How unrealized bond losses are hampering the banking industry

November 21, 2022 2:55 PM

Increasing losses on banks' bond portfolios are becoming more than a mere annoyance, particularly for some smaller institutions.

After this year's sharp rise in interest rates prompted massive losses across the bond market, banks are underwater on bonds they purchased when rates were low. Bond prices go down when rates increase and higher-paying bonds become available.

The losses are likely to be temporary and only on paper. Still, banks are facing a higher risk that they'll have to sell the bonds before they reach their maturity date and return to their original value — thereby "realizing" what are currently "unrealized losses."

In the meantime, the losses are lowering the value of banks' equity. That's because every quarter, banks have to adjust the value of any bonds they mark as "available-for-sale." Over the past three quarters, those values have fallen thanks to inflation and the Federal Reserve's rate increases.

The bond losses are affecting banks big and small, though "for the smaller banks it is a bigger issue," said Michael Rose, a bank analyst at Raymond James. Their decreased equity levels could trigger restrictions on their borrowing from the Federal Home Loan banks and lessen their value as they look to buy other banks or sell themselves.

Unrealized bond losses are also a growing source of investor hand-wringing, even as bank executives argue that they should not be a big concern.

What follows is a look at four ways the issue is impacting banks.

Bloomberg

Buybacks have become less popular

Megabanks curtailed or cut their share repurchases earlier this year due partly to the unrealized bond losses, as their regulatory framework made those losses matter more.

Tougher rules apply to the eight global systemically important banks — including JPMorgan Chase, Bank of America, Wells Fargo, Citigroup and Bank of New York Mellon — and the major custody bank Northern Trust.

Those banks have felt an impact from unrealized bond losses on their regulatory capital. As a result, they have less excess capital to distribute to shareholders, and they have adopted a more cautious tone on buybacks.

"We're going to continue to be prudent with respect to buybacks," BNY Mellon Chief Financial Officer Emily Portney told analysts last month. "I think that's natural given the continued volatility that we're seeing across the markets and, frankly, the uncertain macroeconomic environment."

Other superregional banks, such as PNC Financial Services Group and U.S. Bancorp, can opt not to include swings in their bond losses in their regulatory capital ratios.

But even if their regulatory capital isn't affected, much of the industry is suffering from lower equity values as they record losses in their accumulated other comprehensive income, or AOCI.

Many banks where tangible common equity has dropped have portrayed it as a more of an optics problem than something that is constraining their decision-making. But the AOCI impact is impacting some bankers' thinking as they consider their own buyback strategies.

"We are currently weighing macroeconomic conditions and their possible impact on AOCI and tangible capital," Mark McCollom, chief financial officer at Fulton Financial in Lancaster, Pennsylvania, said on a recent earnings call. "As a result, we will likely pause until deeper in the fourth quarter before we would consider repurchasing common shares."

Similarly, James Rollins, chief executive of Cadence Bank in Tupelo, Mississippi, said the AOCI impact "is not helping us … so we've not been using our stock buyback program."

"I think we want to continue to be conservative with capital, especially looking at the economic and geopolitical headwinds that we see," Rollins said.

Investors have become more concerned

Some investors are worried about banks' declining tangible common equity, although there's debate on whether those concerns are valid.

The concerns have escalated throughout the year, with a continuing climb in interest rates leading to quarterly declines in bond portfolios and coinciding with broader macroeconomic fears.

"When investors get nervous about the economy, they worry about levels of tangible common equity, and that level has been reduced significantly," said Christopher McGratty, head of U.S. bank research at Keefe, Bruyette & Woods.

The "doomsday" scenario is that liquidity-strapped banks will have to sell the bonds in question to raise cash, said David Feaster, a bank analyst at Raymond James. That would turn what are currently unrealized losses into realized ones, forcing them to take an actual hit on their regulatory capital rather than wait for the situation to work itself out.

While that outcome remains unlikely, it is "not a crazy scenario" and shows how important bank liquidity will be next year, Feaster said.

Regional bank executives downplayed the impact of declining tangible common equity ratios during remarks at a recent investor conference.

James Leonard, Fifth Third Bancorp's chief financial officer, called tangible common equity an "antiquated" measure, arguing that the liquidity coverage ratio is a better metric, and one that regulators currently use to determine banks' health.

Regions Financial CFO David Turner made a similar point about the decreased importance of tangible common equity in the aftermath of the 2008 financial crisis.

At Birmingham, Alabama-based Regions, the tangible common equity ratio fell to 5.01% during the third quarter, down from 7.79% a year earlier. But the bank's executives "don't really care what that ratio goes to," Turner said, arguing that the ratio "only gets to be an issue if you're in a liquidation mode."

"We don't have challenges from our regulatory supervisors on that at all," Turner said. "We don't have a challenge by our rating agencies on that at all."

Some institutions risk hitting borrowing limits at the Federal Home Loan Banks

Some smaller banks may be more concerned because of regulations that prevent them from borrowing from Federal Home Loan Banks if they have negative tangible capital.

Thirty banks with Federal Deposit Insurance Corp. charters had negative tangible common equity ratios at the end of the third quarter, according to an analysis from Janney Montgomery Scott. The vast majority of those banks are privately held, and their median asset size is $228 million.

As the deposit market becomes more competitive, banks have increasingly turned to the Federal Home Loan Banks to fund loans. But banks with negative tangible equity may run up against borrowing limits put in place by the Federal Housing Finance Agency, which seek to guard against credit risk at the Federal Home Loan Banks.

In a letter this month, the Independent Community Bankers of America, which represents small banks, asked the FHFA and bank regulators to make certain changes. The small-bank trade group said the current rules may "needlessly undermine access to liquidity amid a period of economic volatility and uncertainty."

"ICBA understands that safety and soundness is of paramount importance, but we suggest that neither has to be compromised in a collaborative effort to ensure prudentially sound banks continue to have access to FHLB advances that allow them to support their communities," wrote ICBA President and CEO Rebeca Romero Rainey.

The letter asked the Federal Reserve, the FDIC and the Office of the Comptroller of the Currency to provide an exception to the rule, which would allow individual banks to be deemed well capitalized and open them up to borrowing from the FHLB.

The ICBA also asked the FHFA to tweak its rules and loosen its regulation — so that the agency's treatment of swings in bond portfolios matches the reduced impact they have at the banks' primary regulators.

In a statement, an FHFA official said the agency is "aware of industry concerns around regulations pertaining to negative tangible capital and AOCI."

"We continuously monitor the rules and regulations in place to ensure the Federal Home Loan Banks operate in a safe and sound manner," the official said.

Merger momentum has slowed as bank valuations take a hit

The unrealized bond losses may also be dampening short-term momentum for bank mergers.

"Academically, you should say it doesn't matter, but it surely does," Gary Small, CEO of Ohio-based Premier Financial, said on an earnings call last month. "I think it's slowed the discussions from where they were in the first half of the year."

The dampened M&A momentum is at least partly due to the bond losses' impact on banks' valuations — which decreases a bank's currency when it's involved in a deal that involves stock, not just cash.

There "just aren't as many opportunities" for mergers and acquisitions, partly because banks looking to be acquired could take a hit due to AOCI adjustments, Thomas Travis, CEO of Oklahoma City-based Bank7 said during a recent earnings call. Meanwhile, buyers' "currencies aren't where they used to be."

"So we don't see a lot of activity out there. We just don't," Travis said.

The unrealized bond losses make it "really, really tough" to do a merger now, said John Allison, CEO of Home Bancshares in Conway, Arkansas.

"It really makes it tough to do a deal with someone if … you look at their bond book and they're upside down," said Allison (pictured above).

Home Bancshares completed its acquisition of Happy Bancshares in April, just after the Fed raised rates for the first time since the start of COVID-19 pandemic, and just before high inflation prompted the Fed to hike rates more aggressively, causing widespread pain in the bond market.

The timing of that merger was "lucky," Allison said. "I'm not looking for a pat on the back, but I think we made the right call."