Bad Choices at the Wrong Time

At some point during the protracted period of record low rates following the global financial crisis (GFC), banks “learned to breath under water,” and when rates rose rapidly, the banking system got the “bends.”

Some of the pain is self-inflicted. Banks failed to manage their funding agility leading up to the rate increase, hamstringing themselves by deploying excess liquidity at historically low rates. Many capitulated at just the wrong time and in the worst possible way by buying massive amounts of mortgage-backed securities (MBS). This was the worst possible way because of a pernicious characteristic of MBS called negative convexity, which causes the weighted average lives (WALs) of these securities to extend when rates rise and suffer dramatic declines in value by pushing cashflows out further where those cash flows need to be discounted at a new higher rate. How long into the future? Well, ask yourself how long a bond backed by underlying 30-year fixed-rate mortgages paying a rate of around 3.5% to 4% will remain outstanding.

What should have been liquid assets that were available to fund the exodus of deposits searching for higher rates is instead entombed on the balance sheet till the dawning of a lower rate environment because selling these securities now would result in immediate and significant earnings and capital damage for many banks. Instead, most banks are willing to bleed underearning assets through the income statement over what is now a significantly longer-than-anticipated life of these securities.

Abundantly capitalized banks will take “one-time hits” and restructure their securities book for the sake of future earnings. This will bode well for these banks because most analysts and investors will digest the one-time hit better than earnings stagnation over the roughly 8-year life of the MBS.

But because many banks are capital constrained, they can’t touch these securities. Doing so would force them to recognize in regulatory capital the unrealized losses that are currently ignored. As a result, they are prone to need higher-cost funding quicker than otherwise would be the case (…hence, all the talk about brokered deposits and other borrowings).

One Bank’s Perilous Reach for Yield

Take Zions Bank (ZION)[1], for example. ZIONs is a $5 billion market cap regional bank. It didn’t fail, nor did it garner much attention through the 1Q23 banks dislocation. Zions even held out longer than most banks, waiting until 4Q20 before beginning an accelerating MBS buying spree that subsequently grew its MBS book from 6% to 23% per quarter through year-end 2021—then the Fed’s rate increases began.

By 3Q22, Zions had unrealized securities losses amounting to nearly $3 billion or nearly 40% of its tangible common equity. The following quarter, the company started reporting significant interest expense from FHLB borrowings. In the next quarter, in an attempted sleight of hand, management changed their definition of tangible common equity to exclude securities losses (See Insert 1) and moved almost $10 billion of securities to “held-to-maturity (HTM)” where further declines in value would no longer result in additional equity consequences but also where none of the securities could be sold without the risk of needing to mark to market the entire HTM book through both equity and earnings (“tainting the book” in accounting parlance). 

Insert 1

By year-end 2022, ZION’s tangible common equity ratio (conventionally calculated) had fallen to just over 3% of tangible assets despite having a common equity tier 1 ratio (CET1 ratio, the primary regulatory target) of 10.5% of risk-weighted assets. The majority of the delta between the two ratios was not due to ZION’s risk weight saturation but was due to unrealized losses on its available for sale (AFS) securities portfolio, which are currently excluded when calculating regulatory ratios. And remember, neither ratio recognizes the $1.5 billion in unrealized losses in ZION’s HTM securities. They get a pass on that despite the fact that only the market value of these securities is actually available to absorb losses.

Selling its mortgage-backed securities book would have resulted in a highly visible hit to regulatory equity. So, instead of selling securities, as of 2Q23, ZION’s has almost $11 billion in HTM securities yielding 2.24%. The vast majority of its HTM securities are “due after ten years.” (See Table 1) These really long-term securities are yielding just 1.86%.

Table 1

In order for these securities to remain on the bank’s balance sheet, ZIONs is incurring a weighted average funding cost on the required incremental funding sources of 5.28%. That’s a negative carry of $329 million annually or more than a 3^rd of ZION’s 2Q23 annualized pre-tax income.  (See Table 2)

Ironically, the Fed facility that was created after the failure of Silicon Valley Bank (SIVB) was created to assist banks in just such manner of obfuscation of real equity positions and is actively facilitating a longer-term destruction of equity by providing the means to produce negative carry such as Zion’s. 

But since supervisory laxity tends only tends to cure by creating moral hazard, it wasn’t a surprising move.

Have a great fall weekend from Cybiont Capital…

Table 2

[1] At present, Cybiont Capital does not have a position in ZIONs, but may in the future.