Prior to this year, bank management teams had been waiting well over a decade to experience a real rising interest rate environment. They caught a glimpse of it between 2015 to 2019 but rates were still historically low.
Then inflation ran rampant this year and the Fed found itself behind the curve, forcing it to quickly raise its benchmark overnight lending rate, the federal funds rate, from practically zero to currently inside a range of 3.75% and 4%. Banks benefit from rising interest rates because it boosts the yields on a lot of their loans and securities, and should ideally lead to margin expansion if banks can hold deposit and funding costs in line.
But the pace of these rate hikes has exceeded all expectations, with the Fed having done four consecutive 0.75 percentage point rate hikes in the back half of the year. Now, it's putting banks in a bit of a bind. Here's why.
Bond portfolios are getting crushed
There's probably some debate as to why, but bank bond portfolios have absolutely exploded since the Great Recession. This is likely due to a combination of stricter regulation and quantitative easing in which the Fed has pumped liquidity into the economy by purchasing U.S. Treasury bills and mortgage-backed securities.
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Between the third quarter of 2008 and the third quarter of 2022, the number of securities owned by all U.S. banks has almost quadrupled from $1.17 trillion to more than $4.7 trillion, according to data from the FDIC. Meanwhile, total assets at all U.S. banks have not even doubled and net loans are only up a little more than 50% in the same time frame.
Bond prices and yields have an inverse relationship, meaning that as bond prices go up or down their corresponding yields will do the opposite. However, these yields are heavily influenced by the federal funds rate, which has shot up this year. So, naturally, bond prices have taken a hit.
There are rules for how banks account for their bond holdings. Banks can either classify them as held-to-maturity, meaning they have the intention of holding the bond until it matures, or available-for-sale (AFS), meaning they intend to sell the bond before maturity.
Bonds held in the AFS portfolio must be marked to market, meaning banks must show the fair value of these bond holdings each quarter. However, because the banks haven't sold the bonds, these are just paper gains or losses because the bank can still recoup the full principal if it holds the bond long enough.
But in the meantime, these paper losses are starting to lower banks' tangible book values, or their net worth, which bank stocks trade relative to. Banks through the first nine months of the year have posted more than $771 billion of unrealized losses through the first nine months of 2022, according to S&P Global Market Intelligence.
In its recently released Semiannual Risk Perspective, the U.S. Office of the Comptroller of the Currency (OCC) recently said that banks with more than $10 billion in assets have seen their AFS portfolios diminished by 7%, while HTM portfolios are down roughly 14%.
Not only do these unrealized losses reduce a bank's tangible book value, but they also impact regulatory capital temporarily, which can impact a bank's ability to return capital to shareholders in the present. Tangible book value is also a key determinant in valuing banks for acquisitions and is one reason M&A has been down this year in the sector.
The Fed is making the situation worse
As I mentioned above, unrealized losses are temporary and will snap back if banks can just hold the bonds long enough. However, if a bank needs to sell the bond early then they take the mark resulting from its current fair value, which would currently be a loss.
So why would a bank sell a bond, especially if it's trading at a loss and generating higher yields for the bank, which is bolstering revenue? Well, it wouldn't... unless it runs into liquidity issues. That's why banks purchase bonds in the first place. They can earn yield if the bank can't find loan growth and are highly liquid so they can be converted to cash.
But if liquidity starts to dry up and banks need to sell bonds, they are looking at huge losses, which would hurt earnings and permanently eat into capital and erode tangible book value. There is still good liquidity in the banking system but the Fed has begun to unwind its massive balance sheet and is now letting U.S. Treasury bills and mortgage-backed securities run off each month to the tune of $100 billion. This will drain liquidity from the economy, which includes bank deposits.
US Commercial Banks Deposits data by YCharts
As you can see, deposits have already started to leave the system, although this also has to do with lower consumer savings and higher interest rates, which has made deposits more expensive, a factor that could separately cut into bank margins next year.
Regulators are increasingly concerned
Back earlier this year there was less concern about bank bond portfolios because many didn't think the Fed would be so aggressive with rate hikes.
The OCC also said in its report that these unrealized bond losses affect "banks' access to timely and cost-effective wholesale sources of funding through reduced fair market values for collateral pledging or to meet margin requirements." It also recommended banks consider a range of scenarios when stress testing and thinking about effective risk management for liquidity and interest rate sensitivity.
While the situation is not yet dire, due to current healthy levels of liquidity, it's now getting a lot more attention because the Fed's rate hikes aren't done yet, deposit pricing could soon rise much quicker than expected, and the Fed is unwinding its balance sheet. There's still a good chance that most banks will be able to weather the storm but there is now much less margin for error. This is a real risk investors must take into account as they evaluate the sector.
