Jeff Davis is a veteran bank analyst. The views and opinions expressed in this piece are those of the author and do not necessarily represent the views of S&P Global Market Intelligence; Mercer Capital, where Davis is the managing director of the financial institutions group; or StillPoint Capital, where Davis is a registered representative.
To the surprise of no one, the Fed raised its short-term policy rates 25 basis points on Sept. 16, pushing the rate paid to banks who deposit cash with it to 3.88%.
Regardless of what one reads in the media, the Fed again followed the bond market and not the other way around. Yields across the coupon curve from two-year to 10-year notes rose over 100 basis points or more since the war with Iran began on Feb. 27 to yield about 4.7% and 5.0% as of Sept. 18.
The upside of rising rates for fixed-income investors is that cash flows can be reinvested at higher rates, but many bank bond portfolios continue to be burdened with low-coupon bonds and mortgage-backed securities (MBS) that have suffered extension risk as prepayments slowed. Worse for banks and other investors in the "carry trade" is when short-term funding costs rise, too, and thereby narrow the spread. As an attorney once said to me about a client holding a bad hand, bad news does not age well.
During the past month or so, Trustmark Corp., United Community Banks Inc. and Farmers & Merchants Bank of Long Beach announced balance sheet restructuring charges. More will be announced in the coming weeks.
Farmers and Merchants, Trustmark and United Community Banks recognized mark-to-market losses by reclassifying bonds that had been carried at cost and accounted for as "held-to-maturity" as "available for sale." The trio then restructured the portfolios by selling bonds with nominal yields — 1.4% in the case of Trustmark and Farmers and Merchants — and redeploying into higher-yielding securities and/or cash parked with the Fed.
Could rising rates uncover old or new issues in the banking system that have remained out of view?
Investors had little reaction to the announcements, and I do not think the muted reactions in the case of United Community and Trustmark were attributable to offsetting gains from other asset sales. The "held-to-maturity" issue, in which many banks have classified longer-duration MBS and municipal bonds with sizable losses, is more nettlesome for private banks because often the investors and sometimes the boards do not understand the issue that is masked by carrying underwater bonds at cost.
While bonds are easy to see, there still may be hidden damage in the financial system from 14 years of zero or nominal Fed policy rates. Whether brilliant, lucky or both, the Fed program that allowed banks to borrow by pledging government-backed securities based upon their par value rather than market value kept the banking system liquid in 2023 after Silicon Valley Bank failed and averted a disaster.
Could rising rates uncover new issues or reveal ones that have remained out of view while the Fed cut rates in the fall of 2024 and 2025?
Commercial real estate (CRE) lending is an obvious concern given the sensitivity of property values to changes in rates, though banks have navigated the repricing of CRE loans reasonably well so far, as opposed to the commercial mortgage-backed securities market, which is stressed with a delinquency rate near 8%. And perhaps some life insurers will face issues to the extent they over-invested in private credit to pick up yield.
BCB Bancorp Inc. has a new CEO who has moved decisively to put bad news in the rearview mirror with a $98 million common raise in mid-September to create capital headroom to incur credit costs upwards of $120 million and record a $50 million deferred tax asset valuation allowance. The balance sheet cleansing was attributed to overly aggressive lending during 2020 through early 2023.
I think banks will experience a limited give-back of the margin expansion they experienced the past year.
Unlike the three bond portfolio restructurings, BCB's restructuring was far more consequential for shareholders. Tangible book value per share of $7.75 was presented on a pro forma basis in the investor deck for the offering, compared to $14.73 per share as of June 30. Investors knew the raise was coming, with the shares trading at a steep discount to book value for some time.
For now, I think banks will experience a limited, and maybe just nominal, give-back of the margin expansion they experienced the past year as funding costs declined more than earning-asset yields for many banks. Deposit pricing competition is intense, and balance sheets are not as liquid as was the case in 2022.
Nonetheless, hopes that "lower" rates would solve issues with problem bond positions and loans are not playing out. The market tends to take a path that inflicts the most pain on positions that need an opposite outcome.
