Rising rates to spur litany of capital losses

July 7, 2013 5:54 pm

Rising rates to spur litany of capital losses

By Tracy Alloway and Tom Braithwaite in New York

US banks have watched billions of dollars of paper profits on their securities portfolios wiped out by rising market interest rates, erasing huge gains made during the prolonged run of increasing bond prices since the financial crisis and ensuring that erosions of capital will be a feature of the coming bank earnings season.

Data released by the Federal Reserve on Friday showed unrealised gains in these portfolios had plummeted from more than $40bn at the beginning of the year to about $6bn, with the most precipitous falls over the past few weeks amid mounting market concern about the “tapering” of the central bank’s bond-buying programme.

It is against this difficult backdrop that JPMorgan Chase and Wells Fargo, the country’s two biggest banks by market capitalisation, will launch the industry’s quarterly earnings season this week, with the return of volatile markets and higher interest rates expected to feature strongly.

“The one thing that has changed is the return of volatility,” said Fred Ponzo, managing partner of GreySpark Partners, a capital markets consultancy. “Prices are depreciating. Whether it’s collateral or capital cushions made of government bonds, these are going to be marked down and that means latent losses will be realised.”

Many industry executives are hoping to benefit from higher interest rates in the quarters to come. John Stumpf, CEO of San Francisco-based Wells Fargo, has been a particularly vocal advocate of higher rates, betting that they will allow his bank to increase the crucial net interest margin between the rate it pays to deposit holders and the rate it charges for loans.

But the immediate effect has been troublesome for the industry, trimming the gains on the huge portfolios of supposedly safe assets such as mortgage-backed securities and US Treasuries, which banks have built since 2008.

As yields have risen, prices have fallen. When they report second-quarter results in the next two weeks, the largest US banks will not be forced to take losses for assets held in so-called “available for sale” portfolios, those captured by the Fed data. But the sharp fall in prices will show up as a drag on capital levels.

Losses in the portfolios deplete equity capital under new regulatory rules. Analysts at Goldman Sachs recently estimated that a 300 basis point increase in interest rates – more than has occurred so far – could reduce Basel III tier 1 common equity capital by a percentage point for the industry, worth tens of billions of dollars.

At the same time, the choppy capital markets have dissuaded companies and consumers from refinancing loans. Wells Fargo and JPMorgan, which report on Friday, are the biggest mortgage originators and they have suffered from a sharp decline in mortgage refinancing, said mortgage bankers and industry data.

On the trading side, Bernstein banking analysts expect bond and commodities trading revenues at the big investment banks such as Goldman Sachs and Morgan Stanley to fall as much as 20 per cent compared with the first quarter of the year. Sales from trading stocks could also fall about 10 per cent, while revenues from advising on mergers and acquisitions and debt sales are expected to “decline modestly”.

“At the end of May, fundamentals for capital markets firms appeared to be moving along a favourable trajectory,” said Brad Hintz, analyst at Bernstein. Then, in June, Ben Bernanke, Fed chairman, announced the US central bank was likely to roll back its bond-buying programme because of an improving economy. “The market had a visceral reaction,” Mr Hintz said.

The yield on 10-year US Treasuries has since jumped to 2.72 per cent, boosted by robust US employment figures published late last week.

Some trading desks, particularly those dealing in interest rate products, benefited from the upswing in volatility, according to some industry executives. Overall investment banking revenues are expected to surpass those in the second quarter of 2012 but still come in down from the seasonally strong first quarter when companies tend to refinance debt.