Yahoo Finance Banks Tap Complex Mortgage Product to Fight Deposit Flight Risk
(Bloomberg) -- Banks are ramping up investments in a complex part of the mortgage bond market that offers shorter-term securities, as they cope with the growing risk of their losing deposits amid high rates.
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Demand from banks is fueling sales of floating-rate, collateralized mortgage obligations, which are constructed from simpler mortgage securities. Overall, there were $25 billion of new CMO sales in April, the highest monthly figure in nearly three years.
That represented as much as 30% of all MBS that month — the largest slice since 2014, according to Bloomberg Intelligence. Analysts and market participants say banks have been a major driver of the increase.
“The CMO machine is revving up,” said Kirill Krylov, a strategist at Robert W Baird & Co. who focuses on mortgages.
Since the Federal Reserve started raising interest rates in 2022, banks have had a harder time hanging onto deposits. Higher rates translate to stronger returns on competing instruments, such as money market funds, and many depositors pulled money out of banks and plunged it into other higher-returning markets.
While banks have taken steps to retain deposits — primarily by paying higher rates — they are also reworking the asset side of their balance sheets by cutting holdings of longer-term bonds and boosting investments in shorter-term securities. The implosion of several regional lenders last year has also made banks acutely sensitive to the risks of owning longer-term debt.
There are around $800 billion of CMOs outstanding, according to Erica Adelberg, a strategist at Bloomberg Intelligence. The share of new CMOs that have floating rates and are backed by Ginnie Mae has been hovering around the highest level in years, according to Oppenheimer & Co. data.
Banks tend to prefer CMOs tied to Ginnie Mae, a guarantor of mortgage bonds that is part of the US government. Bank regulators assign those products risk weights of zero, and that’s not expected to change under upcoming rules known as Basel III Endgame.
Mortgage-backed securities are a staple of bank balance sheets alongside Treasury bonds, and CMOs are just one type. But they differ from products that simply pass through income to investors, because CMOs can be customized to meet the needs of whoever is buying them.
The securities are complicated, but they are generally designed to lower risk for banks by, for example, cutting the maturities on the securities or carrying floating rates. Because they are built with government-backed mortgage bonds, investors don’t face the risk of losing principal if borrowers default. In that regard, they are very different from the kinds of securities that blew up bank balance sheets during the financial crisis.
The CMOs that banks have been gobbling up are often structured so that the rates reset each month, although there are limits as to how high or low the coupons can go.
“Banks are trying to retain less sticky deposits, which are liabilities they treat as floating rate,” said Nick Maciunas, a strategist at JPMorgan. “They need to match that on the asset side, and one way to do that is with floating rate CMOs, which have relatively short durations.”
If rates go down significantly and mortgage borrowers start refinancing in large waves, the CMOs banks are investing in would become less attractive. But, for now, they offer an opportunity to minimize interest rate risk while also delivering attractive yields.
“Short-term yields are currently quite high,” said Walt Schmidt, a strategist at FHN Financial. “CMOs are very low duration bonds with wide spreads that live near the front of the yield curve, so they confer both of those benefits.”
The trend coincides with other steps banks have been taking to right their balance sheets since the failure of Silicon Valley Bank in March 2023.
When the market noticed that SVB was heavily invested in longer-term bonds whose market value had dropped, its stock price dropped and the bank began losing deposits, causing ripple effects across the sector.
Regional banks that remain standing have had to raise capital, sell assets, boost deposit rates and become more sophisticated about balance-sheet management.
“For 15 or maybe even 17 years you had very, very low fluctuations in interest rates and you had nothing on the horizon that presented indications of material changes in interest rates,” said Greyson Tuck, president of Gerrish Smith Tuck, which provides legal and consulting services to US community banks. “Banks got very comfortable in structuring their portfolios around that.”
Now though, “the banks are having to fight deposit flight by meeting depositor and market demands for higher rates.”
US banks have lost about $386 billion in deposits, or 2% of total deposits, since the end of 2021, according to seasonally adjusted Federal Reserve data.
They have recouped some funds by offering better rates and paying special attention to commercial customers that typically have higher average deposits, Tuck said. Lenders have also been highlighting products that distribute deposits across multiple institutions to benefit from a $250,000 federal insurance maximum on each, and bulking up teams that manage investments, he said.
While all lenders can buy CMOs, regional banks are most focused on them.
For instance, Western Alliance Bancorp — one of the lenders that faced worries last year over possible deposit flight — boosted its CMO holdings by several-fold during the first quarter of 2024 to roughly $3 billion, according to Bank of America data.
Similarly, East West Bancorp, a California-based lender focused on Asian American communities, quadrupled holdings of CMOs in the first quarter, the Bank of America data show. CMOs now account for more than two-thirds of its total $6 billion in mortgage bonds backed by government agencies.
Western Alliance and East West Bancorp declined to comment.
--With assistance from Bre Bradham.
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