As we frequently point out around here on Capital Matters, the ending of ultra-low rates was always bound to cause trouble. The only issue was when and where that trouble would occur, and how bad it would turn out to be.
Here’s another candidate for an area in which there could be trouble (via the Financial Times):
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.
But the banks bought those bonds when they were yielding more or less nothing. With interest rates having risen sharply since then, the market prices of those bonds will have (for now anyway) fallen quite some way (as a rule, the prices of outstanding bonds will fall when interest rates rise).
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.
Normally if a bank holds securities they have to be marked to market (i.e., valued at their current market price). Doing that to the bonds bought during that period (and, I assume, many of those bought before then) could trigger a hit to the capital base of the banks that hold them, a hit that, depending on its size, could mean that the banks in question might be required to raise new capital. That’s generally not something that shareholders want to hear.
Meaning that they won’t want to see this:
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.
In essence, if those securities are classified as held to maturity (meaning that the bond will be held until it is due to be repaid), they do not have to be marked to market (there’s a certain, if imperfect, logic to that). But if that’s how they are labeled, they cannot be sold. Other holdings are designated “available for sale” (AFS) and have to be marked to market.
It’s not difficult to guess what banks have done.
To keep capital ratios 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.
The appearance of “problematic” and “banks” in the same sentence rarely bodes well for what is to come.