The largest banks are dumping their holdings of Fannie Mae and Freddie Mac debt, and it's contagious.
It turns out small banks have been doing the same thing.
GSE bonds at all U.S. banks (excluding mortgage-backed securities) fell from $213.5 billion, or 1.47% of total assets, in the third quarter of 2013, to $152.3 billion, or 0.93%, in this year's first quarter, according to data compiled by BankRegData.com. That is the lowest level in the past decade.
Big banks' motivation is easy to pinpoint: the need to comply with recent federal liquidity regulations that are supposed to improve large financial institutions' odds of withstanding the next financial crisis. What's driving community banks to follow their lead is murkier since those rules do not apply to small players.
Yet the impact on all banks is clear. Though the bond sales are lessening systemic risk in the eyes of regulators, they are cutting into profits at a time when banks are hard-pressed for growth. Meanwhile, Fannie and Freddie could see the cost of debt issuances rise if the drop in demand from banks remains pronounced.
Fannie and Freddie debt traditionally has offered higher yields than other securities, but other factors have made them less desirable, said Karen Shaw Petrou, managing partner of Federal Financial Analytics.
Since the passage of the liquidity coverage ratio requirement almost two years ago, many institutions have steadily unloaded ownership of debt obligations issued by Fannie, Freddie and other government-sponsored enterprises because of the way GSE debt is scored in the liquidity equation. The factors of concern to banks include how the quality of the obligations is judged, and their higher risk weighting, Petrou said.
Those considerations, combined with other new rules meant to prevent banks from being overly leveraged, mean "the capital cost of [GSE] paper is generally higher," she said.
GSE-issued obligations receive only 80% credit as high-quality liquid assets in the Fed's liquidity coverage ratio, said Marty Mosby, an analyst at Vining Sparks. U.S. Treasuries, on the other hand, get 100% credit.
Regulators in September 2014 approved the LCR, which was designed to provide banks with enough liquid assets to cover a sudden funding crisis. The rule, written by federal regulators, is a tougher version of the LCR developed by the international Basel Committee.
The rule applies only to banks and bank holding companies with at least $50 billion of assets; those above $250 billion of assets must adhere to an even tougher rule.
Some of the biggest banks have therefore rushed to the exits. JPMorgan Chase held about $3.3 billion of GSE securities in the third quarter of 2013, but reduced its holdings to just $36 million in the first quarter.
Bank of America and Capital One Financial hold no GSE debt. The same is true for at least 30 other large banks, including the Citizens Financial Group in Providence, R.I., and M&T Bank in Buffalo, N.Y.
Among banks with at least $50 billion in assets, GSE-issued obligations made up about 0.36% of total assets at March 31.
Smaller banks rely more heavily on GSE debt to generate yield. For banks with less than $50 million in assets, they were about 6.2% of total assets. For those with assets of $50 million to $99 million, they were about 5.8%.
The shift out of GSE paper may have helped larger banks meet liquidity requirements, but in some cases they have hurt returns. Wells Fargo's return on assets "has been migrating downward since" the second quarter of 2014 for a number of reasons, including the liquidity coverage ratio, Scott Siefers, an analyst at Sandler O'Neill, said in a Wednesday research note. Wells Fargo's ROA has declined from 1.45% in the second quarter of 2014 to 1.16% in this year's first quarter.
Even more surprising, some smaller banks have also unloaded GSE debt despite the potential to lower yields and returns. For example, during the first quarter the $1.6 billion-asset Moody Bancshares in Galveston, Texas, sold all of its $7.9 million in GSE bonds, and the $759 million-asset Wayne Bank in Honesdale, Pa., unloaded its $9.2 million holding. In the third quarter, the $814 million-asset First Federal Bank of Louisiana in Lake Charles sold its entire $24.9 million position.
That may be a case of smaller institutions taking a copycat approach to what the larger banks are doing, said Bob Mahoney, chief executive of the $1.9 billion-asset Belmont Savings Bank in Massachusetts.
"The asset thresholds don't mean that much," Mahoney said. Belmont has not owned GSE-issued paper since 2012. "Regulators start talking about these rules in examinations, even at smaller banks. And it starts evolving down to lower-asset banks as a type of best practice."
If a small bank is struggling with liquidity requirements, such as having too small a portion of its securities portfolio in cash or cash equivalents, it might "shift to government bonds and out of Fannies and Freddies to win some Brownie points," Mahoney said.
Then there are some banks that have seen their GSE holdings disappear for reasons beyond their control.
The $1.7 billion-asset Union County Savings Bank in Elizabeth, N.J., sold its entire $1.1 billion portfolio of Fannie Mae and Freddie Mac securities some time during the first quarter. Union County had held at least $1 billion of GSE debt in its securities portfolio since the first quarter of 2013. The Fannie and Freddie bonds were redeemable and the agencies called the bank's entire position during the quarter, said Donald Sims, the bank's CEO.
"It was not something intentional on our part," Sims said.