Big US banks bulked up on bond holdings during the pandemic. Customer deposits were abundant. Ways to deploy them were not. America’s consumer and commercial banks poured their excess cash into debt securities. These included Treasuries and mortgage-backed securities.
Investors must now consider the threat posed to bank stocks by huge notional losses on these holdings.
The bond investments helped soften the blow that low rates and tepid loan growth had on net interest margins. But as the Federal Reserve aggressively reversed course this year, their value plunged.
The numbers are staggering. As of November 30, US lenders held $5.5tn of securities on their balance sheets, according to Federal Reserve data. That is 44 per cent more than before the pandemic.
There is a big gap between how banks value their holdings and what these are worth on the market. The Federal Deposit Insurance Corp reckons US banks are sitting on nearly $690bn of unrealised losses on their securities portfolios at the end of the third quarter, up from $470bn in the second quarter.
That represents a Grand Canyon-sized chasm on balance sheets. Fortunately, valuation rules allow banks to soften the blow to capital adequacy.
Banks can classify their security holdings as “held-to-maturity” (HTM) or “available-for-sale” (AFS). Those that are labelled HTM cannot be sold. But that means any changes in market value will not count in the formulas regulators use for calculating capital requirements. By contrast, any losses in the AFS basket have to be marked to market and deducted from the bank’s capital base.
To keep capital ratio stable, many banks have shifted assets away from AFS toward HTM. More than half of the $690bn in unrealised losses are from the HTM basket.
For now, US banks remains awash in liquidity and are suffering no obvious financial stress. But rising deposit outflows and the increase in unrealised losses could become problematic if they need to sell investments to meet unexpected liquidity needs.
Bond holdings could emerge as a serious pressure point for banks in volatile markets. Investors should watch out for this in 2023.
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