U.S. Banks 3Q23 Preview: MBS Taking the L

Although the sector has calmed substantially since the post-SVB hysterics, the salient interest rate (and credit) questions remain key points of focus for 3Q23 earnings—especially given the sharp bear steepener this quarter. We spotlight the expected impacts on both unrealized loss positions as well as the mounting profitability drag from higher concentrations of low-yielding securities for certain banks; positively however, there is ample reason to expect less relative funding cost pressures as cumulative deposit betas should continue flattening out as we get close(r) to the end of the hiking cycle. On the credit side, Commercial Real Estate (CRE) should still be the main focal point of concerns, though we reiterate our general comfort with exposures; NPL formations should pick up and we may see incremental reserve building as banks continue to hone in on the only CRE asset class showing any real signs of fundamental strain (office), but relatively small exposures and sizeable existing reserves provide downside comfort. And while we’re sanguine about the sector’s fundamental outlook for 3Q23 earnings and still see value in bank spreads, there’s potential for some volatility as rating agency cuts still hover: it’s been 65 days since Moody’s placed six major banks on review for downgrade.

The sharp rise in long-term as the curve re-steepens will put the spotlight back on the topic of unrealized losses in the securities portfolios in 3Q23—as well as the knock-on effects to profitability, capital, and liquidity. While unrealized losses will undoubtedly increase again in 3Q23, we continue to believe both the large banks and the Category III and IV regional banks are well-equipped from a capital and liquidity standpoint to ride out the impact, especially as acute deposit outflow pressures have subsided, bolstering liquidity and reducing the need or risk to codify losses (and that’s without even getting to the Fed’s par value BTFP liquidity facility). Still, the rate moves continue to provide a margin challenge given still-rising funding costs, with a number of banks face an earnings drag from low coupon, long duration securities while pending regulatory changes (AOCI opt-out elimination, higher RWAs via Basel III) force more careful capital management.

Of course, the rising rate impact to securities valuations is nothing new for the sector dating back to 2022, and this will be the second consecutive quarter of meaningful rate increases on an end of quarter basis after 1Q provided some relief. We expect the 3Q23 steepener impacts to play out quite differently to 2Q as the long end of the curve rose far more rapidly than the short end, essentially the reverse of how the curve played out in 2Q. In short, we believe this dynamic will turn out to be slightly better for most banks from a profitability and net interest margin standpoint, with the deceleration in short-end rates having positive implications for funding dynamics and beta acceleration; however, banks with longer-duration exposure in the securities portfolios, particularly from RMBS, will see increased pain from fair value marks.