Rising Rates Seen Squeezing Swaps Income at Biggest BanksDakin Campbell
The revenue engine that generated $42 billion for three of the biggest U.S. banks in less than five years is beginning to sputter as some borrowing costs rise.
The revenue comes from derivatives used by JPMorgan Chase & Co., Bank of America Corp. and Wells Fargo & Co. to protect against interest-rate swings. Most of the contracts are swaps that exchange payments tied to a floating rate for ones that are fixed. Banks that benefited from swaps guaranteeing a flat rate could see profit drop as the spread between the higher fixed and lower variable rates narrows or reverses.
The swaps “created some earnings at a time when they needed them,” said Charles Peabody, an analyst at Portales Partners LLC in New York. “The impact will start to recede.”
When the Federal Reserve begins reducing its $85 billion of monthly bond purchases, driving up long-term rates, lenders may struggle to replace income, Peabody wrote in a June 21 report warning about the possibility at Bank of America. Even talk of tapering by Fed Chairman Ben S. Bernanke in May led to a rise in rates and a 33 percent second-quarter decline in the value of swaps positions in which Bank of America received a fixed rate.
At JPMorgan, the largest U.S. bank by assets, interest-rate derivatives boosted income by $19.9 billion from the beginning of 2009 through June 30, according to data compiled by Bloomberg from company filings. No. 2 Bank of America, which has said interest-rate swings are its most significant market risk, added $7.3 billion in the same period. Wells Fargo, the fourth-biggest lender, reported $15.3 billion in income from the contracts.
Citigroup Inc. was the only one of the four biggest U.S. banks to post a loss from interest-rate hedging, according to filings. The amount was $5.4 billion over the four and a half years. Mark Costiglio, a spokesman by the New York-based company, declined to comment on why the lender showed a loss while others reported a gain.
The banks don’t disclose the full impact of interest-rate derivatives on earnings or capital in their filings.
“The amount of interest-rate risk banks have remains locked inside a black box,” said Frank Partnoy, a professor of law and finance at the University of San Diego who structured derivatives at Morgan Stanley. “Even a sophisticated investor who reads all the footnotes to bank financial statements cannot determine how much money they are making on interest-rate bets or how much exposure they have.”
Rising rates threaten interest-rate swaps known as receive fixed, those in which a bank or another party agrees to receive a payment based on a fixed rate and pay an amount linked to one that fluctuates. The positions profit when the fixed rate, tied to a longer maturity, is above the floating rate in what’s known as an upward-sloping yield curve.
Banks also take the other side with contracts known as pay fixed, agreeing to make payments based on a constant rate and receive an amount tied to a floating rate. In addition to swaps, which are essentially bets that rates will rise or fall, lenders use options, futures and forwards to manage interest-rate risks.
As rates move higher, banks with large net holdings of receive-fixed swaps can get hit in two ways, Peabody said. An increase in long-term rates reduces the value of their positions, while a rise in short-term rates erodes the income they produce as the spread between what’s received and what’s paid shrinks. The position loses money if the floating rate rises above the fixed one.
Banks holding a receive-fixed swap “lose money on a mark-to-market basis when rates rise,” Siddhartha Jha, author of “Interest Rate Markets: A Practical Approach to Fixed Income,” said in an interview. “You are receiving a lower rate than what the market is offering.”
Losses on swaps caused by higher long-term rates can either directly hit a bank’s income statement or erode its equity before crimping future earnings, depending on how the contracts are characterized under accounting rules.
Because the contracts are used to hedge other positions, the income shouldn’t be viewed in isolation, according to people with knowledge of the banks’ strategies. Much as the derivatives helped some banks offset loan and bond income depressed by lower returns, rising rates will make those assets more profitable, said the people who asked not to be identified because they weren’t authorized to speak about the matter.
“Our goal is to manage interest-rate sensitivity and volatility so that movements in interest rates do not significantly adversely affect earnings or capital,” Jerry Dubrowski, a Bank of America spokesman, said in an e-mailed statement. The bank uses many different instruments to manage that risk, he said.
Higher long-term rates already have boosted the value of some assets. Mortgage-servicing rights, contracts assigning the right to collect mortgage payments, gained in the second quarter to offset declines in derivatives used to hedge them, Standard & Poor’s analysts wrote in a Sept. 23 report.
Bank of America, led by Chief Executive Officer Brian T. Moynihan, 53, had receive-fixed swaps with a notional value of $98.7 billion at the end of June compared with $19.4 billion of pay-fixed swaps. That means most of the Charlotte, North Carolina-based lender’s interest-rate swaps are vulnerable to rising rates.
To avoid an impact to earnings, Bank of America will need to find ways to maintain or replace an average of $408 million in quarterly net interest income it gets from interest-rate derivatives, according to data compiled by Bloomberg. JPMorgan will have to find $1.1 billion of income and San Francisco-based Wells Fargo $848 million. The calculations assume lenders don’t enter into offsetting trades or exit positions.
The derivatives income represents about 3.3 percent of the $1.29 trillion in net revenue the three lenders took in from 2009 through the end of June.
The Fed cut the overnight lending rate to close to zero in December 2008, increasing the difference between the yield on the three-month Treasury bill and the 10-year Treasury note to more than 3.8 percentage points. That made the receive-fixed trade a profitable one for banks.
Banks that locked in a fixed rate for five years on an interest-rate swap trading at 3.52 percent on June 8, 2009, have fared well as floating rates have fallen. The three-month London interbank offered rate dropped to 0.25 percent yesterday, a 27-month low. The average estimated duration of Bank of America’s receive-fixed swaps was about 5 years at the end of June.
In the past four months, swaps users started bracing for higher rates. Bernanke’s May 22 comments that the Fed may slow its bond purchases used to keep long-term rates low drove the yield on the 10-year Treasury note as high as 3.005 percent on Sept. 6 from 1.61 percent on May 1.
“When, not if, interest rates rise, the banks will lose a major source of income from the carry trade they have been enjoying and the Fed has been subsidizing,” said the University of San Diego’s Partnoy. “Also the interest-rate bets that are hidden within the banks will suddenly become losing bets.”
A change in the long-term trend for interest rates, in this case heading higher after a 30-year period of declining borrowing costs, can catch lenders off guard.
In 1993, Columbus, Ohio-based Banc One Corp. said it used derivatives to boost annual net interest income by $446 million. By 1994, Banc One, then the nation’s eighth-largest lender, suffered losses tied to rising interest rates that ended a quarter-century run of annual earnings increases. The Fed increased the overnight lending rate seven times, taking the rate from a then record-low 3 percent in February 1994 to 6 percent a year later. The company was sold to JPMorgan in 2004.
Bankers have warned of parallels to 1994. Goldman Sachs Group Inc. CEO Lloyd C. Blankfein said May 2 at a conference in Washington that investors at that time were used to low interest rates and shocked by losses when borrowing costs rose.
“I worry now -- I look out of the corner of my eye to the ’94 period,” Blankfein said.
Bank of America had $2.7 billion of unrealized losses on interest-rate cash-flow hedges at the end of June, according to its second-quarter filing. It said about $936 million of that amount, pretax, will hit income in the four quarters through June 2014. New York-based Citigroup may record $1 billion of losses over the same period, according to filing.
So far, short-term rates haven’t risen, and Fed officials are taking a measured approach, unexpectedly refraining from reducing bond buying after the central bank’s Sept. 18 meeting. Traders don’t expect the Fed to raise the overnight borrowing rate until July 2015, according to Fed funds futures.
“You can do a relatively low-risk carry trade as long as you are confident the Federal Reserve, other central banks and market participants will continue to keep short-term rates low,” Stephen Ryan, a professor of accounting at the Stern School of Business at New York University and author of “Financial Instruments & Institutions,” said in an interview. “Banks may view this as a good gamble.”
Banks say they’re poised to benefit from rising rates as profit margins climb on loans such as mortgages. Bank of America would get $1.03 billion more net interest income if the “long rate” rose by 1 percentage point without the short end moving at all, according to its second-quarter filing. JPMorgan would bring in $900 million in the same scenario, according to a company presentation, and Citigroup $88 million.
Even such disclosures don’t provide the full picture. Bank of America said its measure of sensitivity to interest rates doesn’t include ineffective hedges.
U.S. accounting rules, known as Generally Accepted Accounting Principles, allow banks to match the financial-statement reporting of derivatives and the underlying hedged items in certain cases. In others, swaps income appears in a disclosure that doesn’t always show the impact of offsetting.
Wells Fargo, the largest U.S. mortgage lender and servicer, said $7.2 billion of the income gathered over the past four and a half years from interest-rate derivatives isn’t reported under rules that account for hedges. The revenue is used to hedge businesses including the lender’s residential-mortgage pipeline and the value of rights to service home loans.
JPMorgan, led by CEO Jamie Dimon, 57, cited similar uses for $16 billion in income from interest-rate contracts.
“Although the extent of these economic hedges directly affects recorded earnings, gauging their full impact is difficult because of disclosure limitations,” S&P analysts wrote in their Sept. 23 report.
New York-based JPMorgan also said other derivatives were intended to protect it against corporate defaults before a wrong-way bet led to more than $6 billion of losses.
For banks, which count interest-rate swaps and other instruments as their biggest derivatives holdings, the shock could be severe, according to Mike Mayo, an analyst at CLSA Ltd. in New York.
The notional amount of interest-rate contracts held by U.S. banks climbed to $179 trillion at the end of 2012 from $11 trillion in 1995, according to the Office of the Comptroller of the Currency. They comprised 80 percent of all derivatives held by lenders last year, the report shows. Worldwide, about $490 trillion of over-the-counter interest-rate derivatives were outstanding at the end of 2012, data from the Bank for International Settlements show.
“We’ve had a 100-year flood in credit risk,” Mayo said, referring to the 2008 financial crisis when banks lost billions of dollars on bad mortgage debt. “We haven’t had a 100-year flood in interest-rate risk.”