Over $500 Billion in Unrealized Losses at U.S. Banks

Data as of July 21st, 2024.

In recent years, the U.S. banking sector has experienced significant shifts due to rising interest rates and the aftermath of the COVID-19 pandemic. One critical area of concern is the surge in unrealized losses on banks' securities portfolios.

Background

Unrealized losses refer to the decline in the market value of a bank's securities portfolio that has not yet been actualized through a sale. These losses are crucial because they can affect a bank's financial health and decision-making even though they do not immediately impact reported income.

Since the Federal Open Market Committee (FOMC) began tightening monetary policy in March 2022, interest rates have risen across the yield curve. This increase in rates has led to:

A significant rise in borrowing costs for firms and households
Severe impact on the value of banks' securities portfolios
According to the Federal Reserve Bank of Kansas City, banks saw their securities portfolios erode by nearly $600 billion, approximately 30% of their capital holdings

Unrealized Losses: An Overview

Unrealized losses on securities are categorized based on how banks intend to handle these securities. Investment securities can be classified as either "held-to-maturity" (HTM) or "available-for-sale" (AFS):

HTM securities are those that a bank intends to hold until they mature, and their value is recorded at amortized cost
Changes in the market value of HTM securities do not affect a bank's reported assets or equity
AFS securities are recorded at market value, and any unrealized gains or losses are reflected in the bank's equity through accumulated other comprehensive income (AOCI)

As of the first quarter of 2024, the U.S. banking system held a collective $517 billion in unrealized losses, with $39 billion of this amount accumulating in the first quarter alone. These losses have primarily been driven by higher interest rates, which have decreased the prices of fixed-income securities such as residential mortgage-backed securities (RMBS).

Implications of Unrealized Losses

Unrealized losses can affect banks in several ways:

Equity Costs

As the value of a bank's securities portfolio declines, investor perceptions of the bank's financial health may deteriorate, leading to increased equity costs.

Debt Funding Costs

Increased liquidity needs and weakened financial strength can raise the cost of debt funding, which banks may pass on to borrowers through higher interest rates.

Reluctance to Sell Securities

Banks may be less willing to sell securities at a loss, creating liquidity demands that can restrict future loan supply.

Mergers and Acquisitions (M&A)

Unrealized losses can dampen M&A activity, as potential buyers may hesitate to acquire banks with significant losses in their securities portfolios. This reluctance can result in a less efficient banking system and reduced aggregate lending.

Recent Trends and Regulatory Impact

The COVID-19 pandemic led to dramatic changes in bank balance sheets. At the onset of the pandemic:

Deposits surged due to federal support programs
Borrowers increased their cash holdings by drawing down existing lines of credit
Banks accumulated approximately $2 trillion in new securities by the end of 2022
These securities were primarily agency mortgage-backed securities and Treasury securities

While these securities are considered low in credit risk, they are not immune to interest rate risk. The rapid accumulation of longer-maturity securities during the pandemic increased the banks' exposure to duration risk, making their portfolios more sensitive to interest rate changes.

The Broader Context

The rise in unrealized losses comes against the backdrop of higher interest rates imposed by the Federal Reserve to curb inflation. Key observations include:

This period marks the ninth consecutive quarter of unusually high unrealized losses for the banking sector
Historical data (2008-2021) shows unrealized losses and gains ranged from $75 billion in losses to nearly $150 billion in gains
The number of "problem banks" has risen to 63, up from 52 in the previous quarter
These problem banks collectively hold $82 billion in assets
Current number of problem banks (1.4% of total) remains within normal range for non-crisis periods

Conclusion

Unrealized losses have emerged as a significant challenge for the U.S. banking sector in the face of rising interest rates. These losses, while not immediately impacting reported income, can affect a bank's equity, funding costs, and overall financial stability.

The strategic management of securities portfolios, regulatory considerations, and the broader economic context all play crucial roles in how banks navigate this challenging landscape. As the banking sector continues to adapt to these pressures, the ongoing monitoring of unrealized losses and their implications remains essential for maintaining financial stability and ensuring continued credit availability.