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.

This tweet aims to provide a detailed overview of unrealized losses, their implications, and the broader context within which these losses have occurred.

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 and has severely impacted the value of banks' securities portfolios.

According to a study by the Federal Reserve Bank of Kansas City, banks saw the value of their securities portfolios erode by nearly $600 billion, approximately 30% of their capital holdings, due to rising interest rates.

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. Conversely, 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, and borrowers increased their cash holdings by drawing down existing lines of credit.

This influx of deposits, combined with a decline in loan demand, prompted banks to accumulate securities rapidly. By the end of 2022, banks had added approximately $2 trillion in new securities, primarily agency mortgage-backed securities and Treasury securities.

These securities, although considered low in credit risk, 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.

As interest rates rose, the value of these securities dropped sharply, leading to record-high unrealized losses by the end of 2022. Unrealized losses on all securities amounted to about 30% of aggregate Tier 1 bank capital, with losses on AFS securities alone accounting for about 10%.

To mitigate the impact on regulatory capital, banks have strategically increased their holdings of HTM securities. While unrealized losses on AFS securities reduce regulatory capital for large banks, HTM securities are reported at amortized cost, shielding their market value changes from affecting regulatory capital.

This strategic shift highlights how banks manage their portfolios to navigate regulatory requirements and market conditions.

The Broader Context

The rise in unrealized losses comes against the backdrop of higher interest rates imposed by the Federal Reserve to curb inflation. This period of monetary tightening, which began in the first quarter of 2022, has resulted in the ninth consecutive quarter of unusually high unrealized losses for the banking sector.

Historical data from 2008 through 2021 shows that unrealized losses and gains on investment securities ranged from $75 billion in losses to nearly $150 billion in gains, underscoring the unprecedented nature of the current situation.

Despite the increase in unrealized losses, the number of "problem banks"—those with a CAMELS composite rating of four or five—has also risen. As of the first quarter of 2024, there are 63 problem banks, up from 52 in the previous quarter.

These banks collectively hold $82 billion in assets, indicating that most of them are smaller institutions. The CAMELS rating system assesses a bank’s financial strength across six categories: capital adequacy, assets, management capability, earnings, liquidity, and sensitivity to market risk.

The current number of problem banks, representing 1.4% of total banks, is within the 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.