While rising rates are a tailwind for bank earnings, they are also pushing up unrealized losses in banks' securities books. That has led many bankers to turn to a strategy that carries its own risks: holding more securities through to maturity.
In the second quarter, publicly traded banks and thrifts reported $24.3 billion of net unrealized losses, higher than the $19.8 billion of losses reported in the first quarter.
The unrealized losses do not affect earnings, but they do flow through accumulated other comprehensive income and tangible common equity. Tangible book value growth is a key metric for investors, and the negative effects on equity can affect key regulatory capital figures, such as the leverage ratio, for some of the largest U.S. banks.
Banks' securities holdings have turned negative due to rising rates, which depress the value of bonds. Many banks have responded by increasing the portion of securities in their held-to-maturity, or HTM, portfolios, as opposed to available-for-sale, or AFS, portfolios. Unrealized losses accrue when there is a drop in the value of securities in AFS portfolios, which banks have to mark to market. Securities in HTM do not need to be marked to market.
Across all publicly traded banks, HTM portfolios accounted for 29.6% of total securities in the second quarter, up from 27.9% in the first quarter and 27.7% a year ago. Five years ago, in the 2013 second quarter, the portion was just 11.8%.
While the migration from AFS to HTM allows banks to avoid unrealized losses that can dent equity, there are significant risks, as well. Banks have been taking on more long-dated bonds, and putting those assets in HTM means risking a commitment to a low-earning asset in a rising-rate environment. That could present issues if rates rise such that banks' funding costs jump or if the bank runs into a liquidity issue and needs the additional capital.
"Almost never do I recommend HTM because you've locked in an option that you can't access if you need that capital," said Howard Benz, managing director of fixed income strategies for Raymond James. He said banks should keep all their securities in AFS.
Benz said bank managers should accept the unrealized losses and simply hold the bonds. Since most of these securities are Treasurys or similarly safe assets, the negative value is immaterial, he said. The bond will keep paying a coupon until maturity, at which point there is no loss.
He acknowledged it can be difficult for management teams to hold the bonds in AFS as unrealized losses mount. Typically, the securities book is handled by a portfolio manager who reports to a CFO, who then needs to sell the CEO or the board on a strategy that involves ignoring unrealized losses.
"It's very difficult to explain to someone who's your boss, 'You need to ignore that $5 million in unrealized losses.' Your boss will say, 'Let me get this straight: You screwed up and we have a loss and now you want to ignore it?'" Benz said.
But Benz said there is little to no chance of an actual loss since the securities tend to be so safe. As long as the bank does not sell the security, there is no loss since the government entity continues to pay interest on the bond until maturity. The primary negative impact comes from the hit to tangible common equity, but Benz said banks have high enough levels of capital that they should weather the equity hit rather than sacrifice the flexibility of AFS.
Among the largest banks, three companies reported HTM portfolios larger than $100 billion: Bank of America Corp., Wells Fargo & Co. and Charles Schwab Corp. Of those three, Charles Schwab reported the largest concentration, with HTM representing 71.8% of the company's total securities book.
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Bank holding companies report information about held-to-maturity and available-for-sale securities on FR Y-9C Schedule HC-B, which can be accessed under the Regulatory Financials section of a company's Briefing Book page on the Market Intelligence website or in MI Office.