Funding costs. Familiarise yourself with the term.
It’s making headlines on Wednesday, having cropped up late last year, and is likely to continue to be a buzzword this year. The reason? For a start wider spreads on government bonds are feeding into banks’ funding costs. At the same time, you still have central banks seeking to normalise their monetary policies — though that could swiftly change if sovereign jitters continue.
It’s basic interest rate risk for banks. Actually, you should familiarise yourself with that term too.
The lower interest rates initiated during the financial crisis have allowed banks to engage in a carry trade; borrowing at rates near zero and then investing in higher-yielding assets. `Normalisation’ means an end to that (easy) trade, and perhaps a rejigging of the distribution of banking profits.
So, without further ado, here’s UBS banking analysts Alastair Ryan and John-Paul Crutchley:
We believe 2009 was the high point for the carry trade, with the ECB’s €614 billion in one-year, 1% money providing the ideal raw material. We expect this year to combine greater funding uncertainty, as the one-year repos expire, with the risk that long-bonds experience price declines. This latter could either occur through a rise in inflation expectations; a recovery in GDP expectations or, independent of either, indigestion as governments seek to finance their epic deficits.
Those banks with the confidence to allow for a period of lower income to avoid the potential for price declines in longer-dated paper should now be allowing their Treasuries to roll off. However, pressure on income for those banks in a less comfortable place may cause them to increase their interest rate risk in order to support near-term earnings. This is what we believe is most prevalent in Spain.
And according to UBS – Spain have been one of the key players in the carry trade:
We can see why the Spanish banks have been putting on the carry trade, because customer spreads are in such rapid decline. This reflects the delayed downward repricing of mortgages . . . At the same time, funding costs are rising as the banks roll over, for example, covered bonds from ‘old’ spreads of perhaps 2bps into ‘new’ spreads around 50bps.
What’s downward repricing of mortgages, we hear you ask?
According to UBS in places like the UK and Ireland, low interest rates help support property prices because those countries have a relatively high number of floating-rate mortgages. Less than 20 per cent of the UK mortgage book is fixed-spread, in Ireland it’s about 60 per cent.
In Spain, in contrast, the fixed-spread mortgage accounts for 100 per cent of Spanish mortgages. UBS also says the Spanish mortgage has a peculiar feature in that it reprices with a lag of 12 months to Euribor — the benchmark rate of the European money market — itself:
This means that the average borrower is still experiencing a decline in his/her interest costs. However, and in contrast to the UK banks, it also translates into significant margin pressure ahead for the local banks.
Oh dear.
And this is not just FT Alphaville picking on Spain (again).
Morgan Stanley also has a note out on Wednesday regarding funding costs for European banks, with an emphasis on the sovereign issue. Their main concern is that the sovereign situation could add 100bps to the cost of new funding for Spain’s banks — more if the economic situation continues to deteriorate.
KBW also has a big banks note. It’s generally negative on Spain but thinks that BBVA and Santander should be able to take market share and at least keep loan growth flat this year. If they do manage that, and if Spain-wide loans don’t pick up, they’ll probably be outperforming the general market:
All three notes, plus a bonus, available in the Long Room.
Related links:
BBVA, an exercise in Spanish banking losses – FT Alphaville
Spanish banking crises, then and now – FT Alphaville
Banks face £6bn bill after cheap loans end – FT
Wells Fargo shuns carry trade, braces for risk of higher rates - Bloomberg