) Inc. to Countrywide Financial (CFC
) Corp. have trimmed their profit forecasts, mortgage companies have gone belly-up, and big investors in mortgage-backed securities have lost their shirts. Rates have eased a bit since then, but the nervousness remains. "We're likely to see a fairly large interest-rate move in the not-too-distant future," says Jeffrey E. Gundlach, who manages $32 billion in mortgage-backed securities for TCW, an investment firm in Los Angeles. "It can get much worse."
Rates have shot up before, of course, but this time things are different. They're coming off 45-year lows, after creating an unprecedented boom in mortgage refinancing, and record issuance of mortgage-backed securities (MBS). The first taste of just how dangerous the shock can be came after the Federal Reserve cut short-term rates by 0.25 percentage points on June 25, less than expected. Bond prices plunged, causing Treasury and MBS yields to surge. In the quickest move since 1927, the yields on 10-year bonds hit 4.5% by the end of August, from its low of 3.1% on June 13. In the span of 60 days, the Lehman Brothers Treasury Index lost 11.6%.
The last surprise upswing in rates, in 1994, had its casualties, too -- but today the $5 trillion MBS market surpasses the size of the U.S. Treasury market. How did it get so large? Instead of holding mortgages they wrote over recent years, banks sold them to Wall Street, which, in turn, bundled them and created fixed-income securities backed by these loan pools. MBS comprise almost half of the $3.6 trillion in new bond offerings this year, according to the Bond Market Assn. Mutual funds, pension funds, and endowments buy these securities -- and so do banks. Financial institutions prefer to hold them rather than holding mortgages directly because they offer diversity and liquidity.
Here's how the problem begins. When rates rise, fewer homeowners refinance and instead stick with their existing lower-rate mortgages. That means, on average, the loans that back a particular security will take longer to pay off. So, a security that investors expected to have, say, a four-year maturity now has a 10-year expected life. Those longer-term assets make the institution's overall portfolio more sensitive to higher rates. Banks seek to offset this increased risk by selling other long-term assets, such as Treasuries, which in turn forces Treasury yields higher. James Bianco of Bianco Research, a fixed-income specialist in Chicago, says the sheer volume "drives interest rates as much as Fed policy."SNOWBALL EFFECT. So vast is this market that the smallest uptick in interest rates now sets off a violent ripple effect. For every one-half-of-a-percentage-point rise in the 10-year Treasury bond yield, MBS holders must rebalance their portfolio by selling about $250 billion worth of Treasuries. That drives down rates further and forces banks and other MBS holders to sell yet more Treasuries. "We have to sell hundreds of billions of Treasuries or their equivalent, and the market simply can't absorb that much," says Doug Greenig, head of agency mortgage trading and derivatives at RBS Greenwich Capital. Selling pressure begets higher yields, which begets more selling. "It's the classic snowball effect."
Ultimately, these assets could put bank balance sheets at risk. Consider that at least six sizable institutions -- Commerce Bancorp (CBH
) of New Jersey, Cincinnati's Fifth Third Bancorp (FITB
) Charter One Financial in Cleveland, Roslyn Bancorp (RSLN
) in Jericho, N.Y., and Baltimore's Provident Bankshares -- have from 28% to 51% of their earning assets in mortgage-backed securities, according to Standard & Poor's. As rates rise, the unrealized loss from the market value decline of the MBS holdings could be very high. Says S&P credit rating analyst Victoria Wagner: "In the past, banks that invested their assets this heavily in MBS experienced unrealized losses as high as 22% of total capital."
So far, most lenders are holding on to their MBS portfolios. They now own $706 billion in mortgage-backed securities, according to analyst Adam Compton of Dresdner RCM Global Investors. Worse, he says, half of the MBS are backed by fixed-rate mortgages of more than 15 years, making them ultrasensitive to rate changes. Still, he says, commercial banks have sold only $63 billion worth of mortgage-backeds through the end of August. Adds TCW's Gundlach: "Banks either have to take some pain today, or do nothing and expose themselves to three times the pain later."
How much pain is anyone's guess. Why? Because banks don't have to account for losses in these securities unless they sell them. "Unfortunately, we believe the market is using an accounting system that masks the impact of interest rate changes on bank earnings and bank balances sheets," says Morgan Stanley's large-cap bank analyst, Betsy Graseck, in her Sept. 19 industry report.
The safest strategy for most banks is to hedge their mortgage portfolios. That's an expensive choice in the face of diminishing profits, but a necessary one. Further losses may be averted if rates continue to climb. Consider that during the two and a half years of the refi boom, hedging cost the 20th-largest mortgage lender -- Pasadena (Calif.)-based IndyMac Bankcorp (NDE
) Inc. -- $372 million in earnings on $716 million of loans. Had it not hedged, its margin on the loans would have been 2.55%, vs. 1.68%, says CEO Michael W. Perry. Since the end of June, however, hedging has prevented $157 million in losses, he says. "You can make a lot of money playing it a little bit fast and loose," he says of competitors that don't opt to hedge. "But now everyone's risk management is getting a stress test."DOWN TO A TRICKLE. Failing to hedge when rates are moving against you -- either up or down -- can put those MBS players out of business. That's what happened to Capital Commerce Mortgage, a Sacramento (Calif.) mortgage originator, which abruptly closed shop last month after failing to hedge against rising rates. Conversely, New Jersey's Beacon Hill Asset Management lost $4 billion and folded last October after its fund managers had taken a large, highly leveraged short position in U.S. Treasuries in July, betting wrongly that interest rates would rise.
That banks will suffer losses in their mortgage portfolios is a given. The end of the refi boom has slowed a river of fees to a trickle. Will other revenues pick up? Maybe an improving economy will spark loan demand, but for now commercial lending is flat. True, higher interest rates ultimately boost the banks' net interest margins -- the difference between a bank's interest income and what it pays to depositors. Until then, nails certainly will have been bitten to the quick.
Corrections and Clarifications
In "What's squeezing banks" (Finance, Oct. 6), a quotation from a report by Morgan Stanley analyst Betsy Graseck was taken out of context. Her point is that bank accounting requires held-for-sale securities portfolios to be marked to market, while most other assets and liabilities are not. So when rates rise, investors see the decline in value of the securities portfolios, but they don't see the increase in value of the loan book and core deposits.
By Mara Der Hovanesian in New York