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Banks need to prove how they can survive higher-for-longer rates

JPMorgan Chase CEO Jamie Dimon recently warned about the possibility that interest rates could surge as high as 7%, exposing those in the financial world who took too much risk when rates were low.

"I am not sure if the world is prepared for 7%," he said last month, adding: "That will be the tide going out."

JP Morgan CEO Jamie Dimon speaks at the Boston College Chief Executives Club luncheon in Boston, Massachusetts, U.S., November 23, 2021.    REUTERS/Brian Snyder
JPMorgan CEO Jamie Dimon. (Brian Snyder/REUTERS) (Brian Snyder / reuters)

Whether US banks are properly prepared for an extended period of high rates will be a central theme running through the third quarter earnings season that kicks off Friday with results from giants JPMorgan (JPM), Citigroup (C), and Wells Fargo (WFC).

The Federal Reserve made it clear in September that it expects rates to stay higher for longer. That stance will continue to place pressure on banks by making deposits more expensive, deepening paper losses on bonds held for investment, and making it more difficult for bank borrowers to pay back their loans.

A focus for many investors in the coming weeks will be what banks say about a key measure of profitability known as net interest income, which measures the difference between what banks earn on their loans and pay for deposits.

Those margins have been under pressure from the Fed’s campaign to cool inflation and the intense competition for depositors that followed the chaos of the spring, when the failures of three sizable regional banks stoked panic throughout the financial world.

"The length of time we stay at these levels is a critical factor," Scott Siefers, a large bank analyst for Piper Sandler, told Yahoo Finance. "If rates stay up here for years, it'll just be this grind higher where banks have to pay more to every incremental account."

Hammered during the regional banking crisis in March, bank stocks have notably lagged the S&P 500 this year, even as they've recovered from their lows reached back in May.

As of Tuesday, the S&P Bank Index ETF (KBE) and the S&P Regional Bank Index ETF (KRE) were down more than 18% and 29% year to date, respectively. The S&P 500, in contrast, has gained nearly 13% this year.

Gerard Cassidy, an analyst at RBC who covers large banks, told Yahoo Finance that if the Fed is done with its interest rate hikes, stocks are likely "bottoming out." But the risk, he said, is that the Fed can’t get inflation under control and has to take rates above 7% in 2024.

"That's the bear case for the banks," Cassidy said about the possibility of more hikes, calling it “long-tail risk” for the industry.

September forecasts from the Federal Reserve suggested one additional rate hike would be necessary in 2023 before rate cuts begin next year.

The lessons of 2008

The big bank that appears to be best positioned for an era of higher rates is JPMorgan, which signaled as early as 2020 that it wasn’t willing to take a lot of risk with an influx of deposits that flooded into all banks during the early days of the pandemic.

Some of JPMorgan’s rivals began investing that money in longer-dated securities in a search for higher yield, only to see the value of those holdings go down once the Fed began raising rates.

The unrealized losses that piled up were partly responsible for the fall of Silicon Valley Bank, which attempted in March to sell large amounts of its bonds at a loss in a last-ditch effort to gain more liquidity.

Dimon, according to a person familiar with his thinking, is concerned that some banks didn’t do enough to fix their balance sheets following the events of this spring. JPMorgan in May purchased operations from another lender seized by regulators, First Republic.

The current period reminds him, this person said, of the months following the March 2008 fall of Wall Street investment bank Bear Stearns, which JPMorgan also purchased with help from the US government.

Not enough institutions used that March 2008 warning to fix their balance sheets, leaving them vulnerable to a systemwide crisis that roiled the global economy in September of that year.

When JPMorgan releases its third quarter results this Friday, its profits are expected to outshine other large banks.

It is the only one of the big four banks expected to show a rise in net interest income when compared with the second quarter. Its jump when compared to the third quarter of 2022 is also expected to far outpace those at Bank of America, Citigroup, and Wells Fargo.

Bank of America is among the lenders that are now paying for a decision to pile hundreds of billions into longer-dated Treasurys and mortgage bonds during the pandemic. Those holdings were down by more than $100 billion on paper as of June 30.

The unrealized losses are a big reason investors have pushed Bank of America’s stock near a 52-week low.

Analysts don’t expect Bank of America to have a need to sell those holdings, and therefore book a loss.

But smaller banks may not have as many options, which could create new concern among investors. All banks held $309.6 billion in unrealized losses as of the second quarter, a 9% rise from the first quarter and a 28% rise from last year.

“An institution that has very large unrealized losses without enough explanation could generate concern and that's what we saw in the spring,” Eric Rosengren, the former president of the Federal Reserve Bank of Boston, told Yahoo Finance.

There will be other challenges to look for in third quarter results. Analysts expect banks big and small to set aside more money for future loan losses and take higher charge-offs as borrowers begin to struggle to repay their debts.

Big banks with sizable Wall Street operations, such as Goldman Sachs (GS) and Morgan Stanley (MS), will also be trying to show that a two-year slump in dealmaking is finally waning.

The drought is far from over, however, according to Dealogic data. Global investment banking revenue is expected to be down by 10% from last quarter and 17% from a year ago.

High rates are not all bad for the industry, some analysts said. They do allow bankers to charge more for their loans, and that could help some institutions when demand for new borrowings picks up.

And bank stocks could recover in 2024 if it’s clear the Fed is done with its campaign to cool inflation.

Aside from the risk that loan losses mount, "higher for longer, ultimately, should be a positive for bank fundamentals," David Chiaverini, regional and midsized bank analyst for Wedbush, told Yahoo Finance.

David Hollerith is a senior reporter for Yahoo Finance covering banking and crypto.

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