US banks have US$620 billion of unrealised losses on their books

THE investment losses that helped take down Silicon Valley Bank (SVB) are a problem, to one degree or another, across the US financial system. In total, the industry ended last year with US$620 billion of unrealised losses on its books from investments in low-yielding bonds.

For most banks, the issue is manageable.

Bonds held in investment books represented less than a quarter of the banking system’s US$23.6 trillion of assets in December, and unlike SVB, lenders usually have a wide array of depositors who are unlikely to all need money around the same time. For the biggest banks, the risks are even smaller. They are perceived as too big to fail. What’s more, the recent rally in the Treasury bond market — sparked, ironically, by the jitters about the health of the banking industry — is helping to shrink the US$620 billion of paper losses. (In the coming weeks, banks will start to post first-quarter data.)

And yet as depositors keep gradually withdrawing their money and shifting it into money market funds and other investments, banks are facing a squeeze. They’re being pressed to pay more for funding while their revenue is limited by the investments they made in low-yielding bonds during the pandemic. That in turn could curb their ability to lend to consumers and businesses, slowing the economy.

“They’re paying more for deposits, and their earnings on bonds are fixed,” said Stan August, a retired bank examiner for the Federal Reserve Bank of Richmond and a former bond analyst at Bank of America. “That’s where the squeeze is.”

When the pandemic hit, and the Federal Reserve pushed down rates once again by pumping unprecedented amounts of cash into the economy, many banks loaded up on long-term government and mortgage-backed bonds. There were some Treasury notes that promised to pay annual interest of just 0.6 per cent over 10 years.

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Then inflation surged and the Fed started urgently driving up interest rates. The value of those bonds plunged, because who would want to buy an old bond paying 0.6 per cent interest when new ones were suddenly paying more than 3 per cent?

Losses on bonds are a risk whenever rates go up, but banks’ holdings were bigger than usual in 2022. All that cash the Fed and the government pushed into the economy quickly found its way into the banking system, giving lenders trillions of dollars to invest. SVB’s domestic deposits, for instance, rose more than 150 per cent from the end of March 2020 through the end of 2022.

Rising deposits on their own don’t necessarily represent a problem for banks. For SVB, they spelt trouble in part because its clients tended to keep large balances at the bank as a condition for receiving services like lines of credit.

That translated to a high percentage of customers’ deposits being bigger than US deposit insurance limits. Clients with high balances at a bank are often skittish about the safety of their funds and more likely to withdraw money fast at signs of trouble.

There were at least three data points for SVB that worried depositors: the speed at which the bank’s deposits had grown, the high percentage of uninsured deposits it had, and the magnitude of losses relative to its equity. These factors helped create a perfect storm.

But even for banks that dodge the storm, bond losses are a problem. A large part of banks’ investment portfolios use an accounting method called “held to maturity” that ensures the firms don’t have to record any losses, or any hits to their balance sheets, from the declining value of their bonds. But they also have to hold onto the bonds until they mature.

As banks’ deposits started to grow during the pandemic, they initially ploughed more money into bonds using a method of accounting called “available for sale”. For these securities, changes in the value of the bonds would affect their balance sheets but not their income statements. That accounting method can force banks to boost their capital levels, though, if their losses get too high.

In 2021, a growing group of banks believed the Fed would soon begin raising interest rates and began switching to counting more of their bonds as held-to-maturity. The biggest banks added about US$1.7 trillion of the bonds to their books over the two years that ended in December. In some cases, they switched bonds over from one accounting treatment to the other. In other cases, they just stopped buying new available-for-sale securities and only added to their held-to-maturity books.

Initially, it worked pretty well. Profits ballooned. The US banking system’s return on equity, a measure of profitability, averaged 12.2 per cent in 2021, the highest since 2006.

But now that inflation and rate hikes have come, banks have suddenly been finding themselves pressured from two sides. Higher interest rates forced banks to pay more money to win deposits, with average one-year CD rates rising to about 2.7 per cent by March, according to DepositAccounts, from 0.35 per cent in May 2022. Consumers and companies have been taking more of their money out of banks and investing it in assets like government bonds. Deposits in commercial banks fell last year for the first time since 1948, according to the FDIC. The worst pain here is for community and regional banks, which lost more than US$100 billion of deposits in the week ended Mar 15, while the biggest banks have been luring funds.

Meanwhile, the value of banks’ bond holdings plunged on paper too. The US$620 billion of unrealised losses in the system at the end of 2022 were for available-for-sale and held-to-maturity securities.

The combination of surging interest rates, high investment losses and heavy deposit outflows is new for most investors and executives in the banking industry. To many, this feels like uncharted territory.

“I have covered this industry for 20 years plus and I have never seen anything like this,” said Ania Aldrich, an investment principal at Cambiar Investors. “In all the stress testing we have done for at least the largest banks have never stressed for anything like this.” BLOOMBERG