Why JP Morgan hates negative interest rates

Banks have been clobbered recently and are trading well below this year. What gives?

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Bank stocks are in a bad neighborhood. Over the last several days, the entire sector was sold off, with HSBC being particularly hard hit, falling almost 10%.

While some argue that it was because of the revelation that certain banks were engaged in highly suspicious transfers, which could run afoul of Anti Money Laundering regulations, there is perhaps a better answer.

To be honest, with Covid and the US-China tensions a lot of things are going wrong for banks, namely

  1. Increased credit risk due to rising defaults
  2. Increased geopolitical risk due to US – China tensions
  3. Flattening yield curve that will kill interest income

Today, we will talk briefly about item no 3, drawing from JP Morgan’s 2019 Annual Report.

Banks have quite a number of ways to generate revenue, but a big portion of it is something called Net Interest Income, or simply put, the difference between the revenue the bank earns by giving a loan and the amount it needs to pay to fund the loan.

For JP Morgan, the Net Interest Income for 2019 was $57.3 billion, compared to total net revenues of $115.6 billion, which means the  Non-interest revenue was $58.3 billion. This net interest income of $57.3 billion is derived from two main sources

This net interest income of $57.3 billion, or $54.7 billion, was derived largely from $1.67 trillion of interest earning assets, excluding $670 billion of market making instruments which only yielded interest income of $3.1 billion. The interest earning portfolio is largely from $1.0 trillion of loans, carried at an average interest rate yield of 5.3%  and $320 billion of investment securities, carried at an average interest rate yield of 3.0% and $280 billion of deposits with other banks at a yield of 1.4%.

Of course, the above yields on the loan and investment security portfolio is only half the picture to come out with Net Interest Income – you need the cost of funds for JP Morgan as well. $1.1 trillion is from deposits, which cost JP Morgan 0.8%, and the remainder is a mixture of term debt at 3.7%, repo-style funding and short term funding.

Overall, the House of Morgan has $2.3 trillion of interest bearing assets at an average of 3.61%, funded by $1.8 trillion of interest liabilities at 1.45%, with the remainder provided by its stockholder capital.

So clearly a reduction of interest rates, or more correctly, the interest rate spread between long term interest rates and short term interest rates,  will impact JP Morgan’s Net Interest Income.  Given that US depositors will balk at paying interest, this means that the likelihood of a reduction in interest revenue due to a fall in long term interest rates will not be met by a similar reduction in the cost to obtain funds for those loans.

Another interesting point to note is the entire $350.7 billion of Investment securities. These comprise largely of $128.2 billion of Mortgage Backed Securities, $140 billion of US Treasuries , $22 billion of foreign government securities and $25 billion of “successors” to CDOs, called Collateral Loan Obligations.

Some would argue that a reduction in interest rates will cause an appreciation of the price of the bonds, so net-net, JP Morgan won’t lose. That is true, but there is a subtle difference.

Illustration of the effects of Comprehensive Income

For example, in 2019 as interest rates fell, JP Morgan’s investment securities registered a gain of $2.9 billion on an after tax basis. However, it could not recognize these unrealized gains and the $2.9 billion did not affect Net Income of $36.4 billion. Similarly in 2018, when Jerome Powell decided to go to war with the Wall Street Casino and raise interest rates, the value of the investment securities fell and there was an unrealized loss of $1.9 billion on an after tax basis. Similarly, the bank did not recognize a loss on reported Net Income of $32.5 billion as these securities were not sold. Wall Street Casinos largely does not care about Comprehensive Income when forming a valuation hypothesis.

The thing to note is that gains in the values of the Investment securities portfolio are largely kept outside the Income Statement and are reported as part of Other Comprehensive Income, which does not affect Earnings Per Share. JP Morgan only realizes the gain if the securities were sold, but those are one off gains and the new funds will be invested in lower yielding securities. Furthermore, the Mortgage Backed Securities have this bad habit of “negative convexity”, meaning that when interest rates fall, credit worthy borrowers tend to prepay their loans and the bank suddenly finds itself with cash which it cannot put to use to earn the higher interest income it did in the previous regime.

Other notes

We have just given a brief comment on the role of interest rates. That is not to say that JP Morgan will suffer a reduction in revenues, after all this scenario of Covid-19 also led to the company originating super huge loans to folk like Boeing at very attractive rates and even more attractive fees. Apart from a massive spike in volatility as a result of something like a war, we feel that US banks could offer good value as what we have said so far did not take into account the “gun-over-a-barrel” style negotiations they could have entered into when a lot of their corporate customers drew down on the credit lines in the 1Q20. Secondly, there is a presumption of massive defaults, but it seems that with the recovery of the US, unemployment will no longer be as bad as the headline grabbing double digit figures that we heard in the April – June period of 2020.

Of course, we caveat that last view with our view on the $10,000 question – geopolitical risk. Our baseline view that a conflict between US and China materializes in 2020 remains unchanged.

 


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