Pondering Q3 2018 earnings for financial firms and surprises that may lie ahead, the conventional wisdom on Wall Street is that higher interest rates are good for banks. But, while rates are currently rising, it’s higher interest-rate spreads that really matter.

Today, spreads are contracting as the Federal Reserve’s Federal Open Market Committee forces short-term interest rates higher. There is actually little demand in the market for higher short-term rates — but who needs demand when we have economists?

That begs a question: Will the FOMC’s relentless quest for “normal” (as defined by the Fed Funds Target Rate) cause a liquidity squeeze among non-bank financial companies later this year or early in 2019?

Last week, the entire Treasury yield curve moved about 25 basis points higher, a remarkably synchronized shift upward that caused many financial stocks to rise in reflexive response.

However, apart from an uptick in high-yield spreads (also last week), the corporate bond complex continues to see spreads grind lower on brisk investor demand. And loan spreads, which compete with bond-market execution and private equity, are not moving.

Meanwhile, in the world of non-bank finance, the prospect of rising interest rates is adding a significant burden on heavily leveraged lenders in the mortgage and consumer finance sectors.

Christopher Whalen

Wells Fargo, Chase, and many others are shedding thousands of staff to right-size shrinking residential lending businesses. There is already a steady outflow of firms and people as smaller issuers quietly shut their doors. We estimate that a significant portion of the issuers in the Ginnie Mae (GNMA) market could be out of business within the year.

Last week some of the biggest non-bank U.S. mortgage lenders declared that while they’re not yet concerned about credit quality, they are very concerned about industry liquidity.

In particular, the risk of over-leveraged developers of multi-family properties going bust is seen as a clear and present danger. By no coincidence, commercial banks are bidding aggressively for deposit business, well in excess of LIBOR plus 1%.

Well more than half of the non-bank lenders in the residential mortgage finance space are probably in breach of loan covenants due to poor profitability, low capital, or both. The question arises as to whether anyone at the FOMC is cognizant of this growing crisis.

Non-banks are, after all, the customers of banks, typically the top 50 or so institutions. We wonder if chairman Jay Powell and his colleagues on the FOMC will start to rethink the plan for boosting short-term rates further when a couple of large GNMA seller/servicers fail and file bankruptcy.

“In years that end with eight — like 2008, 1998, and 1988 — we tend to see bad stuff happen,” notes one veteran mortgage banker. “When we’ve seen Treasury yield spreads invert, it is without exception a precursor to a liquidity issue. Today we have a non-bank mortgage finance industry levered a zillion to one with no credit risk, falling volumes and spreads, and no profits. We have to borrow money to make money, so higher interest rates are bad.”

Something that economists and many investors fail to appreciate is that an increase in the absolute rate of interest in the market raises the overall cost of funds for banks as well as their customers. The rate charged for advances to fund new mortgage loans or to resolve delinquent loans is an important variable cost for a non-bank.

Rising rates are a significant negative factor in terms of credit quality for these highly leveraged businesses. Rising funding costs can also negatively affect the value of mortgage-servicing assets.

The cost of funds for U.S. banks is increasing about 55% every 12 months, but interest earnings are rising by single digits. Thus, we predict that the growth rate of bank net interest income will flatten out and then go negative in 2019.

This developing squeeze on net interest margins is another example of the collateral damage caused by the “extraordinary” policy actions taken by the Fed from 2009 to 2015. What the Fed had giveth in previous years, the Fed now taketh away by arbitrarily raising funding costs.

We keep wondering why chairman Powell and other members of the FOMC refer to the current state of U.S. monetary policy as “accommodative” when asset prices in housing, commercial property, and stocks are at record levels.

And there is still a shortage of assets, real and financial — in technical terms, a dearth of duration — measured in the trillions of dollars. For this reason, we fully expect the 10-year Treasury bond to take a run at 3% yield between now and the end of the year as markets discount further Fed actions on interest rates.

Without an increase in spreads on bonds and loans of all types, it’s difficult for banks to reprice their assets to adjust to rising funding costs. Take JPMorgan Chase (JPM), for example. At JPM, less than half of the total book is actually loans. The overall return on assets is dragged down by the relatively low returns on the bank’s bond portfolio.

In the second quarter JPM earned 2.1% on its $2.5 trillion in assets after funding costs, vs. a weighted average of 3% for the other 118 U.S. banks with more than $10 billion in assets (designated as “Peer Group 1” by the FFIEC).

On the other hand, the bank earned a little over 5% gross spread before funding costs on its lending book — better than three quarters of its peers, with an average almost a point higher than the overall market average.

On the liabilities side, the cost of interest-bearing balances at JPM was 1.45% for Q2 2018, up 40 basis points since the start of the year. When you ponder the fact that this cost-of-funds figure could be 2% by year end, you start to appreciate the enormity of the surprise in store for investors in bank stocks.

As of Friday’s close, JPM was trading over 1.6x book value on a beta of 1.1. The Street has JPM delivering single-digit revenue growth through 2022, but we suspect that those forward revenue estimates will be revised downward in good time.

Of course, earnings-growth estimates are in the 20% to 30% range, suggesting continued cost cutting. Indeed, a number of sell-side firms have recently boosted earnings estimates for JPM.

The two key factors behind large bank earnings over the past decade are (1) cheap funding from the FOMC, and (2) cost cutting. As quarterly funding costs for U.S. banks “normalize” from $30 billion for Q2 2018 to more than $40 billion by year-end, revisions to earnings estimates for JPM and other banks may start to turn downward.

Given where interest rates are today, quarterly bank funding costs should continue to climb into the $60 billion to $70 billion range by next summer.

When people stare at the numbers for the banking industry and try to guess what is going to happen next, they most often end up talking about the past. Understanding the oscillating cycles of credit, liquidity, and market risk is perhaps more important.

At present, high home prices and low loan-to-value (LTV) ratios provide a buffer for banks and investors against credit risk. We don’t expect to see significant credit losses on residential assets in the banking system for several more years.

But there is considerable liquidity risk building in the financial markets as the FOMC continues its clumsy path toward normalization. Former Fed governor Kevin Warsh is right: the FOMC should have reduced the balance sheet before raising the Fed Funds rate.

Past actions by the U.S. central bank have distorted traditional indicators of credit demand, raising the possibility that market conditions actually are tighter than policy makers may suppose.

Inverted yield curves may not predict recessions, but they do serve as a great indicator of liquidity risk events.

Christopher Whalen is chairman of Whalen Global Advisors, a provider of investment banking and consulting services to institutional investors and corporate clients worldwide. This article was initially published in Whalen’s online publication, The Institutional Risk Analyst. It is reprinted here with Whalen’s permission.

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