The Simplified Bank Stress Test

Aug.21.12 | About: iShares 20+ (TLT)

Bloomberg reported on 20 August 2012 that banks are stepping up their U.S. Treasury buying. As deposits increased 3.3% to $US 8.88 trillion in the two months ended July 31 2012, business lending rose 0.7% to $7.11 trillion, Federal Reserve data show. This inherently means that banks aren't lending money to the private sector, but are lending their money to the U.S. government. Peter Schiff pointed this out on the Peter Schiff Show of 20 August 2012. Banks bought $136.4 billion in bonds (NYSEARCA:TLT) already this year, pushing their holdings to $1.84 trillion.

Let's compare the debt maturities in 2011 (Chart 1) with debt maturities today. (I talked about debt maturities in this article).

Chart 1: U.S. Treasury debt by Year of Maturity (2011)
Click to enlarge

You can immediately see that short term debt has doubled in 1 year time. The biggest buyers of these Treasuries were the Federal Reserve, domestic investors, banks, emerging markets like Japan and China. It's no wonder that bond yields have gone down with all this buying of U.S. Treasuries. But these yields have started to rise sharply just recently, topping 1.85% for the 10 year U.S. Treasuries (Chart 3).

Click to enlarge
Chart 3: 10 year U.S. Treasury yield
Click to enlarge

Let's focus on the U.S. banks and analyze the impact of these rising yields on U.S. bank earnings.

First, we take a look at earnings. The average net interest margin at the four largest U.S. banks -- JPMorgan Chase & Co. (NYSE:JPM), Bank of America Corp. (NYSE:BAC), Citigroup Inc. (NYSE:C) and Wells Fargo & Co. (NYSE:WFC) -- shrank to less than 2% from 3% a year earlier. Basically banks get money from the Federal Reserve at 0% and lend it back to the government for 2%. But banks aren't really earning a lot of money holding these U.S. Treasuries at 2% yield.

Second, we take a look at the balance sheet's assets. The banks were forced to get into U.S. Treasuries as the Federal Reserve pushed interest rates to 0% in 2008. Since 2008, banks have increased their U.S. Treasury holdings + agency securities from 52% to 68% (Chart 4). This also means that Treasuries and related securities are the biggest portion of the balance sheet of the banks. This makes it very easy to perform a "simplified" stress test on the banks. We just focus on the biggest portion of their balance sheet, which is U.S. government bonds. If yields on U.S. government bonds rise, there will be a point where banks become insolvent, let's find out this inflection point. (note that the official stress tests on the banks don't even take into account a rise in interest rates)

For example Bank of America had $43 billion in U.S. Treasuries at the end of 2011. That amount of U.S. government and agency securities (trading account assets) has since gone up to $76 billion in June 2012. Non-U.S. sovereign debt (trading account assets) has increased from $42 billion (December 2011) to $51 billion (June 2012). Mortgage backed securities (which are similar to U.S. Treasuries as I discussed here) have increased from $205 billion (December 2011) to $248 billion (June 2012). If we add this up, we have roughly $375 billion in U.S. Treasury, agency and MBS assets (which are sensitive to market interest rates). The book value of the company is roughly $215 billion.

If interest rates on 10 year U.S. Treasuries were to go from 1.8% to 4%, the value of those Treasuries would drop 20%. Similarly, if interest rates were to go to 7%, the value of those Treasuries would drop 40%. (To calculate this yourself, you can read this article where I made an example calculation on Swiss bonds.) As for the 5 year U.S. government bonds, the yield needs to go above 10% for these bonds to drop 40% in value. That would mean that Bank of America would become insolvent if 10 year U.S. Treasury yields were to go above 7% based on the amount of U.S. Treasuries, agency debt and MBS they have on their balance sheet (as the decline in asset value is bigger than the book value). Similarly, if 5 year U.S. government bonds go above 10%, we get the same outcome.

This simplified example is only applicable to Bank of America, which has a relatively small amount of U.S. Treasuries on its balance sheet. If we extrapolate this to other banks (who have 68% of their assets in U.S. Treasuries and agency debt (Chart 4)), then we have a much gloomier picture.

The Federal Reserve should be ready for another round of QE3 soon, otherwise bond yields will continue going upwards. For the Federal Reserve, this doom scenario needs to be avoided at all costs. Markets are already anticipating QE3 as the U.S. dollar is just recently starting to drop against the euro (Chart 5).

Click to enlarge
Chart 5: EUR/USD
Click to enlarge

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.