The second-largest holding in Warren Buffett and Berkshire Hathaway's (BRK.A 0.51%) (BRK.B 0.61%) massive $350-billion-plus equities portfolio is Bank of America (BAC 3.15%), which also happens to be the second-largest bank by assets based in the U.S. In the first quarter of the year, Bank of America reported that its tangible book value (TBV), essentially its net worth, had fallen about 3.2% from the previous quarter. Banks tend to trade relative to their TBV, so a falling TBV is normally not a good sign. Should investors be worried? Let's investigate.
Changes in other comprehensive income
When banks have excess liquidity, which they've had a lot of lately, they will often take this liquidity and invest in bonds because even though bonds don't yield as much as loans, it's better to have cash making something instead of just sitting there.
Image source: Motley Fool.
When banks invest in bonds, they classify them in one of three ways on the balance sheet. One is held-for-trading, for which banks intend to sell bonds fairly quickly, usually within one year of purchase. Another is held-to-maturity, which, as the name suggests, means bonds purchased to hold until they mature. The last classification, and the one most important for this article, is bonds available-for-sale (AFS), which are bond purchases banks make to hold for a long period but still probably sell them before they reach maturity. AFS securities are held on the balance sheet at fair value. As a result, banks must account for the realized or unrealized gains of these AFS securities each quarter, which can impact a bank's equity.
In the first quarter, yields on bonds increased very quickly as the market anticipated the Federal Reserve's plans to aggressively raise its benchmark overnight lending rate, the federal funds rate. Bond yields and bond prices have an inverse relationship -- when bond yields rise, bond prices take a hit, which leads to a markdown on bank balance sheets through an accounting convention called accumulated other comprehensive income (AOCI).
Data source: Bank of America. Chart by author.
It's not uncommon to see other unrealized losses in AOCI. But in the first quarter of 2022, Bank of America saw a big unrealized loss of $8.3 billion due to fast-rising interest rates, which drove the decline in bond prices. However, not all of that hits the bank's equity. Bank of America's Chief Financial Officer Alastair Borthwick said on the bank's most recent earnings call that the changing value of the bank's AFS securities resulted in a decline of $3.4 billion, which does impact equity. But rising rates also led to a roughly $5.2 billion decline in the value of the bank's derivatives, which did not impact equity. You can see the impact on TBV per share in the quarter.
Data source: Bank of America. Chart by author.
Should investors be worried?
The good news is that while bank stocks have been down this year, I don't think it was necessarily due to the erosion in tangible book value. In fact, Bank of America's Chief Executive Officer Brian Moynihan said that to be cautious, the bank hedged a large chunk of its AFS securities to prevent a bigger hit from AOCI. Furthermore, Moynihan reminded investors that impacts from AOCI are temporary in nature because as the bonds mature, they tend to boost revenue and make up for earlier losses from AOCI fairly quickly. So, while these AOCI hits are denting TBV, they are most likely just a near-term headwind.
