Research — 25 Nov, 2022
Investors worry about bank liquidity, earnings drag from underwater bonds
The large amount of unrealized losses sitting in banks' bond portfolios has raised liquidity concerns in the investment community and has negatively impacted valuations of banks with portfolios that are extensively underwater, according to Brett Rabatin, director of research at Hovde Group.
As interest rates surged higher this year, the values of bonds that most banks own have taken considerable hits, leaving institutions with large amounts of unrealized losses in their available-for-sale portfolios.
The issue was not a cause for concern for some since those unrealized losses are captured in accumulated other comprehensive income, or AOCI, and do not impact quarterly earnings or regulatory capital for banks with less than $700 billion in assets. However, Rabatin noted in the latest Street Talk podcast that investors have expressed concern because unrealized losses negatively impact tangible book values, and deeply underwater bonds that carry below-market rates could ultimately serve as a drag on net interest margins.
"I think the big thing that investors need to focus on is, who's going to be able to fairly maintain that margin year over year by the fourth quarter of '23, because it's looking like there's going to be some potentially sizable pressure depending on what happens with rates from here," Rabatin said. "The big part of this question is just what happens with margins and what do banks do to kind of get away from the situation of having these long-dated securities portfolios?"
Rabatin said the larger the negative mark that a bank has on its bond portfolio, the more it becomes evident to investors that the institution has a long duration asset that could serve as a headwind to its margin for some time. In a recent analysis, the Hovde team mesaured the impact that AOCI has on tangible book value per share, including disclosed mark-to-market adjustments to held-to-maturity portfolios, which do not flow through AOCI. The team said in the report that the measure could serve as a potential gauge of higher proportions of long-duration investments sitting on a given bank's balance sheet.
That distinction has been reflected in the valuations of many bank stocks, which are currently trading at discounts to historical levels. For instance, Rabatin said the top 15 names in Hovde's coverage universe trading at a largest discount to their median, adjusted price-to-tangible book value over the last five years had a median AOCI mark of 28% relative to tangible book value per share. That compares to 20% for Hovde's entire coverage universe and 17% for the top 15 names trading at the smallest discount to their 5-year median.
"It does appear there's some correlation on valuations relative to the size of the AOCI mark on the balance sheet," Rabatin said.
A number of investors have expressed concern that the losses embedded in bank bond portfolios could be permanent, fearing that banks would have to sell securities at a loss to meet their liquidity needs in the face of deposit outflows across the industry. Rabatin noted that while deposits have declined another 1% in the fourth quarter, according to the Fed's H.8 data, which tracks commercial bank balances on a weekly basis, banks still have ample, alternative sources of funding from the Federal Home Loan Banks, brokered CDs and possibly other sources like partnering with financial technology companies.
"I don't think it's going to be a broad issue, but it's a fair question that could evolve from here, and that's going to depend on deposit outflows from here for the industry relative to market alternatives. And it certainly it makes funding loan growth more challenging than it has been from a balance sheet perspective," Rabatin said.
The earnings headwind from holding lower-yielding securities is likely to get more pronounced over the next few quarters as funding costs are expected to increase a quicker pace. Banks' deposit costs have not risen that much yet despite significant tightening from the Federal Reserve. Deposit betas, or the percentage change in fed funds that banks pass on to customers, are expected to rise significantly in the coming quarters as customers begin to eye higher-yielding alternatives. Rabatin said banks have not competed that aggressively for deposits with each other that much yet but noted that they may increasingly have to compete with the Treasury market, where one can obtain yields over 4% by purchasing relatively short-term paper.
If that occurs, banks with higher concentrations of lower-yielding securities could see their margins come under pressure.
Still, Rabatin believes the rate cycle has created some opportunities where banks are trading at a notable discount to their historical valuations. He highlighted that Cadence Bank is trading at a notable discount to the 5-year median tangible book valuation. The analyst said Cadence has a large mortgage-backed securities portfolio and its AOCI mark equates to 35%. However, Rabatin also noted that the company continues to generate cost savings from its merger of equals that closed a year ago, and that he expects profitability to improve more than at peers.
Rabatin further said that Popular Inc. is being mispriced at current levels. He acknowledged that the company's expense guidance and the delay of its capital plan were net negatives, but he still expects the company to be a "cash cow" in Puerto Rico.
"Puerto Rico could be significantly unique in this rising deposit beta environment and the Puerto Rico banks may have very lagging deposit beta," Rabatin said.
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