Interest rates have been on the rise since the start of the current year. While rising interest rates usually mean higher income and the resultant wider net interest margin for the US banks, it also means a drop in the book value of the fixed income instruments held by these banks.
Let’s see which banks will be hurt the most and why.
Rates on the rise despite QE
The third round of quantitative easing was mainly aimed at bringing long-term Treasury and mortgage rates down. However, despite the Fed’s commitment to continue its easing programs, rates have gone up since the start of the quarter. That’s because of speculations about the Fed’s exit. The speculation started in mid May and since then the markets have started pricing in the impact of the Fed’s exit.
As a result, the 10-year Treasury yield climbed 66 basis points (bps), while 30-year fixed mortgage rates jumped 89 bps since the start of the current year. While the rise in rates theoretically means higher net interest margins for banks, they also mean book value erosion. However, both the positive and negative impacts of rising interest rates are different for banks.
Let’s see which factors lead to higher book value declines in some banks rather than others.
Fixed income portfolio duration
Banks are thought to possess large portfolios of fixed income instruments which yield interest income. However, with the rise in rates, the value of these fixed income portfolios declines. The decline in their value is dependent on the duration of the fixed income portfolio. For those who are not familiar with the term duration, it measures the sensitivity of change in the portfolio value to move in the interest rates.
Credit Suisse provides estimates of the large cap banks’ durations. According to those estimates, Wells Fargo & Co (NYSE:WFC), PNC Financial Services (NYSE:PNC) and Bank of America Corp (NYSE:BAC) have the highest estimated durations of 3.5 years, 2.3 years and 2.3 years, respectively.
Book value sensitivity
This high duration of the fixed income portfolios at the aforementioned banks leads to a more book value that is more sensitive to rising interest rates.
A 100 bps increase in the interest rates will bring about a 0.4% decline in Wells Fargo & Co (NYSE:WFC)’s tangible common equity, while declines for PNC Financial Services (NYSE:PNC) and Bank of America Corp (NYSE:BAC) are 0.26% and 0.21%, respectively. Similarly, if we talk about the banks’ tangible book values, Wells Fargo will experience around 4.5% decline in book value, followed by 3% at Bank of America and 2.9% at PNC Financial.
Credit Suisse estimates that Wells Fargo & Co (NYSE:WFC)’s book value has plunged 0.2% since the start of the second quarter, compared to a 0.3% plunge in Bank of America Corp (NYSE:BAC)’s book value. Besides, Citigroup has experienced around 0.7% decline in its book value over the same time period.
Impact on interest income
While Wells Fargo & Co (NYSE:WFC)’s book value might be hit the most from increasing interest rates, its top executives have made it clear that the bank’s interest income will experience some expansion. Bloomberg reported the bank’s CFO saying that Wells Fargo is well positioned to benefit from rising interest rates. The bank is considered not to be stuck with loans and securities which lose value as the interest rates go higher.
According to the financial disclosures provided by the banks, PNC Financial Services (NYSE:PNC)’s net interest income is not expected to move significantly if the rates go up 100 bps, while Bank of America’s projected interest income is expected to go up by 8.9%.
Conclusion
Looking at the fixed income portfolio durations of the aforementioned banks, it’s clearl that Wells Fargo & Co (NYSE:WFC) will experience the most book value decline due to the rising interest rates. However, all is not bad for Wells Fargo, its investors can expect an increase in its interest income.
Other banks that might experience declines in their book values include PNC Financial and Bank of America Corp (NYSE:BAC). I would recommend investors stay away from these last two banks until rates stabilize.
Red Chip has no position in any stocks mentioned. The Motley Fool recommends Bank of America and Wells Fargo. The Motley Fool owns shares of Bank of America, PNC Financial Services, and Wells Fargo. Red is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
The article Book Value Erosion a Concern for These Banking Stocks originally appeared on Fool.com and is written by Red Chip.
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