March 12, 2025 | In the last issue of The Institutional Risk Analyst (“Silicon Valley and the Large Bank Dead Pool”), we provided our annual subscribers with a list of the top 100 banks sorted by the yield on mortgage-backed securities (MBS). Our basic thesis is that all banks will be selling more low-coupon assets as it becomes ever more clear that the long-expected US interest rate rally is not going to materialize.
Why are banks selling COVID era securities with low coupons now? First and foremost negative cash flow. The average cost of funds in the industry is over 5% of average assets, so owning an MBS with a 1.5%, 2% or 2.5% coupon is a really bad trade. Banks barely earn 1% on assets, so losing points on an underwater mortgage portfolio could literally kill the bank.
Bank managers who have refused to restructure impaired MBS portfolios deserve the full critical attention of shareholders next month at the annual meeting. Bank of America (BAC) is top of the list, but they are not alone by any means. Charles Schwab (SCHW), Comerica (CMA) and Bank OZK (OZK) all reported MBS yields below 3% in Q4 2024. Why haven't the managers of these banks been fired for such poor performance?
The second risk issue with legacy MBS paper is spreads. Fannie Mae 6% MBS trade pretty reliably inside a point over the yield on the 10-year Treasury, but yield spreads for MBS 2s and 2.5s can range between a point and many points over the 10-year, if you have the stomach to stare at the TBA screen for a few minutes.
As we wrote this comment on Tuesday, we actually saw some sellers in Fannie Mae 2.5s at yield spreads of 5 and 6 points over the Treasury curve. Hello. The indicated bid for 2.5s is about 83 cents on the dollar with a spread inside of 1% over 10s. The bid for size is a lot lower, points lower. The screen shot below from Bloomberg shows indicated prices for low-coupon MBS. The Fed is the largest owner of those tasty 1.5s and 2s, followed by large banks such as BAC and SCHW. Yummy.
TBA Market
Source: Bloomberg (03/11/2025)
While we were working with the list of banks with low yields on mortgage exposures, we noticed that Northern Trust Co (NTRS) had a negative 3% yield on its MBS, this after tracking well-above peer on this key metric. What gives?
Mortgage Backed Securities by Yield (%)
Source: FDIC/BankRegData
The table above from BankRegData shows part of the Q4 data from the FDIC for the top 100 banks sorted by the yield on all MBS, commercial and residential. NTRS had been performing very well through Q3 2024, with a yield on MBS over 4% which put NTRS into the 90 percentile of Peer Group 1. What happened?
We reached out to IR at NTRS and, naturally enough, they had no idea. So we called Bill Moreland at BankRegData and of course he immediately surmised what was happening. “The negative value is most likely an error in the call report or some type of sale. A negative value for yield is rare, but not unheard of,” Moreland relates.
In fact, the data provided by NTRS to FDIC tells the tale. BankRegData derives the Q4 data but subtracting the Q3 YTD from the full year. “Note the enormous drop in Avg MBS Securities,” Moreland notes. “They apparently liquidated a huge chunk of their CMBS.”
The housecleaning by NTRS should be viewed as a positive sign by analysts and investors, in our view. Banks that take proactive steps to reduce legacy MBS exposures and thereby improve NIM and earnings get a gold star. And no surprise, NTRS is one of the best performing banks in the US based upon 1 year total return. The WGA Bank Top Index is shown below.
With the selloff in financials over the past month, a number of leaders from 2024 have fallen by the wayside, most notably SoFi Technologies (SOFI), now #3 behind Dime Savings (DCOM) and Bank of NY Mellon (BK). And to our earlier comments about consumer lenders, Ally Financial (ALLY) is down for the past year after being near the top of the group in 2024. Indeed, Ally is now in the bottom 10% of the 100 largest US banks based upon one-year total return.
We expect financials to continue to give ground in the near term as investors slowly, painfully come to the realization that the FOMC is not looking to reduce short-term interest rates anytime soon. Meanwhile, as we will discuss in our new Housing Finance Outlook on Monday, the impact of the changes to the markets for MBS planned by the Trump Administration will add volatility to financials.
If we told you that the Trump White House was planning to end the issuance of all MBS by Fannie Mae, Freddie Mac and Ginnie Mae, how do you think this will impact financials? How do you think this will impact home affordability?
If we told you that there are people in the Trump Administration who believe that ending the government guaranty on agency and government MBS will result in lower Treasury bond yields, would you believe it? We kid you not. Stay tuned.
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