Banks have made moves in recent years to protect their securities portfolios from rising rates, and the efforts continued in the fourth quarter of 2016 as unrealized losses grew on their balance sheets.
Many institutions have steadily built their held-to-maturity (HTM) bond portfolios to shield securities from swings in the market. Those portfolios grew in the fourth quarter of 2016 as long-term rates jumped in the aftermath of the U.S. presidential election, pushing the banking industry's securities underwater.
HTM portfolios can offer institutions some protection from such changes in the market. Unlike available-for-sale (AFS) portfolios, HTM portfolios are not subject to mark-to-market adjustments on a quarterly basis.
Values in banks' AFS portfolios swung to a loss in the fourth quarter, as banks reported unrealized losses totaling $5.20 billion, compared to $19.06 billion in unrealized gains in the portfolios at the end of the third quarter. The Federal Reserve's H.8 release, which tracks commercial bank balances, shows that the group of institutions began reporting net unrealized losses the week ending Nov. 23, 2016, just weeks after the election.
While unrealized losses might not serve as a headwind to earnings, mark-to-market adjustments in AFS portfolios flow through accumulated other comprehensive income and impact tangible common equity. Banks have sought to mitigate the impact of changes in market valuations on their book values through an increased reliance on HTM portfolios.
Those portfolios grew to 25.0% of all securities at the end of the fourth quarter, up from 23.2% a year ago and 19.9% two years ago. In the fourth quarter, the banking industry in aggregate grew HTM securities by 14.4% from year-ago levels, while AFS securities inched 3.6% higher in the period.
Banks have more than doubled their HTM portfolios in the last three years as they have reacted to new capital and liquidity standards and prepared for higher interest rates. Much of the increase in HTM portfolios came while long-term rates remained low.
The market changed considerably late in 2016 after Donald Trump's surprise victory in the U.S. presidential election caused long-term rates to surge. Shortly after the election, investors sold long-term Treasurys on the belief that the U.S. would post stronger economic growth, while others weighed the possibility that the deficit would increase as the Trump administration boosted infrastructure spending while cutting taxes.
The yield on the 10-year Treasury has risen almost 60 basis points since the election and stands about 100 basis points higher than the recent low experienced in the wake of the U.K.'s decision to leave the European Union in the summer of 2016.
The threat that raising rates could pose to banks' securities portfolios has become even more pronounced for institutions with more than $50 billion in assets, which are subject to the liquidity coverage ratio (LCR). That provision requires them to hold higher concentrations of market-sensitive securities such as Treasurys and Ginnie Maes.
Other regulations have caused banks to be more wary of swings in the market and the impact changes in values would have on their balance sheets. The originally proposed Basel III rules in the summer of 2012 required accumulated other comprehensive income to flow through regulatory capital at all banks. A year later, the final Basel III rules allowed non-advanced approach institutions, generally those with less than $250 billion in assets, to opt out of that provision.
HTM portfolios have grown by 116.0% since the LCR surfaced in proposed form in the fall of 2013, while growing considerably more since the Basel III rules were first proposed. Conversely, banks' AFS portfolios have risen 5.0% since the fall of 2013.
RMBS remain by far the largest portion of securities in banks' HTM portfolios but became slightly smaller portions of banks' investment portfolios, falling to 59.4% of all bonds in those portfolios in the fourth quarter from 59.7% in the linked quarter.
Even though long-term rates remain well above the levels witnessed in the summer of 2016, the yield on the 10-year Treasury has declined in the last few weeks. The 10-year Treasury yield fell to 2.38% on March 27, slightly below the levels seen at year-end 2016, as the market digested news that the Trump administration was abandoning efforts, at least for now, to reform the Affordable Care Act. The decision prompted some policy analysts to question how quickly the White House could move forward with proposed fiscal stimulus and tax reforms.
Still, even with the yield falling from recent highs, the level of unrealized losses in banks' investment portfolios has risen. Since the end of the fourth quarter, the Federal Reserve's H.8 release shows that commercial banks reported net unrealized losses totaling $12.7 billion through March 15. That compares to a net unrealized loss of $11.4 billion as of December 2016.
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