
Mortgage-heavy banks have enjoyed 21% stock appreciation YTD, in part due to their postfolio-ing strategy. It's time to pay close attention to asset duration, yield curve movements, and other players' movements before continuing full-bore ahead. The new patterns need to be more fully formed to provide sufficient comfort with model assumptions for both mortgages and MBS holdings going forward.