The investment losses that led to the failure of Silicon Valley Bank (SVB) are, to varying degrees, a problem that exists throughout the U.S. financial system. The unrealized book losses of the U.S. banking industry on investments in low-yield bonds totaled $620 billion at the end of last year.
For many banks, this is a manageable problem.
Investment bond holdings represent less than a quarter of the $23.6 trillion in assets in the U.S. banking system at the end of last year. Unlike SVBs, depositors at banks are usually diverse and unlikely to need money all at once. Big banks are even less risky. It is considered too big to be crushed.
What’s more, the recent rally in Treasury prices is narrowing the $620 billion loss on the books. Ironically, the rally stems from concerns about the health of the banking industry.
Still, banks face a tough time if depositors continue to phase out their funds and shift investments to things like money market mutual funds (MMMFs). Funding costs have risen amid limited income from low-yield bond investments during the coronavirus pandemic. That could constrain banks’ ability to lend to consumers and businesses, slowing the economy.
“Payments on deposits are going up, but the gains on bonds are steady. is the cause of the bank pressure,” he said.
As the Fed pumped unprecedented amounts of money and lowered interest rates to prop up the pandemic-hit economy, many banks increased their investments in long-term government bonds and mortgage-backed securities. Among them was a Treasury bond with an annual interest rate of 0.6% for more than a decade.
But when inflation soared and authorities started raising interest rates, the value of those bonds plummeted. Who would buy a 0.6% trading bond when the yield on newly issued bonds suddenly exceeded 3%?
Any time interest rates rise, there is a risk of loss in bond investments. Moreover, banks held more bonds in 2022 than usual. The money that the US Fed and government poured into the economy flowed into the banking system, giving financial institutions huge amounts of money to invest. SVB’s domestic deposits, for example, grew by more than 150% from the end of March 2020 to the end of last year.
Source: Bloomberg
A large portion of a bank’s investment portfolio employs a ‘held to maturity’ accounting approach. This means that when the bond’s value goes down, it doesn’t have to be recorded as a real loss, which hurts the balance sheet.
Source: Bloomberg
As bank deposits began to grow during the pandemic, financial institutions initially put more money into bond investments using the “available-for-sale” accounting method. Under this approach, changes in bond value affect the balance sheet but not the income statement. Of course, if losses get too high, banks will be forced to raise their capital levels.
In 2021, more banks became convinced that the Fed would soon enter a phase of interest rate hikes, and they began to switch their bond investments to maturity holdings.
Source: Bloomberg
Initially this worked. profit increased. The U.S. banking system’s return on equity averaged 12.2% in 2021, the highest since 2006.
But banks were under pressure on both sides as inflation rose and interest rates were raised. The interest rate hike forced U.S. banks to pay more interest to attract deposits. Commercial bank deposits fell last year for the first time since 1948, according to the Federal Deposit Insurance Corporation, as consumers and businesses withdraw money from banks to invest in assets such as government bonds. Meanwhile, the value of bonds held by banks plummeted. Combined unrealized losses on held-to-maturity and available-for-sale bonds stood at $620 billion at the end of last year.
Soaring interest rates, rising investment losses and severe deposit outflows are a new experience for many investors and banking industry executives, and many feel they are uncharted territory.
“In more than 20 years of covering this industry, I have never seen anything like this,” said Ania Aldrich, investment principal at Cambia Investors. I have never been tested for my tolerance to the situation.”
Original title:US Banks Have $620 Billion of Unrealized Losses on Their Books(excerpt)
