Bond Slump Saddles Big Banks; Large Banks Can’t Avoid Trouble When Interest Rates Rise

July 31, 2013, 3:22 p.m. ET

Bond Slump Saddles Big Banks

Large Banks Can’t Avoid Trouble When Interest Rates Rise

DAN FITZPATRICK and SHAYNDI RAICE

The recent market turmoil exposed a new weakness in the balance sheets of large banks: they hold so many bonds that they can’t avoid trouble when interest rates rise. When long-term rates jumped by a full percentage point in May and June amid worries the Federal Reserve would taper its bond-buying stimulus program, bank investments in mortgage-backed securities and Treasuries got slammed. J.P. Morgan ChaseJPM +0.72% & Co., Bank of America Corp., BAC +0.55% Citigroup Inc. C +0.70%and Wells Fargo WFC +0.55% & Co. saw a measure of the paper value of these holdings fall by more than $13 billion during the second quarter.The rout shows how difficult it can be for the biggest financial institutions to maneuver when markets get choppy.

Banks in recent years piled into bonds in search of returns as a way of making up for lackluster loan demand and billions in annual income lost to a slew of new U.S. regulations. But now the size of these portfolios is exposing banks to vulnerabilities even though their holdings are largely considered safe. Bond instruments now comprise nearly 99% of the $1.159 trillion investment portfolios held by the top four banks, according to Charlottesville, Va., data provider SNL Financial.

The second-quarter losses didn’t affect banks’ earnings because of a quirk in accounting rules that allows institutions to keep any paper losses on long-term bonds out of the profit-and-loss equation. As a result, the four biggest banks were able to churn out more than $20 billion in net income during the quarter, a 33% jump from the same period a year earlier.

But analysts said the unrealized accounting losses, which result from a quarterly evaluation by the banks of how much the securities are worth, could hurt banks in the long run. They can reduce the banks’ reported book value, or net worth, and have the potential to eat away at the capital they hold to protect against future losses. Planned international rules require banks to count securities gains or losses as part of their total common equity, a key measure of a bank’s ability to absorb future losses.

Zions Bancorp, ZION +1.30% a midsize lender in Salt Lake City with $54 billion in assets, warned in a recent presentation that the amount of capital held by the industry would drop by $200 billion to $250 billion if long-term rates were to rise by three percentage points. That would result in $2 trillion of reduced lending capacity, according to Zions.

If rates shoot up, “it’s a very significant issue for the industry,” said Zions investor-relations director James Abbott while making the presentation to analysts.

Higher rates aren’t all bad for banks. If rates keep rising, banks would be able to charge more for their loans, and increase the margin between what they pay to borrow money and how much they make on lending and investments.

But violent jumps in rates can catch banks off guard, experts said.

From early May through July 17, more than $37 billion in unrealized accounting gains vanished, leaving paper losses of more than $3 billion, according to an analysis of Federal Reserve data compiled by Keefe Bruyette & Woods Inc. The drop was the sharpest since late 2007 and early 2008, according to KBW.

The biggest swing among the major banks belonged to Charlotte, N.C.-based Bank of America. Unrealized losses on its long-term bond holdings more than doubled to $7.71 billion in the second quarter from $3.48 billion in the first quarter. Income tied to the value of investment portfolios held by J.P. Morgan Chase & Co. and Wells Fargo & Co. went down by slightly more than $3 billion apiece, while the value of Citigroup Inc.’s holdings decreased by $2.86 billion. In all cases the movements represented less than 2% of the value of the banks’ total portfolios.

Banks mostly are choosing securities such as Treasuries, mortgage bonds and other instruments traditionally considered safe. At Bank of America, mortgage bonds issued by housing giants Fannie Mae, FNMA -0.65% Freddie Mac FMCC -1.38% and Ginnie Mae comprise 84% of the bank’s $241 billion securities portfolio.

But while those bonds carry a low risk of default, they still are prone to rising interest rates when investors pile out, as they did in May and June, when the 10-year Treasury yield jumped a full percentage point.

“The challenge for these larger banks is it’s absolutely impossible to reposition your balance sheet on a dime,” said banking analyst Todd Hagerman of Sterne Agee & Leach Inc. “It takes several quarters to reposition yourself for such a move.”

Smaller banks also are wrestling with the fallout. Farmers Capital Bank Corp.FFKT -1.01% in Frankfort, Ky., which has $1.8 billion in assets, reported a $4.2 million drop in its securities portfolio during the second quarter, compared with a gain of more than $7 million in the year-earlier period. The bank’s book value declined more than 5% as a result of the paper losses.

“There’s not a lot you can do to deal with something like that in a proactive manner,” said farmers Chief Financial Officer Doug Carpenter. “You more or less are left at the mercy of something like that and dealing with it going forward.”

Investing in securities during a time of weak loan growth seemed like a smart move a year ago, said Frank Sorrentino III of Englewood Cliffs, N.J.-based ConnectOne Bancorp Inc. CNOB +1.95% “Everything was moving in the right direction. Now it’s not just in neutral, it’s going in reverse.”

The danger, said analysts, is that such losses have the potential to erode an institution’s capital base, as happened in 1994 when a sudden rise in interest rates caused trouble for a slew of banks, securities firms and hedge funds. Goldman Sachs Group Inc. GS +0.99% had to sell a stake to raise $250 million and fill a capital hole that developed partly as a result of the rate movement.

If long-term rates go up by another percentage point or more by the end of the third quarter, said Gerard Cassidy, bank analyst with RBC Capital Markets, “the banks will have much bigger challenges to deal with than they currently realize.”

Even if banks remain in relatively safe investments, “it still creates the potential for major mishaps,” said banking analyst Mike Mayo of investment firm CLSA Americas. The big movements in the last quarter were “a reminder of what’s the biggest risk for the banking industry over the next five years.”