Think Rising Rates Are Good For Banks? Think Again!

Episode Summary

Executive Summary: Chris Whalen argues banks are normalizing after an extraordinary Fed-driven period: loan yields, funding costs, and credit losses are reverting toward 2019 levels, while balance sheets likely shrink. He expects modest recession risk, weaker bank stocks, pressure on mortgage and non-bank lenders, and major market stress from the Fed’s massive Treasury/MBS holdings, convexity, and rising rates.

Main Topics: Bank profitability is normalizing, not booming (Priority: 5/5): Whalen says investors should use 2019 as the baseline, since 2020-21 were distorted by QE, stimulus, and reserve releases. He expects modest growth, smaller bank balance sheets, and returns that improve mainly through shrinking rather than expansion. Credit costs are returning as a core bank expense (Priority: 5/5): During the pandemic, banks benefited from very low defaults and reserve releases; now credit losses are reappearing, especially at JPMorgan and in consumer lending, making earnings less flattering than during the QE era. Rising rates do not automatically help banks (Priority: 5/5): The key is net interest margin, not headline rates. Funding costs may rise, but loan yields have barely moved for large banks because competition for quality assets is intense and banks are flush with deposits. Fed balance sheet runoff and MBS convexity risks (Priority: 5/5): Whalen argues the Fed’s Treasury and mortgage-backed security holdings are hard to unwind because low-coupon securities are deeply underwater and mortgage prepayments have disappeared, extending duration and creating potential losses. Mortgage and housing markets face a reset (Priority: 4/5): He expects 6% mortgages, weaker refinancing, falling mortgage volumes, and pressure on banks, mortgage originators, and smaller institutions that cannot hedge rate risk effectively. Recession and credit stress may hit non-banks hardest (Priority: 4/5): Whalen is most skeptical of fintech/non-bank lenders that rely on models proven only in easy-credit conditions. He expects higher delinquency when recession exposes underwriting weaknesses. Global and Russia-related exposures are concentrated in certain banks (Priority: 4/5): He says U.S. banks are mostly insulated except JPMorgan and Citi, while European banks have larger direct and indirect exposure to Russia, commodities, shipping, and aircraft leasing losses.

Key Arguments: Banks were artificially supported by QE, reserve releases, and ultra-low funding costs; earnings are now reverting toward pre-pandemic norms. Headline higher rates are not enough to boost bank profits if deposit and wholesale funding costs rise and loan pricing remains competitive. Large banks have weak pricing power on loans because they compete for top-tier assets; smaller banks often earn higher gross yields. The Fed’s MBS portfolio is problematic because low-coupon mortgages will not prepay, extending duration and making sales into an illiquid market costly. The Fed may face optics and political issues if it takes losses and cannot remit profits to Treasury. Housing and mortgage lending are likely to slow sharply as rates rise, hurting originators and banks with mortgage exposure. Non-bank lenders and automated-underwriting platforms are vulnerable because they have not been tested through a serious recession. European banks are more exposed to Russia and commodity-market disruptions than U.S. banks. Investors should expect volatility and use selloffs to buy quality financial names rather than chase overvalued bank stocks. The market’s “rates up = banks up” narrative is overly simplistic; spreads, not nominal rates, determine profitability.

Data Points: Bank asset cost of funds: 11 basis points - Record low cited for third quarter last year on $22 trillion of bank assets. Gross loan yield for big banks: Inside 4% - Whalen says the average big-bank gross yield before funding and admin costs is under 4% today. Citibank gross loan yield (Q1 2021 to current): 5.44% to 5.46% - Example used to show that loan yields barely rose despite higher market rates. Loan yield change at Citi: 2 basis points - Year-over-year increase cited as evidence of limited pricing power. U.S. Bank valuation peak: 2.0x book value - Used to illustrate a special period of strong bank valuations. JPMorgan valuation peak: 1.75x book value - Shown as unusually strong but still reasonable relative to other extremes. American Express valuation: 6.5x book value - Cited as the best-performing bank-like business in the country. Credit card balances at banks: Down almost 20% - Balances fell during COVID as consumers paid off debt instead of borrowing. Federal Reserve balance sheet: About $9 trillion - Referenced when discussing reserve liabilities and asset holdings. Fed capital cap: $40 billion - Chris says Congress capped Fed capital, creating optics issues if losses occur. Potential Fed funds target range: 2% to 2.5% or 3% - Whalen warns pushing rates this high may trigger liquidity stress. Mortgage rates forecast: 6% by end of June - His expectation for where mortgage rates could move as the Fed tightens. Housing price example: 30% above prior purchase price - Used to illustrate cash-driven housing demand and inflation pressure. Banking sector shrinkage forecast: 10% to 15% - He expects the industry to shrink to improve returns and economic efficiency. Mortgage industry layoffs forecast: 30% to 40% - Expected headcount reduction as refinancing and origination volumes collapse. Federal Reserve MBS/Treasury ownership: Two-thirds of low-coupon securities - Whalen says the Fed owns most of the low-coupon production from the QE period. Citi Russia exposure: $7.8 billion - Mentioned as Citi’s direct and indirect exposure announced on April 14. Commercial bank credit card book: Approaching $1 trillion - Current receivables are rising back toward pre-normalization levels. JPMorgan credit card default rate vs Citi: Citi defaults 2.5x to 3x JPMorgan - Used to contrast Citi’s higher-risk card book with JPMorgan’s lower-risk business. Capital One gross defaults in 2009: 11% - Historical example of severe credit stress in consumer finance.

Pivotal Quotes: "The key driver for bank valuations is credit." — Chris Whalen: He explains why loan growth alone is not enough to drive bank stock performance. "Rates are rising. That's good for banks? No, that's what they have taught buy-side managers to say when they appear on CNBC." — Chris Whalen: He rejects the simplistic market narrative that higher rates automatically benefit banks. "If the Fed goes ahead and tries to sell this paper into an illiquid market, they're going to take enormous losses, 10, maybe 12-point loss on the security." — Chris Whalen: Discussing the Federal Reserve’s mortgage-backed securities and the difficulty of unwinding them.

Implications: Expect slower bank earnings, weaker mortgage activity, and valuation pressure as credit normalizes and the Fed drains liquidity. Quality banks may still offer opportunities on selloffs, while non-banks and mortgage lenders face the sharpest strain.