The Big Idea
Lessons learned in banking 2022
Tom O'Hara, CFA | December 16, 2022
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Explosive loan growth and a swift rise in interest rates both cut into bank capital this year and changed the management of balance sheets. While it would be natural to assume that securities portfolios would shrink during a period of strong loan growth, the surprise was that capital became the primary driver of securities mix and accounting treatment. Portfolios piled into Ginnie Mae MBS and shifted into held-to-maturity accounts. Many of these trends should continue for much of 2023.
#1 Securities portfolios decline
A persistent theme for US banks in 2023 has been the growth of overall assets due to loan growth but a reduction in securities portfolios (Exhibit 1). For the APS tracking group of around 40 of the top 100 banks, assets in the third quarter grew by $52 billon while securities portfolios declined by $150 billion.
Exhibit 1: Securities portfolios shrinking while balance sheets grow
Along with the rotation out of lower risk-weight securities and into higher risk-weight loans, capital ratios deteriorated in 2022. And for most non-G-SIBs (global systemically important banks) that have been able to shield their regulatory capital ratios from declines in the value of their available-for-sale (AFS) securities portfolios, they have still experienced reductions to their tangible capital. This has pressed most banks into using the held-to-maturity (HTM) classification more heavily (Exhibit 2). For the APS tracking group, while AFS portfolios declined by over $600 billion this year through September, HTM portfolios actually increased by close to $400 billion.
Exhibit 2: HTM grows as banks look to protect book value
#2 Zero percent risk-weight asset preference with Ginnie Mae dominating
To help repair capital ratios, banks invested more heavily into 0% risk-weight (RW) securities (Exhibit 3).
Exhibit 3: 0% RW securities up 1 percentage point in 22Q3 to 18%
While US Treasuries carry a 0% risk-weight, they are relatively low-yielding securities and therefore are generally not a bank’s first choice (Exhibit 4). The chart below shows that most banks’ holding of Treasury debt stayed flat or declined year-to-date through September, with the APS tracking group overall seeing a $52 billion decrease.
Exhibit 4: Treasuries flat to down at most banks as they seek higher yields
Instead, banks are growing their allocation to 0% risk-weight Ginnie Mae securities (Exhibit 5). For the APS tracking group, Ginnie pass-throughs increased by about $25 billion year-to-date through September and have generally been attractive from a relative value perspective. Par 30-year MBS nominal spreads are around their post crisis wides seen in early 2020, although an increase in volatility has resulted in an increase in option cost and therefore tighter option-adjusted spreads. Still, our colleague Brian Landy last week noted that Ginnie OASs tightened less than conventionals, helping to compensate investors for the greater prepayment risk and lower convexity, and that up-in-coupon Ginnie offers the best projected total returns.
Exhibit 5: Banks opting for higher yielding Ginnie pass-thrus in the 0% risk-weight arena
#3 Fannies, Freddies, private-label MBS and munis out of favor
By comparison, most banks had reductions in their holdings of Fannie Mae and Freddie Mac pass-throughs year-to-date through September (Exhibit 6). For the APS tracking group, these securities declined by more than $170 billion. While offering a relatively low risk-weighting of 20%, the 0% risk-weighting of Ginnie Mae is more desirable when trying to repair capital ratios in a hurry. The same may be said for most private-label MBS, which for our tracking group, declined by 2% year-to-date through September. Some may argue that part of the decline is attributable to the general lack of new issuance volume in 2022, but part of the explanation is certainly due to risk-weightings higher than Ginnie Mae.
Exhibit 6: Fannie and Freddie securities dropped due to higher risk weights
In the world of securities, another relatively high risk-weight asset class that is vulnerable when banks are trying to repair capital ratios would be state and municipal debt, where general obligation bonds carry a 20% risk-weight and revenue bonds a 50% risk-weight. For the APS tracking group where most of the banks do have muni positions, those declined by 7% year-to-date through September (Exhibit 7) with only a small handful of banks adding any meaningful positions.
Exhibit 7: Muni bonds decline as banks repair capital ratios
Another interesting trend in declining securities portfolios is that CMOs declined by a larger percentage than pass-throughs (Exhibit 8). For our tracking group, of agency MBS holdings, CMOs started the year at 15%, but represented 22% of the total decline of the agency MBS bucket. Some of this differential could be explained by banks selling securities to maintain liquidity and opting to sell shorter-duration CMOs where the mark-to-market hit and resulting accounting loss was lower. Although there does not appear to have been much outright selling, shorter-duration CMOs would continue to be a relatively attractive segment of the portfolio to tap in order to minimize losses.
Exhibit 8: Agency CMOs decline by a disproportionally large amount