A topic I’ve been thinking and writing about a lot lately is why bank stocks aren’t performing better given soaring interest rates. There is a common narrative that banks should outperform during upswings rates. Yet despite the fact that the average 30-year fixed mortgage has risen from 3% to 5.25% in recent months, bank stocks aren’t doing much overall:
Of course, there have certainly been worse investments out there. A flat return over the past year beats what has been offered in speculative tech stocks or SPACs, for example. But for investors who thought the banks would be a boon early in the Fed’s rate hike cycle, it must be a disappointment nonetheless.
So what’s wrong? The simple answer is that banks make money from interest rate spreads, not from the overall level of returns. When short-term interest rates rise faster than long-term rates, as is currently the case, banks may actually see their profitability indicators decline. This factor explains much of the banks’ underperformance.
There can, however, be other more specific things that go wrong. For an example, take a look at First Hawaiian (NASDAQ: FHB), a relatively large regional bank serving Hawaii. With $25 billion in assets, 51 branches and nearly 300 ATMs, First Hawaiian is not just a small community bank. It is also a fascinating example as it is one of the regional banks that has invested the most in mortgage-backed securities “MBS” as part of its balance sheet. This is where the problem lies.
Our story begins with the company’s first quarter results, which it released on Friday. Judging by the headlines, it all sounds good, right?
And yet, FHB stock would continue to trade down nearly 5% on the day, and now finds itself near 52-week lows. For an earnings beat, revenue beats the quarter, that’s not a big action on the stock price:
First Hawaiian has a problem that doesn’t immediately show up in its profits. That problem is the value of his investments.
To understand, let’s back up for a second. Most regional banks mainly invest their deposits in self-initiated loans. A depositor places money in the local bank, and then said bank uses that capital to make a mortgage or lend to a local hospital or something like that. When a bank makes a loan, it can keep it on its balance sheet at cost. There is no secondary market, so the value of this loan is not adjusted quarterly.
However, banks also have the option of investing their deposits in other credit securities. Most regional banks invest only a small portion of their capital in other loans and investment securities. However, some banks choose to use these other loans to build up a much larger portion of their assets. Some banks that have done this now find themselves in a difficult situation.
When interest rates rise, the value of their investment securities falls. Think about it. If you’ve had a 3.5% mortgage for 30 years and similar mortgages are now underwritten at 5.5%, traders would demand a significant discount to buy your old 3.5% mortgage paper. For banks that have purchased other people’s mortgages or similar negotiable instruments, they must now mark their investment securities to market. And it’s not a fun process given the current market conditions.
First Hawaiian is sort of a poster for this phenomenon. It holds about a third of its total assets in mortgage-backed securities. That’s way higher than what you’ll see at most regional and community banks. Here is First Hawaiian’s results this quarter:
As you can see, there’s a mix of about $13 billion in own loans and $8 billion in investment securities. This line of investment securities fell significantly this quarter as interest rates soared, depressing the value of existing securities. As a result, the bank’s total equity fell by more than 10%. That’s no small thing for a bank. The overall figure we are discussing here, $372 million, may not seem huge in the context of a bank of assets totaling $25 billion.
But remember that banks operate with a lot of leverage. A hit of $372 million is actually a significant portion of the bank’s total positive shareholders’ equity. Now let’s translate that into book value, a term most bank investors should be familiar with.
From First Hawaiian’s balance sheet data, we can see how much book value has fallen this quarter compared to last:
Between December 31, 2021 and March 31, 2022, the book value per share fell from $20.84 to $17.90, a decline of more than 10%. Tangible book value, which excludes intangibles, fell more than 20% from $13.03 to $10.10.
Is this a big problem? Yes it is. Here’s First Hawaiian’s book value since its IPO in 2016 according to YCharts. YCharts has not yet entered Q1 earnings data into its database, so it still has a book value of $20.84 from last quarter. As you can see, with book value now down to $17.90 this quarter, First Hawaiian wiped out many years of book value gains in a single quarter:
And, keep in mind that the book value was based on the end of the last quarter, which ended March 31. Given the movement of interest rates over the past few weeks, the book value would likely be significantly lower at $17.90 if the portfolio were priced at prevailing prices by the end of April.
Lost paper or real problem?
An FHB stock bull can easily object that this is just an accounting exercise. As the bank slide I posted above shows, this has no impact on the bank’s regulatory capital requirements, nor does it impede the bank’s ability to pay dividends or redeem its shares.
If First Hawaiian holds these mortgage-backed securities to maturity, it won’t lose any money. The loss is simply due to falling prices because interest rates have risen. But if the plan was to hold those assets to maturity anyway, there’s no change in the future cash flows that First Hawaiian will receive.
That said, there is a cost to First Hawaiian investors, even if there is no permanent write-down of bank capital. On the one hand, it reduces the flexibility of the bank. I would note that over the past few years, First Hawaiian has accumulated far more MBS assets than before.
He held about $4 billion of those assets at any time between 2014 and 2019. That figure has jumped to more than $8 billion since the pandemic began. Presumably, much of this growth was due to the fact that the Hawaiian economy had been weak in recent years, and then the pandemic was particularly harsh due to the decline in Hawaiian tourism since March 2020.
When the economy recovered, First Hawaiian might have wanted to turn some of that MBS paper into its own Hawaii loans. Now, however, it would have to make substantial losses on MBS paper sales to free up that capital. For now, the losses are only latent and will never materialize if these assets are held to maturity. But if the bank wants to use that money for other purposes, those paper losses would materialize.
On the other hand, First Hawaiian’s book value is now much lower than it was last quarter. And, given the current trend in interest rates, this could well continue into the second quarter.
First Hawaiian has averaged a return on equity (ROE) of approximately 9% over the past several years. Based on my metric of being willing to pay 10x ROE in terms of book value, I would be willing to pay something like 0.9x book value for FHB stock, all else being equal. Let’s assign a small premium since this is a Hawaiian bank and these assets are scarce, as relatively few banks compete in this isolated market.
For the sake of simplicity, we’ll say that First Hawaiian deserves to trade at a multiple of 1.0x book value. Prior to this quarter, First Hawaiian had a fair value of $20.84. Now, thanks to the decline in value of their investment securities, the book value and therefore my price target drops to $17.90. And there is a downside risk to this figure, because if interest rates continue to rise, the book value will fall again in the next quarter. In any case, the stock is hardly a bargain at $26.
Eventually, higher interest rates will eventually work their way through the system. First Hawaiian’s old low-yield securities will mature, and it can redeploy them into higher-yielding assets. This should both boost earnings and put its book value back in the right direction. However, this could take several years. In the meantime, many banks are benefiting from higher interest rates, while First Hawaiian finds itself in a surprisingly strong headwind at the moment.