The Federal Open Market Committee (FOMC) voted on September 18 to cut the target range on the Fed funds rate by 50 basis points to 4.75%-5.00%. The move stunned the market, which had generally expected that the Fed would only cut by 25 basis points and, according to the CME FedWatch Monitor, raised the probability of another 50-basis point cut on November 6 to 50-50. The 10-year Treasury yield increased on speculation that the Fed was moving too quickly to cut rates and might reignite inflation. Meanwhile, after the meeting, Chair Powell told reporters that he believed the neutral interest rate was higher than it had been during Covid, and that the era of cheap money was probably over. The 50-basis point cut lowered the Fed's interest expense rate on bank reserve balances and the reverse repo facility (RRP) to 4.90% and 4.80%, respectively.

Notably, Fed Governor Michelle Bowman dissented from the decision to cut rates by 50 basis points, preferring that the FOMC cut only by 25 basis points. In addition, the European Central Bank, which had refrained last month from cutting its benchmark rates, resumed cutting with another 25 basis points, while the Bank of England, which cut its benchmark rate by 25 basis points last month, held back on another cut at its meeting this month. Thus, as it stands, the Fed and the ECB have so far cut their benchmark rates by 50 basis points, while the Bank of England is only down by 25 basis points.

Besides voting to cut rates, the FOMC agreed to continue to let the Fed’s balance sheet shrink under Quantitative Tightening (QT). However, throughout QT, since it began in July 2022, its effect on bank reserves has been negligible and they remain abundant. The reserves and RRP balances equaled $3.2 trillion and $304 billion, respectively. The balance of both has been unchanged all summer. On the other side of its balance sheet, the System Open Market Account (SOMA) Treasury Notes and Bonds edged lower by $22 billion, to $3.7 trillion, just under the Fed's $25 billion QT cap for Treasurys, which it reduced from $60 billion back in the summer. Its portfolio of Agency MBS shrank by $12 billion to $2.7 trillion, a pace well below the $35 billion cap the FOMC voted to maintain at its meeting this month.

The 2s-10s Treasury spread, which inverted in July 2022 and had reached a low of minus-100 basis points in July 2023, returned to a positive spread this month and is currently at plus+25 basis points. Meanwhile, the spread between the constant maturity yield on 3-Month Treasury Bills and 5-Year Treasury notes, which inverted in November 2022, remains inverted by over 120 basis points this month, about 20-30 basis points narrower than where the spread stood before the Fed's rate cut decision this month. The rate on residential mortgages, which had peaked at over 7% a year ago, is down to 5% and 6%, respectively, for 15 and 30-year terms, which are the lowest rates on mortgages in a year, but which are still more than 2 points higher than the average mortgage rate since the Global Financial Crisis (GFC).

A return to a positively sloped yield curve remains a crucial requirement for banks to succeed in expanding their net interest margins (NIM) while the Fed cuts the range on its benchmark rate. While an inverted yield curve impedes banks' ability to add yield on the interest-earning asset side of their balance sheets other than cash, it offers opportunities to improve NIM on the liability side. Bank treasurers are looking at strategies to lock in forward rate funding in 3-year Secured Overnight Financing Rate (SOFR) swaps and futures. by managing deposits in the brokered markets, and by looking for ways to optimize pledged collateral.

Bank investment portfolios remain significantly impaired as an earning asset even now as the Fed begins to cut rates. In aggregate, the commercial banks at the end of June 2024 held $5.6 trillion Treasuries and Agency MBS worth $5.1 trillion, of which 60% of the unrealized loss is locked away in Held-to-Maturity (HTM) accounts, especially so at banks with total assets over $100 billion. Banks with total assets under $100 billion in total assets held most of their underwater portfolio in their Available-for-Sale (AFS) account. Their portfolios are so far underwater that more than a third of the U.S. banks would fall below the well-capitalized threshold if they were to execute a sale and earn back on their entire portfolio, selling bonds at a loss, and buying new bonds.

The Fed continues its push in the wake of the Silicon Valley Bank disaster to encourage banks to incorporate the discount window as a source of liquidity in contingency funding planning. On June 24, the Fed launched Discount Window Direct, an online portal through which a bank could request an emergency loan. This month, the Fed's Board Staff said in response to a Frequently Asked Question (FAQ) regarding Regulation YY, that an untapped line with the Fed's discount window or with the FHLB can demonstrate that a large bank holding company (BHC) can meet its Internal Liquidity Stress Testing (ILST).

On June 24, the U.S. Supreme Court overturned its 1984 Chevron U.S.A., Inc. v. NRDC decision, making it easier for banks to sue bank regulators. This month, the Fed announced that it was backing away from its Basel 3 Endgame proposal that it published last year that would have raised capital requirements on large banks and extended some of the capital requirements that currently apply to banks with total assets over $250 billion, to banks with assets over $100 billion. It intends to repropose a scaled-back capital requirement. Much of the original proposal will be shelved in recognition, as Vice-Chair of Supervision Barr put it this month, of finding a better balance between capital resiliency and efficiency. Bank treasurers at institutions with total assets between $100 billion and $250 billion still expect that they will be required to capitalized accumulated other comprehensive income in their regulatory capital calculation.

The Bank Treasury Newsletter September 2024

Dear Bank Treasury Subscribers,

Truthfully, since we took it out of the box, it came in last summer and was a clunker. And that name is tame compared to the ones our editorial staff called it trying to put it together when they were trying to figure out how parts FF and GG were connected using screw M4 but only after first connecting everything to side panel B.

The buyer’s remorse worsened after we got it together because the grill never worked right, not just the side with the gas grill. You see, the grill came with a side for charcoal grilling, perfect for emitting greenhouse gases, but like the gas grill side, useless as a means of reliably grilling something you would want to eat. Because the damn thing never heated up to the 600 degrees of Fahrenheit that its predecessor had achieved. Even when you got it up to 450 degrees Fahrenheit, the heat was uneven, and hamburgers either got cooked so long they turned into burnt choking hazards or ended up undercooked that they were just tartare.

A grill—something your editor-in-chief intended to induce staff back to the office after Covid-- became a source of frustration and discontent. And in all fairness, staff complaints about what’s cheap is cheap are legitimate, at least regarding grills. At least this was what staffers said they learned from sales representatives they consulted when researching why the grill had become, if not always, a huge fail.

The budget department came in for especially severe censure, if not outright condemnation. You would think from the unfortunate things said at the morning staff meeting that it had committed a human atrocity for penny-pinching on what members saw as a critical office amenity as vital as the coffee maker. Your editor-in-chief remained above suspicion for pushing a gas grill strategy based on the age-old economic philosophy known as trying to get something for nothing, which bank treasurers will understand as they are firm believers in free options and will tell you all day long how much they wish there were a hedge that would fix all of their balance sheet problems, but would be free.

By the beginning of the summer, senior management at the newsletter decided it was time to buy a new grill, which was significant given that the old one was only a year old. Staff aired their views. But while some of our staff writers were in favor of the models they saw selling for over $40,000, that measured 17 feet long, and that included a natural gas grill, an Asado grill, an ice maker, and a refrigerator, your editor-in-chief signed off on a more modest yet still upscale three burner model with a sear station for $900, that did not come with a pizza oven but did offer free assembly.

However, this was not the end of the story, and we know our readers are wondering where we are going. Once again, it was our budget people to blame who insisted that we wait to buy the new grill at the end of the summer to take advantage of the Labor Day sales. Now, Labor Day sales are a great way to save money when buying clothes, for example. If you need a new bathing suit, you can get huge markdowns by waiting until the end of the summer to make your purchase. It’s half off, or even more, to take unsold inventory off from a retailer’s hands. And theoretically, there was nothing wrong with our budget department’s assumption that grills are a summer thing like a bathing suit and that we could save 50% on the grill.

But that is not the case, and it does not matter when pricing a Labor Day sale clearance discount for outdoor gas grills. Thus, in return for waiting an entire summer with our old grill, letting our staff grumble away that they had better hamburgers at home and why they come in to eat a choking hazard, going through propane tanks like there was no tomorrow, and ruining a lot of grillable meat, the selected grill that retailed for $900 at the beginning of the summer, was purchased for $850. For an extra $50 tip to the delivery workers, they carted away the old grill after assembling the new one.

Why Bank Treasurers Bought Clunkers

Now, our readers might ask what the replacement of the newsletter's outdoor grill has to do with bank treasury, whether your editor-in-chief's fixation on the $50 savings is somehow a metaphor for the Fed's 50-basis point cut this month or some other stretched connection with banks. Everything from the perspective of the newsletter comes back to bank treasury. But there is a lesson here. What comes to mind as we try to figure out how the new grill works and remain befuddled about using its searing station is that the bond portfolios that bank treasurers have on their balance sheets have much in common with the old grill we replaced.
A stretch? It is obvious. Think about it this way. You have a bond portfolio; face it, it's a clunker. Like most bank treasurers in this country, just judging by the Fed's H.8 data, your portfolio is mostly a mix of Agency MBS and Treasurys, with the Agency MBS accounting for 60%-70% of the portfolio depending on whether you are a large bank in the H.8 sense and need to hold a lot of Treasurys for purposes of your ILST and Liquidity Coverage Ratio (LCR), or a small bank in which case you go for MBS over Treasurys any day because they yield more. In either case, it is fair to say that you or your predecessor, who you replaced last year and who everyone conveniently blames for all of the bad bonds you have today, bought many of the bonds in your portfolio from 2018 through 2021 when rates were at 0%, right back where they were after the GFC.

You couldn't help it. Those were active years to buy bonds because loan-to-deposit ratios were approaching multi-decade record lows. Cash was everywhere, and bank treasurers openly admitted to drowning in so much liquidity that they were starving for yield. You had to do something with the money, and even though you knew that those tidal deposit inflows were not going to last forever, 15 basis points to park cash at the Fed overnight when returns were a couple of hundred basis points better to lock up some money in bonds was hard to pass up. The spread between a 15-year mortgage guaranteed by Freddie Mac and a 3-month Bill was 230 basis points at the end of 2021. It is maybe half that spread today. How would you have walked so easily past that opportunity?

You would have had to have worked at a bank with a lot of fee income not to have cared about earning that spread, to have had the discipline to say no to your bond sales rep's plaintive cry expressed through Bid Wanted In Competition (BWIC) blasts to buy their trader's stale bond inventory. Going into 2022, facing limited loan demand, most bank treasurers had to consider bonds that were at least nominally accretive to NIM.

NIM is the game's name, and if there are no loans to buy, bonds are the next best thing. Bank treasurers learn this on Day 1 in bank treasury school. When your securities portfolio represents, on average, 25% of total earning assets as it does today, NIM is NIM, bonds are going to be part of it, and you at least look at the BWIC your coverage sends over Bloomberg.

2018 to 2021 were not great years to brag about buying bonds, whether mortgages or Treasurys. The average yield on a mortgage security was under 3%! No one should expect to buy those bonds and brag about it. But the truth is that bond buying has not been great for a long time, at least pre-dating most of your bank's bond sales coverage and going back to the GFC. They were probably then in what your friends across the "pond" would call knickers. You would need to return to even before then to recall the last time you bought a bond with a decent yield. Like before the present century! There was something to that Y2K business.

Really, since then, either yields were too low or the yield curve was too flat to buy bonds and be happy about it. The awful part was that the term premium you earned for extending the portfolio's duration was negative. You had to pay to increase the extension risk. It was always something. Not that you like to complain, but we are just saying.

Okay, maybe at the end of 2018, bond yields were not so bad. For example, 15-year Freddie Mac mortgage rates had just peaked at 4%, a decade high. However, that did not last long, as the rate on new mortgages fell to 2% by the end of 2021.

Going into 2022, before the Fed's first 25-basis point hike and until November 2022, bank treasurers still believed that yield curves were naturally positively sloped and inverted curves were rare. You were supposed to be able to buy bonds and roll down the curve to maturity. Today, 22 months later, the 2s-10s curve may be back in positive-sloping territory if you want to call 20 basis points a positive slope, but in the 3-month-5-year part of the curve where bank treasurers are most focused, you still roll up a curve that is inverted by over 100-plus basis points. The inversion has persisted so long that what bank treasurers not too long ago would have called rare is now standard, mainstreamed like tartare.

At the end of 2021, bank treasurers could have played it safe and put their excess deposits into liquid, short-term securities with floating rates. They did not have to buy fixed-rate coupons with 2 and 3 handles. Floaters would not have done much for their NIMs, and they were expensive to buy, but today, those securities would be rolling off as per contract and would not extend as they are now for years to come. Then again, clunkers are clunkers, and you get what you pay for. But bank treasurers do not like to pay up, not for bonds and not for outdoor grills.

No one is saying bank treasurers were irresponsible with their bond selection. Of course, they did their homework, followed protocols, and discussed their investment plans with their boards. However, they might have been talking to the wall, considering how much anyone took the risk that the Fed would suddenly go hard and fast very seriously. Not when the Fed took its time to raise rates the last time it lifted off from the 0-lower bound in December 2015. Forward guidance was supposed to eliminate surprises, and in 2021, Fed officials were still more concerned with protecting gains in employment than preventing "deviations" in inflation.

They must have looked up the bonds they were buying on Bloomberg. The newsletter’s executive management didn’t just buy any grill off the internet sight unseen, either. They reviewed the features that came with it. Your editor-in-chief remembers thinking that getting a side to use charcoal would be neat, even though he had not used charcoal to grill anything in decades.

It is just that when you are buying implied Government-guaranteed securities, your bank’s loan-to-deposit ratio is in the 60s, and your board is screaming at you to do something about the narrowing trend in NIMs, you do what you do. Earlier that year, you worried that the Fed might try a negative interest rate policy called by NIRP, a lovely acronym, to boost the economy.

You did not have much choice. You needed bonds, and we needed a cheap grill. And no one expected the old grill to be such a clunker out of the box, any more than anyone expected the Fed to hike rates over 15 months, from March 2022 to July 2023, by 525 basis points. According to the dot plot published in December 2021, the Fed did not expect this, which projected a 2.5% terminal Fed funds rate by 2024.

Sometimes, as experienced as many bank treasurers are, you just do not see the true nature of tail risk. Sometimes, a risk that you think has less than a 1% probability of happening may be more than 50% because of related factors that make their connection challenging to see in real-time. Artificial intelligence software today, offered by Straterix, a corporate sponsor of this newsletter, has applications that can help a bank treasurer better appreciate risk probability and see how seemingly unrelated events can have terrible consequences for a bank’s financial health unless treasurers make adjustments quickly to their bank’s risk exposure.

But even without today’s AI technology, bank treasurers knew that the handwriting was on the wall when they were still buying bonds late into 2021. The Fed was getting ready to tighten, and as every bank treasurer knows, you do not buy bonds at the beginning of a rate-hiking cycle. You wait for that cycle to end and, like waiting for Labor Day, purchase bonds at a discount when the rate-hiking season, like the summer season, is over. But they couldn’t wait that long. Money was still piling up, and loan growth was negative at the end of 2021.

HTM: Hedging By Other Means

If they couldn’t wait, why didn’t they hedge? They knew about the optionality they were selling when they were busy buying negatively convex securities and funding their purchase with hot money. But hedging was not much of an option in 2021. For one thing, putting hedges on MBS bonds was and still is super complicated. Auditors are skeptical that the derivative instrument you want to use to hedge them is compelling enough to count as a hedge.

The Financial Accounting Standards Board published multi-layered hedge accounting in 2022, which intended to make the hedge accounting process a little less fraught for bank treasurers. But Accounting Standards Update (ASU) 2022-1 was not around in 2021, and the last layer of hedge accounting in ASU 2017-12, intended to make hedge accounting easier, was too difficult to use to be of much help.

So, instead of hedging, bank treasurers bought fixed-rate bonds and booked many of them in their HTM accounts. That way, their 2- and 3-handle bond purchases would not be marked to market if the Fed started raising rates in 2022. They would not have to worry about AOCI related to the bonds marked-to-market in the AFS portfolio from depressing their equity under Generally Accepted Accounting Principles if the Fed went a little faster and higher than was expected.

As bank treasurers knew, the only downside was that you could not sell bonds in HTM if needed for liquidity purposes or if, after you bought them, you realized that you had just bought the worst bonds you had ever bought in your career. But that was okay because, as noted, banks were practically drowning in liquidity at the end of 2021, so selling bonds for liquidity just would not come up, and if you did need to sell a bond back then, your biggest worry was what you were going to do with the money. There was just so much money back then and not many great options to put it. Today, the Fed maintains “abundant reserves” with $3 trillion in reserve deposits. In 2021, reserves at $4 trillion were on steroids.

HTM was the next best thing if you could not figure out the accounting to hedge, and the largest banks, staffed with many accounting experts, still booked many of their bond purchases in that account. According to Q2 2024 call reports, the four largest banks, on average, have 60% of their bond portfolios locked up in HTM. HTM represents only a third of the bond portfolio for the average large regional bank with total assets over $100 billion and is even a less popular accounting strategy for smaller banks because they are allowed, unlike the largest banks, to exclude the fair value adjustment for bonds in their AFS portfolio from the calculation of their regulatory capital. Bank treasurers at smaller banks today have only a tenth of their bond portfolios locked up in HTM.

The bank treasurers who did avail themselves of the no mark-to-market accounting features of HTM must have wondered what could go wrong with their plans and did not see the possibilities. There was no mark to market to worry about in HTM, and if rates went up, the underwater bonds would only create a slight drag on NIM. That was their thinking. Nothing that they could not offset with the lag they expected to earn on their low-cost deposits in which they were drowning. HTM was a time-honored, legitimate balance sheet strategy under normal interest rate conditions.

Except after 2022, when rates have not been normal and bonds purchased to fix NIM has not worked so well for bank asset-liability management. Bonds that are so profoundly underwater, such as the ones in bank HTM and AFS accounts, do not perform as intended, even if there are no mark-to-market accounting implications. They are clunkers; the worst thing about clunkers is when you are stuck with them.

Even though they knew at the end of 2021 that the Fed would raise rates in 2022, history suggested that the pain would be tolerable. From December 2015 to December 2018, the Fed raised the Fed Funds rate by 225 basis points, and the average bank bond portfolio’s negative fair value adjustment was just 2%-3%. When the Fed raised rates between 2004 and 2006, they were the same. At its worst at the end of September 2023, the average difference between fair and amortized cost in the AFS portfolio for all commercial banks equaled 15%. This time was different.

HTM, AFS, and $40,000 Grills.

There is a reason why your editor-in-chief doesn't want to buy a $40,000 outdoor barbecue. Experience proves that every grill you buy will eventually die on you. There is not much you can do about it. It's the cycle of life. You can take care of it, cover it, or do whatever. None of that matters. Eventually, something rusts or breaks, and you must buy a new one. But if you buy a $40,000 grill, replacing it is not so simple. You do not just go out and buy a new one if the one you just bought last season stops working or never performed in the first place.

Bank treasurers intuitively get this thinking, which is why, until the GFC, most bank treasurers kept very little, if any, of the bonds they bought in HTM. Because cheap grills are like a bank treasurer's AFS portfolio, if you need to get out of the trade because it is giving you undercooked or burnt hamburgers, even if you bought it yesterday, you can buy a new cheap one on Amazon that will be at your front door tomorrow no questions asked except that you may need to assemble it yourself. But that is with a grill.

Replacing one cheap grill with another is not that big a deal. The difference between a bank treasurer's bond portfolio and an outdoor grill is that the portfolio is not cheap; even the one you thought would be cheap is not so affordable when you see the cost to replace it because even the AFS portfolio is turning out to be pricey to get out of right now.

Lesson Number One: Don't Wait For Labor Day To Buy A New Grill

There is nothing good that will come out of holding on to a bond portfolio concentrated in Agency MBS 2- and 3-handle fixed-rate coupons that have extended well beyond the up 100, 200, and 300 basis point scenarios you ran them through when you bought them, any more than it makes sense to hold on to a grill that does not work. Given current market rates, given what the Fed is projecting to do to the front-end of the yield curve, given the Treasury refinancing calendar everyone worries about that is going to put upward pressure on the belly, and long end of the curve, the best advice this newsletter can offer is that you should sell your underwater bond portfolio in AFS as soon as possible and buy better bonds. Timing is now.

Unfortunately, there is nothing you can time with your HTM book but grin and bear its undercooked or burnt hamburgers for a long time or until you leave for a better life somewhere far from the bank treasury world. But you know, that bid you do not like in the market today for your underwater AFS bonds will probably still be live in a year because there is not much room for mortgage rates to rally from here. Yields could even go higher if inflation suddenly starts surging again.

Get out while the going is good. The 10-year Treasury yield fell to 3.6%-3.7% this month even before the 50-basis point rate cut on September 18th. The Fed projects that the funds rate will drop by 200 basis points by 2026, so unless the present yield curve inversion persists, where will mortgage rates rally? And, if the only thing that happens is the front end comes down, and the back end stays anchored, you will have a flat yield curve next year, hardly a great time to buy new bonds to replace the underwater ones you are holding on to right now.

So, do it now. Get 6-handle MBS bonds in your portfolio right away. That way, they can start helping NIM before the end of the year. You may think you will never buy another MBS bond again, but come on, you know you cannot resist a nominally NIM-accretive asset!

Do it. Sell the bonds and buy new current coupons. Because if you do, you will book a significant loss in current period earnings and subtract a chunk of capital from your regulatory calculation if you are one of the many banks below $250 billion in total assets that currently can still ignore AOCI in the AFS book. But, in return for taking that upfront loss, that pain of second thoughts from your bank examiner who worries all the time about your capital cushion when not going on about your contingency funding—in return for selling now, you can expect that as your most recent quarterly result fades left on analyst spreadsheets, that the new bond portfolio freshened with new production, 6-handle MBS, will earn back that loss. A sale earn-back is a beautiful thing! Music to the ears of your bond sales coverage who is waiting to send you their BWIC list.

Bank treasurers can lament that the yield curve is still inverted, and the overnight rate is still its highest yielding point. If there is one thing, or one of a few things, that every bank officer would list as critical to expanding NIM, it's getting back to an average yield curve. The treasurer of a large regional bank based in the southeast told analysts at a conference this month that,

"… the curve steepens; we get a more normal-shaped curve as the Fed begins to ease, and that will benefit us from a repricing standpoint into the future."

A positive slope is critical, according to the CFO of another large regional bank in the Midwest,

"The biggest factor…is a normal sloped yield curve, which we still don't have. Hopefully, we'll start to get to that. We have seen a little bit of steepening."

The yield curve is one of the biggest issues along with rates for banks, according to the chairman and CEO of a large regional bank based on the East Coast,

"But the bigger issue for us and everybody else is the long-term outlook for rates and the steepness of the yield curve."

Taking Advantage of an Inverted Front-End

However, that inverted yield curve, which is a headwind for NIM, is ideal for restructuring the underwater bonds in your portfolio. Selling bonds and doing nothing more than afterward sitting on the cash at the Fed earning 4.9% would still be more accretive for NIM than sitting in the bonds you own, at least until the next FOMC meeting. That is when we might be down another 50 basis points, judging by the latest Personal Consumption Expenditure inflation print. But you would still be better off selling now.

Now, opportunity costs are one thing, but the fact is that bank treasurers who did nothing over the past year watched the 10-year Treasury Note rally by over 120 basis points, its yield down to 3.75%. Thanks to that rally, the fair value loss on their aggregate bond portfolio fell through the end of June 2024. In the last month, the Treasury 10-year rallied by 80 basis points, which should narrow that fair value loss even more. If bank treasurers wait long enough, their mark-to-market problems in their fixed-rate mortgage securities portfolio will disappear.

Of course, if they bought bonds last year when mortgage rates had 7-handles on them when mortgage rates were peaking a year ago, they would be sitting on unrealized gains in their AFS bond portfolios right now. But remember that mortgage rates may remain higher even after the Fed reaches the terminal Fed funds rate. Because, people, the era of cheap money is over! Just as companies call employees back to the office and the grind of a 5-day in-office workweek, it is time to remember that money is not free. The neutral rate is higher than it was before Covid, Chairman Powell told reporters after the FOMC meeting this month,

"It feels to me the neutral rate is probably significantly higher than it was back then."

This from the man who beheld the unobservable R-Star and told the assembled in Jackson Hole four years ago that the neutral rate had fallen, observing then that,

"The general level of interest rates has fallen both here in the United States and around the world. Estimates of the neutral federal funds rate, which is the rate consistent with the economy operating at full strength and with stable inflation, have fallen substantially, in large part reflecting a fall in the equilibrium real interest rate, or "R-star." This rate is not affected by monetary policy but instead is driven by fundamental factors in the economy, including demographics and productivity growth—the same factors that drive potential economic growth."

Whether members of the FOMC really know where the neutral rate is or not, it is hard to miss the point that offices are cutting back or canceling Taco Wednesdays and other strategies to woo employees back into the office. We are not going to visit the 0-lower bound again anytime soon. So, there is not much to wait for.

The cost of holding on to your clunker portfolio is the opportunity cost illustrated in Figure 1. Even though 15- and 30-year mortgage rates are lower today than a year ago, the book yield on an average bank's MBS book, including both HTM and AFS, is still multiple points lower.

**Figure 1: Yield on an Average Commercial Bank's MBS Portfolio Compared to the Current 15-Year Mortgage Rate**

Then, you still need to think about your current funding costs. It costs NIM to fund underwater bonds, and if the effective Fed Funds rate is your proxy for your marginal funding rate, then as shown in Figure 2, assuming the book yield on your bond portfolio is equal to the book yield of an average commercial bank’s bond portfolio in Q2 2024, your negative carry on the portfolio is 3 points.

Your interest-bearing liabilities comprise 76% of your earning assets, and your investment portfolio is a quarter of those assets, so those 3 points represent a sizeable chunk of your NIM. Selling underperforming bonds and ridding your balance sheet of the expensive funding that goes with them is a time-honored way that bank treasurers use to fix their balance sheets.

**Figure 2: Book Yield on an Average Bank-Owned MBS Portfolio Less Effective Fed Funds Rate**

Stuck With The Old Grill

So, the timing is now for a sale and earnback restructuring. The bad news, though, is that bank treasurers cannot get out of the underwater bonds in the HTM account, and many cannot get out of the clunkers sitting in their AFS portfolio, either. In aggregate, for all commercial banks, at the end of June 2024, the difference between the amortized cost and the fair value of the Agency MBS sitting in their AFS account equaled $203 billion. The same for the HTM account equaled $310 billion, which is concentrated with the largest banks with total assets over $100 billion.

So, the largest banks are stuck with the lousy grill. Most of it, anyway.

For the record: The mark-to-market in the Agency MBS bonds that the 4,509 chartered commercial banks with total assets under $100 billion held in their AFS portfolio at the end of June 2024 equaled $102 billion, and the unrealized loss equaled $103 billion in the AFS book for the other 33 banks with total assets over $100 billion. In the case of the smaller peer group, when the Basel 3 Endgame is ultimately reproposed and finalized, AOCI will still be excluded from its regulatory capital calculation. Tangible common equity before the deduction for AOCI equaled $1.5 trillion in aggregate for the banks in the large peer group and $740 billion for the banks in the small peer group.

Thus, a bank in the small peer group has limited opportunity to execute a sale and earn back on its AFS bond portfolio, given the size of the upfront deduction it would incur against its regulatory capital. If large banks had no other problems with regulators trying to increase their capital requirements, they could write the check for the loss and get out of their AFS bonds. AOCI, on a pre-tax basis, lowered tangible common equity ratios at the end of June 2024 by an average of 1-3 percentage points across the size spectrum of banks by total assets. But, the averages in Figure 3 are deceiving.

According to the Q2 2024 call reports, were 1,595 banks below $10 billion in total assets. If they were to sell their underwater bonds today and realize the loss, they would fall below that minimum 9% threshold under the Community Bank Leverage Ratio for a well-capitalized bank. There were 186 banks whose capital ratios would fall on average by eight percentage points, and their CBLRs would end up under 4%. No doubt their bank examiners would have a thing or two to say about that.

Banks that have executed these sales and earnbacks touted their benefits. Speaking to analysts earlier this month at a conference, the CFO of a regional bank based in the southeast looked forward to a good tailwind coming from the restructuring it did last year,

“We did the repositioning of the securities portfolio… part of that impact you had in the second quarter, part of the impact will come this quarter. In the longer term, we benefit from fixed-rate asset repricing. And that will come through over the next few years, and it will be a steady tailwind to the margin.”

The CFO at a large regional bank based in the Midwest told analysts that the restructuring improved the value of the portfolio and that his bank's capital ratios were so strong it could afford the upfront charge,

“We sold CMOs and CMBS. Average yield on those was about 2.3%, average duration just under six years. We started to reinvest those, which again, we will do over time. We'll get better liquidity profile on that portfolio. Doesn't impact…tangible common. And obviously, we used some capital, but we were running well above our stated targets anyway.”

**Figure 3: Tangible Common Equity Ratio**

If You Can't Buy A New One, You Can Always Try To Fix The Old One

Unable to sell their entire portfolio of underwater bonds, many bank treasurers have been selling off pieces since the end of last year. However, no bank treasurer since Silicon Valley Bank (SVB) has attempted to sell off their entire AFS book. Beyond that strategy, which still leaves them upside down on the asset side of their balance sheet, bank treasurers continue to think about funding strategies to take advantage of an inverted yield curve and how to lock in forward rates. The opportunity to help their cause on the liability side of their balance sheet seems compelling. For example, the 3-year Treasury note yield is 3.4%, 120 basis points below 3-month Treasury Bills.

Our corporate sponsor, Eris Innovations, points out that entering into an interest rate swap with a 3-year Secured Overnight Financing Rate interest rate swap futures contract can be one way for bank treasurers to manage funding expenses. R&T Deposit Solutions recommends using its reciprocal network to free up collateralized deposits, enter into committed brokered balance accounts, and swap the balance.

Stable Balance Sheet Liquidity Reconsidered

Doing it all, ala SVB might be prohibitive, if not reckless, considering what happened to that bank. However, bank treasurers still have a problem that goes beyond their NIM issues, opportunity costs, and tangible capital resources to mark to market. If the bonds they booked in their AFS accounts are not liquid enough to sell, how are they liquid? If their bond portfolio is not fluid, they had better consider contingency funding because their bank examiner sure is.

Maybe as your bond portfolio is not liquid, you should add it to your loan book and turn your loan-to-deposit ratio into a ratio of your earning assets to your deposits. That ratio might be a more accurate measurement of stable funding today and would show that your bank’s stable funding profile is much tighter than it appears. See this month’s Slide 4 in the chart deck for more information.

Discount Window Push

Since the SVB fiasco last year, the Fed has been after bank treasurers to downgrade their reliance on FHLB advances for contingency funding and to incorporate the discount window in their planning better. To further its push on the discount window, last June 24th, the Fed launched a new secure online portal called Discount Window Direct. Bank treasurers can use the portal to request a loan. Typically, bank treasurers use the phone to ask for an emergency loan from the Fed, so a point-and-click concept might make the process less cumbersome, not to mention less awkward and potentially less dramatic if one imagines what a call would be like for a bank treasurer to make in the 11th hour, with no other place to turn and with deposits flying out the door.

Of course, there is a setup to use the system, and it takes a lot to coordinate between the Discount Window at each of the 12 Federal Reserve banks and the 11 FHLB advance desks to make the portal work. This month, the Fed sought industry input on the discount window portal through a request for comment (RFC). As stated in the preamble, the Reserve Bank wants a perfected, first-priority security interest in the collateral it takes for the loans it makes. When a Reserve Bank receives a pledge of loans from a depository institution,

“…the Reserve Bank will file a financing statement on the pledged loans, conduct a lien search, and, if necessary, take steps to protect its security interest against the claims of other creditors. In some cases, a Federal Home Loan Bank FHLB may have a blanket lien that already encumbers some of a depository institution's assets. The Reserve Banks and FHLBs coordinate to ensure that the same collateral does not secure advances to the same borrower.”

And the Fed’s Board Staff said yes, which is a significant concession. To be able to point to your capacity to borrow from the Fed’s discount window in a stressful scenario should be part of your contingency funding plan. Duh! However, a year ago, SVB and Signature Bank could not borrow from the window when they failed, and one of the reasons might be that the Fed was not encouraging banks to prepare, to point to their untapped lines at the window or FHLB as a contingency funding source. If the Fed did not care, why should the banks?

The Board Staff’s reasoning went like this. Regulation YY only requires a large bank holding company to show that it can monetize HQLA under different stress scenarios. It does not say how it has to show that it can monetize it; it just says it can. While FAQs are not exactly rulemaking, and Board Staff does not make rules, publishing their reasoning may make it easier for bank treasurers to think beyond just sitting on a pile of reserves to meet liquidity planning requirements. Instead of locking up cash,

“A covered firm can incorporate the discount window, SRF, and FHLB advances into its ILST scenario analysis, as a supplement to private market monetization channels, including for the 30-day planning horizon. The Federal Reserve encourages firms to assess the full range of liquidity sources.”

If You Can't Buy A New One, You Can Always Try To Fix The Old One

Unable to sell their entire portfolio of underwater bonds, many bank treasurers have been selling off pieces since the end of last year. However, no bank treasurer since Silicon Valley Bank (SVB) has attempted to sell off their entire AFS book. Beyond that strategy, which still leaves them upside down on the asset side of their balance sheet, bank treasurers continue to think about funding strategies to take advantage of an inverted yield curve and how to lock in forward rates. The opportunity to help their cause on the liability side of their balance sheet seems compelling. For example, the 3-year Treasury note yield is 3.4%, 120 basis points below 3-month Treasury Bills.

Our corporate sponsor, Eris Innovations, points out that entering into an interest rate swap with a 3-year Secured Overnight Financing Rate interest rate swap futures contract can be one way for bank treasurers to manage funding expenses. R&T Deposit Solutions recommends using its reciprocal network to free up collateralized deposits, enter into committed brokered balance accounts, and swap the balance.

Stable Balance Sheet Liquidity Reconsidered

Doing it all, ala SVB might be prohibitive, if not reckless, considering what happened to that bank. However, bank treasurers still have a problem that goes beyond their NIM issues, opportunity costs, and tangible capital resources to mark to market. If the bonds they booked in their AFS accounts are not liquid enough to sell, how are they liquid? If their bond portfolio is not fluid, they had better consider contingency funding because their bank examiner sure is.

Maybe as your bond portfolio is not liquid, you should add it to your loan book and turn your loan-to-deposit ratio into a ratio of your earning assets to your deposits. That ratio might be a more accurate measurement of stable funding today and would show that your bank’s stable funding profile is much tighter than it appears. See this month’s Slide 4 in the chart deck for more information.

Discount Window Push

Since the SVB fiasco last year, the Fed has been after bank treasurers to downgrade their reliance on FHLB advances for contingency funding and to incorporate the discount window in their planning better. To further its push on the discount window, last June 24th, the Fed launched a new secure online portal called Discount Window Direct. Bank treasurers can use the portal to request a loan. Typically, bank treasurers use the phone to ask for an emergency loan from the Fed, so a point-and-click concept might make the process less cumbersome, not to mention less awkward and potentially less dramatic if one imagines what a call would be like for a bank treasurer to make in the 11th hour, with no other place to turn and with deposits flying out the door.

Of course, there is a setup to use the system, and it takes a lot to coordinate between the Discount Window at each of the 12 Federal Reserve banks and the 11 FHLB advance desks to make the portal work. This month, the Fed sought industry input on the discount window portal through a request for comment (RFC). As stated in the preamble, the Reserve Bank wants a perfected, first-priority security interest in the collateral it takes for the loans it makes. When a Reserve Bank receives a pledge of loans from a depository institution,

“…the Reserve Bank will file a financing statement on the pledged loans, conduct a lien search, and, if necessary, take steps to protect its security interest against the claims of other creditors. In some cases, a Federal Home Loan Bank FHLB may have a blanket lien that already encumbers some of a depository institution's assets. The Reserve Banks and FHLBs coordinate to ensure that the same collateral does not secure advances to the same borrower.”

And the Fed’s Board Staff said yes, which is a significant concession. To be able to point to your capacity to borrow from the Fed’s discount window in a stressful scenario should be part of your contingency funding plan. Duh! However, a year ago, SVB and Signature Bank could not borrow from the window when they failed, and one of the reasons might be that the Fed was not encouraging banks to prepare, to point to their untapped lines at the window or FHLB as a contingency funding source. If the Fed did not care, why should the banks?

The Board Staff’s reasoning went like this. Regulation YY only requires a large bank holding company to show that it can monetize HQLA under different stress scenarios. It does not say how it has to show that it can monetize it; it just says it can. While FAQs are not exactly rulemaking, and Board Staff does not make rules, publishing their reasoning may make it easier for bank treasurers to think beyond just sitting on a pile of reserves to meet liquidity planning requirements. Instead of locking up cash,

“A covered firm can incorporate the discount window, SRF, and FHLB advances into its ILST scenario analysis, as a supplement to private market monetization channels, including for the 30-day planning horizon. The Federal Reserve encourages firms to assess the full range of liquidity sources.”

This generosity on the part of Board Staff, they said, does not mean that banks can count on untapped lines of credit at the window as an “asset” to meet liquidity coverage ratio requirements. Let’s not go crazy.

“Covered firms cannot include a line of credit (including borrowing capacity at the discount window or FHLB) as a cash flow source that reduces the amount of their net stressed cash-flow need in their 30-day ILSTs.”

But here was an important little nugget, a bone maybe, as Board Staff concluded,

“Finally, an asset that qualifies as HLA that is pledged to a central bank or U.S. government-sponsored enterprise (such as the FHLB) but is not needed to secure an outstanding advance is considered unencumbered for the purposes of Regulation YY.”

A blanket lien by a bank’s FHLB on its balance sheet can complicate its ability to borrow from the window. Therefore, the Board Staff’s concession helps, at least as far as the ILST is concerned. Whether this helps motivate bank treasurers to value contingency funding from the discount window over advances from their FHLB remains to be seen.

Chevron and the Basel 3 Endgame

June 24th was a momentous day. On the same day the Fed launched Discount Window Direct, the U.S. Supreme Court overturned Chevron, a 1984 Supreme Court decision that had defied administrative agencies to make rules as they saw fit. After that day, the Court made it easier to sue a regulator, and suddenly, bank regulators who were pushing by bank regulators to raise capital requirements with the Basel 3 Endgame Proposal looked a little offside.

Michael Barr introduced the Basel 3 Endgame proposal last year, and the proposal was so severely panned as causing unmitigated economic damage, if not competitive harm to the banking industry that lobbyists felt emboldened to advertise to people attending football games in the U.S. last winter how bad it was. But the Vice-Chair of Supervision was undeterred. In July of last year, he defended the proposal and insisted the industry needed more capital,

“Banks rely on both debt and capital to fund loans and other assets, but capital is what allows the bank to take a loss and keep on operating. The beauty of capital is that it doesn't care about the source of the loss. Whatever the vulnerability or the shock, capital is able to help absorb the resulting loss and, if sufficient, allow the bank to keep serving its critical role in the economy. Higher levels of capital also provide incentives to a bank's managers and shareholders to prudently manage the bank's risk, since they bear more of the risk of the bank's activities.”

That was then. This month the Vice-Chair of Supervision explained why the Fed was pulling its proposed Basel 3 Endgame and would repropose it,

“Since I joined the Federal Reserve Board as Vice Chair for Supervision, I have spoken many times about the importance of bank capital to the safety and soundness of banks and the stability of the financial system…But capital has costs too. As compared to debt, capital is a more expensive source of funding to the bank. Thus, higher capital requirements can raise the cost of funding to a bank, and the bank can pass higher costs on to households, businesses, and clients engaged in a range of financial activities. These activities are critical to a well-functioning economy that works for everyone. That's why it is important to get the balance between resiliency and efficiency right.”

Which is a major about face. And capital was not the only topic. Bank regulators really want to make it easier for bank treasurers, to make hedging easier and to promote more securities clearing. He went on,

“Moreover, we will clarify that uniform MBS positions would be treated as having a single obligor, regardless of whether they were issued by Freddie Mac or Fannie Mae. This change will enable firms to recognize hedging across these securities. With respect to derivatives activities, I plan to recommend that the Board adjust the capital treatment for client-cleared derivatives activities by reducing the capital required for the client-facing leg of a client-cleared derivative. This change would better reflect the risks of these transactions, which are highly collateralized and subject to netting and daily margin requirements. This also would avoid disincentives to client clearing.”

The banking industry had won. Hearing these remarks during the course of an analyst conference held earlier this month, the chairman and CEO echoed the Chevron decision in his answer,

“I think to do it in this present form would invite a lot of litigation.”

The Basel 3 endgame had to be pulled, the chairman and CEO of a large regional bank in the east said, because it was an economic mess, and not because it would have raised capital requirements that much,

“Most regionals were hit with a very modest increase in risk-weighted assets (RWAs). So, it was manageable. It just wasn't the right thing to increase RWAs on things like low and moderate low-down payment mortgages or small business loans…We were against it because of the economic impact of it.”

The about face was nothing short of miraculous, according to the CFO of a regional community bank based in the west,

“Finally, the administrative state perceives limits on what it can do…a miracle!”

The New Barbecue

The barbecue store carted away the old grill just a few days after Labor Day. It had the new one assembled and up and running in no time, which, as far as newsletter staff was concerned, considering how long the outdoor grill saga went on, was a modern-day miracle. But already, there are complaints about hamburgers that are coming out very burned.

One thing about grills that people often overlook is that they are not idiot-proof, and you have to know how to use them. When you think about it, this is why banks have bank treasurers. Bank treasurers know how to manage the balance sheet. You have to pay attention and understand what you are buying. If you buy new Agency MBS bonds for the portfolio, you do not purchase premium bonds that will rapidly prepay on you.

That’s what’s called skill and paying attention. The real secret with hamburgers is that it does not matter whether you have the cheap grill, the $900 grill with the sear station you cannot figure out, or the $40,000 grill that is a whole outdoor kitchen. To get good results, you need a grill master who knows what they are doing. That person is your bank treasurer.

The Bank Treasury Newsletter is an independent publication that welcomes comments, suggestions, and constructive criticisms from our readers in lieu of payment. Please refer this letter to members of your staff or your peers who would benefit from receiving it, and if you haven’t yet, subscribe here.

Ethan M. Heisler, CFA

Editor-in-Chief

Download this Newsletter as a PDF

This Month’s Chart Deck

Even if the Fed’s dot plot published this month becomes a reality and the range on Fed funds falls to under 3% by 2026, bank treasurers believe they will likely still be stuck with fixed-rate assets yielding less than three percentage points below the rate on current production. Their assets are deeply underwater, and the fair value difference with amortized cost adding both bonds booked in Held-to-Maturity (HTM) and Available-for-Sale (AFS) on June 30, 2024, equaled $513 billion, the majority of which is tied to the HTM portfolio as discussed in this month’s newsletter (Slide 1).

With current mortgage rates in the 5%-6% range (Slide 2), even though these rates are lower than where they were a year ago, most bank portfolios are not only underwater, but they generate book value interest income below their accounting cost of funds (Slide 3) and cost banks a lot of net interest margin (NIM) every day they remain on the balance sheet. Even worse, the loss in the AFS book is too significant to sell bonds at a loss, meaning that an average bank’s bond portfolio is not a very liquid asset, maybe no different from a liquidity standpoint than the loan book. Adjusting the loan-to-deposit ratio to include the bond portfolio (Slide 4) suggests that regional and community bank balance sheet stable funding tightened in the last two years, and it might be more stretched than it appears to be at large banks.

The Fed may already have begun cutting the Fed funds rate. However, it is still proceeding with Quantitative Tightening (QT) at a monthly run-off pace of $22 billion Treasurys and $11 billion-$12 billion mortgage-backed securities (MBS). However, though the size of the Fed’s balance sheet theoretically impacts the balance of deposits in the banking system, over the last 18 months since the failure of SVB, deposits have been growing while the Fed’s balance sheet has continued to shrink (Slide 5). The Fed reduced the rate it pays on interest on reserve balances to 4.9% and the rate it pays on reverse repo facility (RRP) balances to 4.8%, which over time will help narrow the cumulative negative Treasury remittances on its balance sheet, which reached minus-$200 billion (Slide 6). Negative remittances increase the Fed’s reserve balances and counter some downward pressure on reserves from QT.

While bank treasurers face earnings and liquidity issues on the earning asset side of their balance sheet, there is good news on the funding side as they hope to bring deposit costs down rapidly. The price for interest-bearing deposits peaked in the most recent quarters (Slide 7). Banks can lock in forward rates on the funding side of their balance sheet and monetize the inversion that persists in the front end of the yield curve (Slide 8) even as the spread between 2s-10s is finally back in positive territory (Slide 9).

Regional and community banks, saddled with low-yielding assets, upside down on their costs, and looking at a limited opportunity to expand operating leverage without loan growth, are still under something of a cloud following the failure of SVB 18 months ago. Their stock prices have slowly recovered this year (Slide 10) but are still not back to pre-SVB trading levels.