May 2, 2023
There have been numerous bank failures in the US over the past few months. The main cause for the failures has been deposit flight (customers with deposits pulling their deposits from the bank). A bank does not keep very much money liquid on hand to cover a very large percentage of customers who would like to withdraw all their deposits. When this happens at any sort of scale, the bank is forced to sell assets. Banks over the last 3-4 years, during the period of time when the FFR (Fed Funds Rate) was at 0%, and 10 year yields were <1%, were still buying these long dated US treasuries and also buying Mortgage Backed Securities (maybe 3-4% coupon since MBS trade at a predictable premium to the 10 year treasury yield).
When a bank is forced to liquidate these “assets” on the open market quickly to raise funds for the depositors who are fleeing, they find themselves in real trouble. Current market rates on the 10 year yield are 3.553% (as of this writing at 11:00am MST 5/1/23). Average 30 year fixed rate mortgages, today, for top tier scenarios, are 6.65% so mortgage backed security bonds would be in this range (6.5+% yeild), or higher for lesser rated mortgages.
In order for a bank to offload these assets to another bank, they need to sell them at a price that is even better than the current rate for said assets. This means selling them at a massive discount or loss to the original purchase price. Just for easy math and understanding, if a bank bought $1B in 10 year treasuries at .5% yield, and the yield today is 3.5%, they would need to sell the treasuries for a huge discount for another bank to take them over and that paltry yield. Maybe that $1B in bonds sells for 600M, or something of that nature (40% discount). It would need to equal or even surpass the same net yield that a bank buying today could get on either new issue treasuries or resale treasuries today on the resale market.
This is akin to buying a house for $500,000 and a year later, circumstances dictate that you are quickly and unexpectedly forced to sell, I.e. you have to sell, and current market rates have your house at $350,000. It’s a bad situation.
The Federal Reserve has created this situation, distorting the market by holding borrowing costs at rock bottom for a very long time, and then aggressively hiking rates to levels few people expected in an incredibly quick time frame.
The market was distorted for long periods of time, and there was lots of malinvestment and misallocation of capital.
These banks who have failed in the first half of 2023 may be just the beginning, as many banks are in similar positions at least with some portion of their portfolios. The banks who have failed are no doubt the worst offenders, the riskiest, the worst loans, the worst asset portfolios. But, if history is any indicator, this contagion spreads and can even effect banks with much better portfolios. Just think if a percentage of a bank’s customers went in today and asked to redeem their deposits, or even just shifted their deposits over to money market mutual funds, which pay more. Banks losing deposits means they do less lending. There will be more to come in this area in 2023, but the message of this post is about duration risks.
For the lenders, they spent money on long investments like 10 year treasuries, but on the short side, they can now buy the same investments at 300-400% better returns than only a year or two ago. Additionally, demand deposits mean that a bank could be on the hook to come up with a lot of money quickly in the very short term.
When buying a house, there could also be duration risk. Similar to the banks above, you buy a house at today’s prices (which are a function of what the cost to borrow is today), you lock in a rate and payment for 30 years typically. In some regards, the duration risk is mostly born by your lender. Mortgage rates may go up but your rate is guaranteed. A bank cannot call a loan due if you get a mortgage at 6.5% but a year later the going rate is 10%. That 6.5% is set for the life of the 30 year mortgage. Additionally, most mortgages have no pre-payment penalty so if the rates go down, you can refinance. In the same scenario, if you buy a house at 6.5% and rates go to 3%, you are free to pay off the mortgage through a refinance and start a new mortgage at the new lower rate. This type of loan is a real asset to a homebuyer and consumer.
Where the duration risk comes in for buyer, however, is also kind of like the banks above. If you don’t plan on holding the mortgage or house to maturity (i.e. 30 years). If you buy a house today, the sale price of your house could be lower in the short duration if you need to sell in the next 3,5,7,10 years, which tends to be the case in a rate hiking cycle which it appears we have entered now after decades of declining rate environment.
I encourage all buyers right now to be mindful of their “duration” estimates, their horizon for the particular purchase. Short term duration outlooks definitely carry some added risk. If you are buying your “forever house” or a property you could stay in or possess for a very long time, you are mitigating your risk.
It’s best to be in a position where you can wait out the market in a prolonged downturn, or where you possibly could even “hold to maturity” if needed.