The price of rising interest rates.
The FDIC just released the aggregated third-quarter performance metrics of the 5,477 banks and thrifts it
insures. The amount of their combined assets ticked up to $17.7 trillion.
These assets – mostly loans but also investments of all kinds – include $3.6
trillion in securities (not including the securities in their trading
accounts). And banks got hit by the biggest quarterly losses on those
securities since the first quarter of 2009.
Banks designate these securities either as “held-to-maturity” securities
(valued at “amortized cost” or book value) and “available-for-sale”
securities (valued at “fair value,” such as market value). For Q3, these were
their unrealized losses – meaning, banks have not yet sold the securities:
- Available-for-sale securities: $51.5 billion in
unrealized losses, or 2% of their amortized cost, as the FDIC said, “the
highest loss level since first quarter 2009.”
- Held-to-maturity securities: $32.8 billion in unrealized
losses.
- Both combined: $84.3 billion in unrealized losses.
Note the damage done in 2018, after years of big gains: $83.4 billion in
Q3; $66.4 billion in Q2; and about $55 billion in Q1; for a total so far this
year about $200 billion in unrealized losses.
Not that this is a huge surprise. For example, Wells Fargo disclosed in
its 10-Q
filing for the third quarter that on its over $411 billion in
available-for-sale and held-to-maturity security holdings, it suffered total
unrealized losses of $8.85 billion so far this year. This includes net
unrealized losses of $3.76 billion in available-for-sale securities and net
unrealized losses of $5.1 billion in held-to-maturity securities (image from
Wells Fargo 10-Q):
Wells Fargo explained that it was its $411 billion of available-for-sale
and held-to-maturity debt securities, such Treasury securities,
municipal bonds ($54 billion), mortgage-backed securities, corporate bonds,
etc. that decreased by “$8.6 billion in balance sheet carrying value” since
the beginning of the year. The reason: “primarily due to higher long-term
interest rates.”
This $8.6 billion decrease in “balance sheet carrying value” largely
bypassed the income statement.
Bond prices fall when yields rise; and in 2018, yields have ticked up
across the yield curve. The weighted-average maturity of Wells Fargo’s
available-for-sale debt securities was 6.2 years. So, with the 10-year yield rising
from 2.4% to 3.05% over the nine months – a move of just 65 basis points – it
nevertheless sent Wells Fargo’s unrealized losses soaring.
And as the FDIC data shows, with banks having incurred $200 billion of
unrealized losses so far this year – of which $8.6 billion stem from Wells
Fargo – it is not bank specific. All banks have this issue.
If banks don’t sell these securities but hold them to maturity, they will
be paid face value at maturity. In other words, those unrealized losses
dwindle and then disappear as the maturity date approaches, even under rising
interest rates.
This assumes that there is no default or other impairment. But if those
securities default, banks will take a loss, classified as an
“other-than-temporary impairment” (OTTI).
Currently, defaults are still rare, as credit is still easy, rates are
still relatively low, and investors are still chasing yield. So most
companies, even risky ones, are not yet having trouble refinancing their
maturing debts or borrowing more to make interest payments. And losses for
bondholders are low at this point.
But credit has started to tighten a little. Parker Drilling is an example
of what happens when the market loses interest in refinancing a company’s
maturing debt. Parker Drilling has unsecured bonds that mature in August next
year, but the credit markets lost interest. Unable to service and roll over
this debt, Parker Drilling filed
for bankruptcy. Holders of those unsecured bonds will get cents on the
dollar. If a bank holds any of those bonds, it would have to take a loss on
them. But this is still a rare case.
Wells Fargo confirms this. So far in 2018, it wrote down its debt
securities by only $23 million due to “other-than-temporary impairment.”
These OTTI losses at banks rise along with rising defaults among corporate
and municipal debt, but this hasn’t happened yet.
Treasury securities that Wells Fargo holds will not see a default as the US
government always has a buyer-of-last-resort in the market (the Fed). The
only possible reason for a default of Treasury securities would be Congress’s
refusal to lift the debt ceiling at the last moment. But not even Congress is
that stupid.
So, losses on Treasury securities that are held to maturity are only
temporary and will reverse as the maturity dates approach — during times of
smooth sailing. However, if the bank is forced to sell those
Treasury securities and other high-quality securities at fire-sale prices, as
it might be during a liquidity crisis, which is what happened to some banks
in 2007 through 2009, it may incur sharp and permanent losses on the
securities it has to sell. These losses, in stressed times, can then combine
with losses from other corners of the bank’s operations and balance sheet
into a very toxic mix.
The West Coast Housing Bubble bursts even without Tech Bust, which is
still to come. In my podcast… THE
WOLF STREET REPORT
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