Following the failure of several prominent midsize U.S. banks, lots of other banks have been thinking about what to do with their underwater bond portfolios and how much liquidity to maintain in an environment filled with uncertainty.
The Boston-based regional lender Eastern Bankshares (EBC 0.77%) chose to take action and sell a portion of its bond portfolio to reposition its balance sheet and remove some of the interest rate risk.
The move is certainly painful and resulted in a big one-time loss, but it was also necessary and now puts the bank on a much better footing in what will continue to be a difficult environment this year.
An unfortunate position
Following the collapse of Silicon Valley Bank, Eastern found itself in a difficult position. The bank's available-for-sale (AFS) bond portfolio, which holds bonds the bank intends to sell before maturity, had ballooned from about $5.7 billion to roughly $8.5 billion after it acquired Century Bancorp at the end of 2021.
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The bank had planned to run that down to a lower level, but this was complicated by fast-rising interest rates, which put the low-yielding bonds underwater. Luckily, Eastern didn't move those bonds into its held-to-maturity (HTM) bond portfolio, which are bonds the bank intends to hold until maturity, and which would have further masked unrealized losses.
Toward the end of last year, Eastern started to see deposits funnel out of the bank and deposit costs rise because most of its deposit base was in low-cost or zero-cost checking accounts. These balances fell from roughly $11.5 billion at the end of the first quarter of 2022 to $9.8 billion at the end of the first quarter of 2023.
Protecting the margin and liquidity
With deposit and funding costs rising and many of Eastern's securities yielding very little, the bank decided that to preserve its margin and boost liquidity, it would sell some of the securities trading at a loss. Eastern sold $1.9 billion of AFS securities, which ended up resulting in a one-time loss of $280 million after tax and a $194 million net loss in the first quarter.
The move is certainly painful and not the way Eastern would like to use its excess capital, but it does put the bank on much better footing in the current environment. For one, even after the remaining unrealized bond losses on its balance sheet, Eastern still has strong levels of capital. The bank also boosted its cash position in excess of $2.1 billion and has enough cash and unused liquidity sources to cover 107% of its uninsured deposits.
Furthermore, the bank is now expecting its net interest margin (NIM) -- which essentially looks at the difference between the interest the bank makes on interest-earning assets such as loans and what it pays out on interest-bearing liabilities such as deposits -- to rise from current levels by the end of the year. Management said this wouldn't have been possible without the securities sales.
There is still a valuable franchise here
Obviously, I would have preferred it if Eastern didn't have to do the securities sales and take the loss, but the Century acquisition was definitely one of the few in-market acquisition opportunities it had.
Then, of course, one could argue that management should have repositioned its securities portfolio sooner, but I think deposit-repricing assumptions were difficult to make, given how low-cost the deposit base was. One thing Eastern did do well was not transfer too much of its securities portfolio into the HTM bucket, despite the decline in their tangible book value.
Even after the deposit outflows, roughly 53% of Eastern's deposit base is still in zero- or low-cost checking accounts, and management did say on its recent earnings call that deposits have stabilized. Eastern also has strong commercial lending relationships (which have been reinforced by the Century acquisition), a good moat in the Boston market, and a commercial loan portfolio still sitting on zero loan losses.
Although pressure will likely remain for most of the year, I still see long-term value in the franchise. The stock currently trades at 114% to its tangible book value, or net worth, and tangible book value should grow as unrealized losses in the securities book continue to decline.
