JPMorgan Chase & Co. (JPM:US) and Wells Fargo & Co. (WFC:US) are leading a shift in how banks account for their bond investments after a $44 billion plunge in value exposed a potential drain on capital under new rules.
The largest U.S. lenders are moving assets into the “held-to-maturity” column of their books instead of designating them as “available for sale,” an accounting method that under post-crisis banking regulations allows paper losses to erode measures of their health. The change pushed the share of securities that the five biggest banks keep in the held-to-maturity category to 8.4 percent, the highest in almost two decades, according to Credit Suisse Group AG analysts.
Banks are seeking to protect themselves from a weakening of their capital as economists predict bond yields will continue to climb from record lows after their biggest investments, government-backed mortgage securities, posted their first annual losses since 1994. While the strategy may bolster banks’ financial standing, overuse of the accounting method may limit their ability to raise cash to make loans as the economy strengthens and mask risks.
“You don’t want somebody loading the boat and taking on tremendous” interest-rate risk by exploiting the distinction, said William Weber, a former Federal Deposit Insurance Corp. official and bank treasurer who now advises lenders on their balance sheets as head of Drexel Hamilton LLC’s institutional depository group. At the same time, “they have the right” to switch their accounting methods, he said.
U.S. deposit-takers invest more in the $5.4 trillion of Fannie Mae, Freddie Mac and Ginnie Mae mortgage bonds than in other securities because they carry little default risk, offer higher yields than Treasuries and are easy to trade.
The top 50 banks owned $1.2 trillion at year-end, increasing those designated as held-to-maturity, or HTM, by $38.4 billion in the three months ended Dec. 31 and reducing available-for-sale, or AFS, investments by $23.3 billion, according to data compiled by Morgan Stanley analysts.
JPMorgan experienced the “most dramatic shift,” the analysts led by Vipul Jain wrote in a Feb. 19 report. The New York-based bank boosted the holdings in the first category by $18.6 billion, while cutting them in the AFS grouping by $16.8 billion. Wells Fargo, based in San Francisco, increased HTM holdings by $6.3 billion, while reducing those in AFS by about $200 million.
The two banks used the HTM designation for less than $10 million of the investments a year earlier, according to regulatory data available through the National Information Center website. Justin Perras, a spokesman for JPMorgan, and Ancel Martinez of Wells Fargo declined to comment.
The risk to debt prices from rising interest rates were underscored last year as speculation over when the Federal Reserve would begin to reduce its monthly bond buying roiled markets. The largest banks went from having $33 billion in unrealized gains on AFS securities in late April to $10.5 billion of losses in early September, central bank data show.
With the Fed poised to continue cutting its bond purchases after reducing them the past two months, benchmark 10-year Treasury yields will advance to 3.4 percent in the fourth quarter, from 2.69 percent today, according to the median estimate of 74 economists surveyed by Bloomberg.
Unrealized, or paper, gains and losses reflect changes in values recorded on a firm’s accounts that don’t result in cash changing hands. Accounting rules allow banks to ignore market-value fluctuations for loans and HTM securities; they record gains and losses on AFS holdings they don’t expect to realize in a way that excludes them from net income (JPM:US)and counts them toward shareholder equity under generally accepted accounting principles.
In the past, that distinction for AFS holdings meant lenders’ capital used in regulatory measures went unaffected, similar to the treatment for HTM bonds and loans. In July, agencies including the Fed and FDIC, in implementing parts of the Basel III accord negotiated by international regulators, included a change requiring gains and losses on AFS holdings to be included in capital, a switch being phased in through 2018.
Banks with less than $250 billion of assets can opt out of the new approach.
The share of all securities held by the top 5 banks in the HTM designation rose to 8.4 percent on Dec. 31, from 4.8 percent a year earlier, reaching the highest year-end level since 1995, according to regulatory data compiled by Credit Suisse analysts led by Mahesh Swaminathan. For the next 20 banks, the share rose to 18.8 percent from 12.8 percent.
When selling HTM holdings, banks risk “tainting” the designation, meaning they could be required to recognize unrealized losses on a broader swath of investments, said Scott Buchta, head of fixed-income strategy at brokerage Brean Capital LLC. That’s why the lenders in the past used the category less and now may find it harder to sell securities to raise cash when demand for loans increases, he said.
“You have in essence locked these bonds away and they’re probably some of the more liquid bonds in your portfolio,” Buchta said. “It really limits your ability to adjust your balance sheet to changes in economic conditions.”
Losses on mortgage securities guaranteed by government-backed Fannie Mae and Freddie Mac or U.S.-owned Ginnie Mae averaged 1.4 percent last year, according to Bank of America Merrill Lynch index data. Fannie Mae’s 30-year securities trading closest to face value lost 7 percent, the data show. The debt is gaining this year, with the market returning 1.7 percent and the current-coupon debt up 2.3 percent.
The top 50 banks supported the agency mortgage-bond market by adding $15.7 billion last quarter after trimming holdings by $46.1 billion the previous period, Morgan Stanley data show.
Bank of America Corp. (BAC:US), the largest holder with $276.9 billion, boosted HTM holdings by about $500 million, while cutting those in AFS by $5.3 billion. Jerome Dubrowksi, a spokesman for the Charlotte, North Carolina-based lender, declined to comment. Wells Fargo, the No. 2 bank investor, owns $134.4 billion, while No. 3 JPMorgan holds $124.3 billion.
At the same time that regulators are putting bank capital at greater risk from bond slumps, they’re also working on separate rules stemming from Basel III that will make lenders increase holdings of easy-to-trade assets such as agency mortgage securities so they can survive a financial crisis.
The use of HTM accounting, which so far appears to be getting done in a “thoughtful” and limited way that shouldn’t increase banks’ risks, is a logical response to the pair of new regulations, said Greg Hertrich, the head of U.S. depository strategies at Nomura Holdings Inc.’s securities arm.
“If you tell banks they have to hold” a certain amount of easy-to-liquidate assets, “it behooves them to find a way to do it in which there isn’t a significant amount of capital volatility from quarter to quarter,” he said.
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