impact of low interest rates

[bmichaud]

Eric,

 

I have had a long weekend so am likely not thinking clearly, but why would BAC earn money on its NIBD base if the base rate went up to 2%? Are those NIBD not already lent out in the form of mortgages and securities held? If the base rate went up to 2%, would BAC not need to in fact pay the $7B extra you are referring to?

 

Again I'm likely not thinking clearly, but generally I am struggling to see why the banks will benefit from rising rates when NIMs are near historic norms right now. In fact, I would imagine a rising rate environment with NIMs near historic norms would be rather negative for book values as securities are MTM via the OCI line on the balance sheet that is conveniently excluded from the income statement....witness BAC and AIG's book values this quarter declining bc of rising rates....

[Palantir]

There is a clear case that suppressed rates are very much the expected case in a deleveraging/post deleveraging environment.

 

And that's "usual" environment?

 

Yes.

[ERICOPOLY]

There is a clear case that suppressed rates are very much the expected case in a deleveraging/post deleveraging environment.

 

And that's "usual" environment?

 

Yes.

 

I see, everything is east of Callifornia because if you keep going east, you get back to California!

 

Similarly, everything is "post deleveraging" environment.

[ERICOPOLY]

Eric,

 

I have had a long weekend so am likely not thinking clearly, but why would BAC earn money on its NIBD base if the base rate went up to 2%? Are those NIBD not already lent out in the form of mortgages and securities held? If the base rate went up to 2%, would BAC not need to in fact pay the $7B extra you are referring to?

 

Again I'm likely not thinking clearly, but generally I am struggling to see why the banks will benefit from rising rates when NIMs are near historic norms right now. In fact, I would imagine a rising rate environment with NIMs near historic norms would be rather negative for book values as securities are MTM via the OCI line on the balance sheet that is conveniently excluded from the income statement....witness BAC and AIG's book values this quarter declining bc of rising rates....

 

Bruce Thompson put out a mid-$7billion figure for how much a 200 bps parallel shift in interest rates would benefit BAC.  How could that be if not for the noninterest-bearing deposit base?  The other deposits would rise in cost by 200bps.  And what a coincidence, 2% of their noninterest-bearing deposit base is roughly the figure he threw out.  So that's where I'm coming from with that.

 

A couple of things that I don't presently have BAC's quantities for:

 

their mix of adjustable interest rate loans

proportion of their loans near maturity (to be rolled at higher rates)

 

Regarding AOCI -- doesn't matter if we're just talking about 200 bps.  The extra $7+b income that Bruce Thompson stated would boost earnings by 45 cents per share (after-tax, fully diluted).  That's a $5 gain in the stock at 11x earnings. 

 

The book value has been $20 for quite some time, but not the stock.  That's because of the earnings.  Book just doesn't matter. 

 

Stock buybacks also eat up capital -- and they don't boost earnings the way Bruce Thompson is talking about.  It doesn't make sense that people want stock buybacks but fear a 200 bps rise in rates.  You get more earnings bang for the buck from the rise in rates.

 

[ERICOPOLY]

but generally I am struggling to see why the banks will benefit from rising rates when NIMs are near historic norms right now.

 

Here are some of BAC's historical numbers which are considerably higher than today:

 

Net Interest Yield:

 

2003  3.36%

2002  3.75%

2001  3.68%

2000  3.20%

1999  3.45%

 

 

The business mix is different today (Merrill) and that might be dragging down NIM, but look at what BAC achieved in their Consumer and Commercial Banking:

 

2003  4.67%

2002  5.26%

[bmichaud]

Eric,

 

I'm an idiot - should have heeded my own warning of not thinking clearly. I misread something you said previously, and I had WFC's 3.5%+ NIM in my head.

 

BAC's current NIM of less than 2.5% is huge upside relative to its own historical norms and the industry norm (see the attached DB report, and specifically the chart that shows the industry average NIM since 1935 around 3.2%, and closer to 3.75% if you look since the 1950s).

 

Also attached is the historical NIMs for WFC and BAC.

 

Regarding a rate rise's impact on the b/s and i/s....

 

I've attached a very messy example of what I'm talking about. I have not quite figured this out, so this is just me thinking outloud.

 

Say a very simple bank has the following balance sheet/income statement:

 

Loans 1,000 - average yield 6%, duration 5 (i.e. 5% move in value for every 100bps move in rates)

Deposits 900 - average cost 2%

Equity 100 (i.e. levered 10 to 1)

NIM 4%

ALL .50%

Expense Ratio 45% of NII

Tax Rate 35%

Shares Out 10

Fair Value PE 12.5X

FVPS $13.81

 

 

Now - say the long-end of the curve rises 2% and the cost of funds rises 1%, resulting in a 1% boost to NIM.

 

Obviously it is not entirely realistic, BUT...say that the loan book is sold immediately for a 10% loss (5 duration x 2% rise in rates = 10% loss), or $65 after-tax, and reinvested at the new 8% rate.

 

1. The equity base is reduced to $65, and with total assets at $935, leverage is now 26.7X

2. Net Income rises to 13.67, or to with ROA rising to 1.46% versus 1.11% previously

 

So in theory yes, earnings rise and the bank should be more valuable. BUT, in my example, leverage ratio skyrockets to 26.7X versus the 10X regulatory limit....

 

What should this hypothetical bank do to boost its capital base? In my example i assume the bank raises 65 of capital at the "new" FVPS price, which obviously assumes the market gives the bank the benefit of the doubt on the multiple. this capital raise dilutes the share count by over 30%, bringing the "new new" FVPS down to $12.38 assuming a 12.5X fair value PE.

 

 

Obviously there are TONS of moving parts with this. First off, banks do not MTM their loan books - on the flip side this means that the loan book will take longer to reprice to market rates than it takes the deposit base to reprice (i.e. deposits likely do not have a 5y duration in this example), thus crimping NIM in the medium term.

 

Second, what portion of BAC's asset base is comprised of assets that are currently over-earning for this low-rate environment? In other words, how much of the asset base will not in fact reprice upwards when rates rise b/c they are already earning a fair yield in a higher-rate environment?

 

Clearly I have not yet figured this out in my head. It just seems too easy that boom we should buy banks and insurance companies because they will do well in a rising rate environment. There has got to be some consequence of rising rates.

Deutsche_Bank_US_Large_Cap_Banks_101.pdf

WFC_and_BAC_NIM.xlsx

Rate_Rise_Analysis.xlsx

[Peregrine]

So an example.  Take BofA:

 

$363.962 billion in non-interest-bearing deposits

 

That's 1/3 of their deposit base.

 

The low rates are killing their ability to earn.

 

Were the risk free rate on short-term money to rise by 2%, they'd get $7.2 billion more profit from those non-interest-bearing deposits.

 

Hi Eric,

 

I think when interest rates get higher, it will have a host of different effects on many things including the banks' ability to attract as many noninterest-bearing deposits like they have. Would banks be able to retain such a large proportion of cheap deposits when conditions are markedly different five years from now? That's a difficult question. Macroeconomics has so many first-, second-, and third-order effects that a rise in interest rates cannot simply occur in a vacuum.

 

Savings accounts at all US depository institutions have increased 76% since the end of 2008. There clearly has been a "flight to safety" that has aided banks' deposit-taking abilities. The problem is that there isn't enough loan demand to sop up all those deposits.

[hyten1]

does anyone have any historical reference, in past raising rates environment what happened?

 

also it depends on how fast the rates rise too, too fast would be bad for banks ... i think

 

man there is just so many moving parts, how do you know?

[bmichaud]

The Deutsche Bank report I posted talks about the various historical rising rate environments.

[ERICOPOLY]

I've attached a very messy example of what I'm talking about. I have not quite figured this out, so this is just me thinking outloud.

 

Me too.  I'm in no way an expert on any of this.  But I had to start a dialogue so the experts could set me straight.  Otherwise, I don't learn anything.  Plus, I like it when people realize how little I understand -- sometimes I think people give me too much credit simply because I had a great 10 years which was due to cheating off of others' research.  I like to be the underdog.

 

Say a very simple bank has the following balance sheet/income statement:

 

Loans 1,000 - average yield 6%, duration 5 (i.e. 5% move in value for every 100bps move in rates)

Deposits 900 - average cost 2%

Equity 100 (i.e. levered 10 to 1)

NIM 4%

ALL .50%

Expense Ratio 45% of NII

Tax Rate 35%

Shares Out 10

Fair Value PE 12.5X

FVPS $13.81

 

 

What about their long term debt?  That gets re-priced as well (to the benefit of the bank).  In BAC's case, that's $258billion -- 28% of all loans and leases.

 

Then there are variable-rate loans.  I am trying to find that figure for BAC.

 

And MSR rights go up in value when rates rise -- this is because they won't be refinanced.

 

[bmichaud]

Precisely - there are so many moving parts for BAC it makes my example almost not even worth discussing. I just am hesitant to model "new BAC" at a clean 3.5% NIM without any other consequence such as the need to rebuild capital for several years. Who knows. I'd rather just assume book value is a reasonable approximation of fair value and reevaluate when it gets there.

[ERICOPOLY]

The problem is that there isn't enough loan demand to sop up all those deposits.

 

This is one of the things I question. 

 

I know there hasn't been enough demand from highest-credit borrowers to soak up all the deposits.

 

But hasn't there been a class of borrowers shut off from credit that normally had access to it?  In July 2011 I had a net worth in excess of $5m, and I couldn't get a 100k loan at a 50% LTV on a 4-plex in Sacramento with a 16% gross rental yield.  My only other debt was my house mortgage -- less than 400k.

 

They seem to be somewhat full of shit when they say they can't find anyone to lend to.

 

[Peregrine]

The problem is that there isn't enough loan demand to sop up all those deposits.

 

This is one of the things I question. 

 

I know there hasn't been enough demand from highest-credit borrowers to soak up all the deposits.

 

But hasn't there been a class of borrowers shut off from credit that normally had access to it?  In July 2011 I had a net worth in excess of $5m, and I couldn't get a 100k loan at a 50% LTV on a 4-plex in Sacramento with a 16% gross rental yield.  My only other debt was my house mortgage -- less than 400k.

 

They seem to be somewhat full of shit when they say they can't find anyone to lend to.

 

Hmm..that's interesting. If you don't mind answering, what banks did you approach?

 

At face value anyway, all the big banks have been complaining about anemic loan demand - particularly the ones that have weathered the financial storm better than others. I think it's very possible that a select few are seeking to grow market share while the vast majority are still retrenching. I think poor loan growth is due to a combination of both low demand and far stricter underwriting standards.

 

Moreover, F&F make up an even larger percentage of the mortgage market than they did before the crisis so bank's loan growth depends far more on the commercial side than before. Mortgage originations have been at record levels in recent years but commercial loan growth has been flat since 2008 end. Combine that with the fact that deposits have grown 75% over the same time span and it's clear to see that banks have been drowning in cash.

 

Also, the new capital rules are forcing banks to keep a higher percentage of earning assets in liquid securities, meaning less room for loans on the balance sheet anyway.

[ERICOPOLY]

The problem is that there isn't enough loan demand to sop up all those deposits.

 

This is one of the things I question. 

 

I know there hasn't been enough demand from highest-credit borrowers to soak up all the deposits.

 

But hasn't there been a class of borrowers shut off from credit that normally had access to it?  In July 2011 I had a net worth in excess of $5m, and I couldn't get a 100k loan at a 50% LTV on a 4-plex in Sacramento with a 16% gross rental yield.  My only other debt was my house mortgage -- less than 400k.

 

They seem to be somewhat full of shit when they say they can't find anyone to lend to.

 

Hmm..that's interesting. If you don't mind answering, what banks did you approach?

 

 

The big ones, Wells Fargo, Bank of America, plus local banks (although in Sacramento they were in distress).  I had a mortgage broker who was saying nobody was interested.  Excuses were that I had no history as a landlord.

 

My mother was here last week complaining that she can't get a credit card today.  She is denied at Wells, BofA, and JPMorgan.  She has never had a card before, always used my father's.  They are married, never defaulted on a loan, house worth $3m and fully paid off.  No debts!  Over $1m in savings.  But no, she can't get a credit card.

 

My father was denied in late 2011 trying to get a $600k line of credit for his home.  He wanted to use the money to buy out his siblings for the family Palm Beach cottage near Sydney.  He was going to put $1.9m of his own money down, and use the $600k from the line of credit for the rest.  So he would have total real estate of $5m with only the $600k lien on the primary residence.  Nope, denied -- Wells Fargo.

 

Then there is my  sister and their husband -- more than $500k in liquid assets, net worth above $2m, both employed at USC, and their HELOC was frozen on them.  Huh?

 

Not sure what bankers are talking about when they claim there are no creditworthy borrowers.

[Mikenhe]

exactly.. I closed on a house in september and had to use cash. Couldn't borrow a cent from the banks.

 

 

wanted a massive 50% from the bank which would have put the loan at less than my annual salary. Way less than our combined annual salary and at a very low % of our net worth.

 

 

I guess the banks decided that me renting a house at three times the price of the repayment per month was sensible fiscal policy.

[ERICOPOLY]

exactly.. I closed on a house in september and had to use cash. Couldn't borrow a cent from the banks.

 

 

wanted a massive 50% from the bank which would have put the loan at less than my annual salary. Way less than our combined annual salary and at a very low % of our net worth.

 

 

I guess the banks decided that me renting a house at three times the price of the repayment per month was sensible fiscal policy.

 

 

All one has to do is look at all the 100% cash deals that were done the last few years by investors.

 

Does anyone with 2 cents of brains in their head really believe these investors all wanted to be doing 100% cash deals?  They wanted to buy all they could!  But nobody would lend to them.

 

Not at 25%LTV.

Not at 50% LTV.

Not at 75% LTV

Not even at 5% LTV!

 

Completely madness to believe there is no loan demand.

[Mikenhe]

exactly.. I closed on a house in september and had to use cash. Couldn't borrow a cent from the banks.

 

 

wanted a massive 50% from the bank which would have put the loan at less than my annual salary. Way less than our combined annual salary and at a very low % of our net worth.

 

 

I guess the banks decided that me renting a house at three times the price of the repayment per month was sensible fiscal policy.

 

 

All one has to do is look at all the 100% cash deals that were done the last few years by investors.

 

Does anyone with 2 cents of brains in their head really believe these investors all wanted to be doing 100% cash deals?  They wanted to buy all they could!  But nobody would lend to them.

 

Not at 25%LTV.

Not at 50% LTV.

Not at 75% LTV

Not even at 5% LTV!

 

Completely madness to believe there is no loan demand.

 

exactly.. This is where the banks need to be brought to task. Explain to the Fed why they won't help encourage the economy by making sensible loans.

 

 

[ERICOPOLY]

So getting full circle on the thread now, I am wondering if low rates are a disincentive to lend to anyone but the lowest-risk borrowers.

 

Forget NIM for a moment.

 

 

Higher-cost deposit environment (7% consumer loan rates for higher risk loans):

Let's say you lend at 7% to a bunch of people that are collectively a bit higher risk... then the economy collapses and Fed cuts rates.  Now your funding costs are lower and your NIM suddenly widens while dealing with the losses from this relatively more risky mix of borrowers.

 

Lowest-cost deposit environment (5% consumer  loan rates for higher risk loansa):

Let's say you lend at 5% to the same bunch of people that are collectively a bit higher risk... then the economy collapses and Fed's hands are tied... they can't cut rates any lower.  Now you suffer the same losses as before but your NIM can't widen because your funding cost is already at all-time lows.

 

 

So in summary, when funding costs are at all time lows you need to starve the economy to some degree out of self-preservation.

 

This is common sense.

[ERICOPOLY]

In short, today you can't afford as much risk since the Fed can't come to the NIM rescue again.

 

Thus, you restrict lending.

[Peregrine]

In short, today you can't afford as much risk since the Fed can't come to the NIM rescue again.

 

Thus, you restrict lending.

 

ROAs and NIMs are much lower for banks than they used to be and appears to continue to contract. There's certainly less cushion for them to take on loan losses than before. That seems likely. What seems odd is the notion that that banks are restricting lending to even very good credits.

[hyten1]

eric, what you said make sense

 

i am curious,  who are the banks lending to (they are still lending billions)? what are these people's finances if they are not lending to erics relatives?

 

hy

 

In short, today you can't afford as much risk since the Fed can't come to the NIM rescue again.

 

Thus, you restrict lending.

[Palantir]

I don't see how this is different from the notion of a "liquidity trap".

[ERICOPOLY]

So... what if jobs market improves, inflation ticks up and the Fed raises rates.  The banks then respond by increasing the availability of credit during this period of rising inflation?

 

I saw an interview of Merideth Whitney where she pointed out that the banks have been underpricing risk for a long time.  I wonder if that started to happen when the Fed would bail them out by cutting rates at the beginning of every economic weakness.  The banks were trained to understand that NIM would expand at the very time that loan losses popped up.  They felt like they had a safety net.  When the Fed initially cut rates to zero, they were mad that consumer rates didn't come down enough -- however didn't they effectively reach a policy interest rate where there was no longer a safety net?  Then they decided to buy enough bonds to bring rates down... but that doesn't bring back the safety net.  It just makes banks worry about what will happen to their loan books when rates go back to normal (not manipulated) levels.

 

 

[ERICOPOLY]

I don't see how this is different from the notion of a "liquidity trap".

 

My understanding of liquidity trap is that when rates are really low, you can't encourage borrowing any further because rates have already hit bottom.

 

But this is different...

 

I'm saying that lending is discouraged because there is no longer a safety net for the banks -- the Fed can't lower their funding costs any further, so there will be no NIM help when the next recession hits.  So they have to tighten their underwriting to prepare for the next crisis. 

[ERICOPOLY]

exactly.. I closed on a house in september and had to use cash. Couldn't borrow a cent from the banks.

 

 

wanted a massive 50% from the bank which would have put the loan at less than my annual salary. Way less than our combined annual salary and at a very low % of our net worth.

 

 

I guess the banks decided that me renting a house at three times the price of the repayment per month was sensible fiscal policy.

 

 

All one has to do is look at all the 100% cash deals that were done the last few years by investors.

 

Does anyone with 2 cents of brains in their head really believe these investors all wanted to be doing 100% cash deals?  They wanted to buy all they could!  But nobody would lend to them.

 

Not at 25%LTV.

Not at 50% LTV.

Not at 75% LTV

Not even at 5% LTV!

 

Completely madness to believe there is no loan demand.

 

exactly.. This is where the banks need to be brought to task. Explain to the Fed why they won't help encourage the economy by making sensible loans.

 

 

I don't understand why they needed to turn me down.  They could have offered me a 7% loan and I would have taken it.  Even an 8% loan.  After all, the difference between a 5% loan and an 8% loan is only 1.8%, not 3% (after I'm done paying taxes).

 

But they wouldn't even offer that.  There was no price at which I was worth the risk.

 

QUESTION:  Are they worried about getting sued if the rate is too high?  Some sort of predatory lending liability?  It seems they could make some really profitable loans here and there if they'd simply ask for more interest rate instead of turning us down flat.