Sunday, July 20, 2008

Interest rate risk, credit risk and a comment on bank margins

A theme of this blog is the interest rate risk and credit risk of American banks. As regular readers know I got the interest rate risk versus credit risk wrong of late.

But being wrong in the past won’t stop me trying to be right in the future. Besides it is worth considering what proportion of a bank’s margin comes from accepting interest rate risk, what portion comes from accepting credit risk and what portion comes from just servicing customers.

The current yield for interest rate risk

Currently you can buy an “on-the-run” Fannie Mae guaranteed 30 year fixed rate mortgage with a yield of 615bps. Before the Fannie Mae credit crisis it was still almost 600bps. Bloomberg gives a series of what the on-the-run mortgages yield – the so-called “perfect coupons”. You can find this sequence by typing MTGEFNCL on your Bloomberg – or just find a graph here.

Currently the intended Fed Funds rate is 200bps and (highly) secured borrowings will cost only (say) 50-100 bps more than Fed Funds.

Now if we presume that the Fannie Mae mortgage is guaranteed by the Federal Government (a good assumption after last week) and is hence riskless then you can earn approximately 300-350bps by taking only interest rate risk. All you do is borrow floating to buy “perfect coupons”. And you don’t hedge anything.

300bps levered 10 times and with 30% tax taken out will still give you a 20% post tax return on equity.

Unfortunately you take a shocking amount of interest rate risk to get that 20 percent return on equity. The mortgages will (at least in normal times) refinance if rates fall. They will however extend for an unknown but long period if rates rise. Pretty well all movements in interest rates are negative for someone taking that sort of interest rate risk. Indeed it is very easy to model insolvency for such a company.

It was my contention – wrong it seems – that the main risk taken by US banks was interest rate risk. You can see the gory details of my mistake here.

State of the banks

There are banks that take mostly interest rate risk and banks that take mostly credit risk.

Banks that take mostly interest rate risk tend to have floating funding and have assets that are either GSE securities or very secure mortgages. Extreme examples included Commerce Bancorp (something I was short on interest rate risk and lost), and New York Community Bancorp. [State Street also takes a surprising amount of interest rate risk whereas Bank of New York tends to prefer credit risk.] Banks that take mostly interest rate risk have had great relative performance. In the event of an inflationary spiral those same banks would under perform massively. [The jury is still out on inflation – another theme of this blog.]

Other banks however eschew almost all interest rate risk keeping their asset and liabilities of matched duration – which usually means keeping securities of short duration. If you took mostly credit risk and were reliant on wholesale funding your very existence is threatened at the moment. To some extent the way I am shorting now is to find smaller banks that were consciously rejecting interest rate risk two years ago – but still have fat margins. They had to have done something bad to maintain those fat margins…

Margins and risk

I mention all this for a reason. If you are earning more than 300-350bps of spread in a bank you are taking some funding or credit risk – because it is simply not possible to earn that in interest rate risk unless you own some very exotic instruments.

Contra: I know of one bank which issues callable funding to buy callable assets. This sounds like it is matched – but if rates go up the funding gets called and they lose (having to refinance at higher rates). The assets however stick around. If rates go down the assets get called – and the funding sticks around and they lose. This bank has held up remarkably well through the crisis because they don’t take many credit risks – even if they do take enormous interest rate risks. The bank could still wind up highly problematic but it won’t get that way on credit.

But short of such exotic behaviours if you are earning more than about 300-350bps you are taking credit risks. If you earn 350-400bps of spread and you specifically disavow interest rate risk then you are taking a very large amount of credit risk. Find me regional banks that rejected most interest rate risk two years ago and I will find you regional banks that are potential credit problems.

Hybrid banks

Most banks fall somewhere in the middle. To pick one of many examples, Webster Financial Corp is a bank which is pretty well run. It is headquartered in Waterbury Connecticut and its management are known to several Connecticut hedge fund types.

Webster made the same mistake as me. It thought that interest rate risk had to be avoided. So it reduced interest rate risk – quite sharply. It decided to take some (quite a small amount) of credit risk. You would call this risk diversification. The stock price shows the result.

Webster was early to recognise their mistake. As I said – they are pretty well run– and in the scheme of things they are hardly a bank that is likely to wind up owned by the Feds. But shareholders have hardly had a nice time.

Webster took mostly interest rate risk. This is its five year margin summary – which shows non-performers including real-estate owned reach the princely sum of 1 percent of assets (on their way quite a bit higher).



Note the interest rate spread was always below 350bps but still above 300bps.

That is very high by global standards because in most countries banks do not have huge refinanceable assets – and hence do not carry the sorts of interest rate risks that American banks take. Its a middling spread by American regional bank standards.

My regional bank

Last week I referred to a regional bank which I had been working on with a reader. Small cap – so we won’t mention its name. I wanted to short the subordinated debt – but couldn’t get a borrow so I shorted the common. It took me about 15 minutes to make that decision.

Here are the things that stood out:

  1. It had specifically disavowed interest rate risk saying that it had shifted its security holdings towards FHLB securities because they could easily be pledged (as they contain little credit risk) and could be purchased with short durations,
  2. It had massively grown its deposit base in deposits greater than 100K by using promotional rates,
  3. After this promotional binge it was the bank most dependent on jumbo deposits that I have ever seen. Given the noise of banks failing the populace could get quite jumpy about jumbo deposits and I would not think that funding base is very secure,
  4. Despite having expensive funding and not taking interest rate risk it had a margin of 4% (now declining) - which suggests it was doing something else to get the margin,
  5. That something was (more or less obviously) accepting credit risk. It had 1.75 times its shareholder equity in home-equity-line-of-credit products, 1.7 times in real estate construction loans and one times its capital in loans secured by vacant property owned by developers. It grew its HELOCs sharply in 2006. In 2006 it also more than doubled its mortgages on unimproved land.

I think there is a fair bet that this regional bank is cactus. I really wanted to short its debt.

But hey – what do I know? The provisions through the income accounts were less than 10 million – and outstanding provisions are about 20. The non-peforming loans are only half Webster Financial – and they think the lending is so good that they expanded loans in every one of these categories during the last quarter.

This of course leads to the real reason I won’t name the bank. I smell a rat. A big, nasty hairy one, but I can’t quite identify what it is. On this blog we don’t want to make it up and want to correct our mistakes – and we will not blurt out quasi-fraud allegations against small regional banks unless of course we have three decent forms of evidence.

The Wells Fargo puzzle

So now I will leave you with a question for which I do not know the answer. How is it possible that Wells Fargo’s margin 450bps? Please – serious answers are gratefully accepted as I do not understand.

This is not unusual in the history of Wells Fargo. There have been several points where their margin was greater than the prime rate.

Wells Fargo’s margin is off-the-scale high by global standards – I once did a global survey and it was the fattest margin major bank in the world.

Prima-facie that is good. High margins allow you to take considerable losses and remain profitable.

But usually have to take some risk to get high margins – and as the calculations above show – it is unlikely to be all interest rate risk. When I did my survey the other super-fat margin financials were subprime credit originators (mostly autos and credit cards).

As I said – I do not fully really understand just why Wells Fargo is quite so profitable. Can someone help?

Please...

2 comments:

David said...

Going through your old stuff at the right time to connect a few dots and enlighten myself. Thanks a lot Hempton.

"So now I will leave you with a question for which I do not know the answer. How is it possible that Wells Fargo’s margin 450bps? Please – serious answers are gratefully accepted as I do not understand."

Perhaps Berkowitz of 1992 is still right in the sense that Wells Fargo has a franchise that is difficult to take away? California is simply a profitable oligopoly market.

http://www.fairholmefunds.com/pdf/oid1992.pdf

John Hempton said...

I think that is the right answer - but it is such a fat margin it seems unlikely...

The margin is higher than the nominal interest rate!

Like wow!

J

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