There is a ticking time bomb out there that the FDIC, FED, and other regulatory agencies are ignoring because they are partially culpable in its creation. After decades of artificially low interest rates that started with President Obama and ended with President Biden, we are now at a day of reconning that will be at best difficult and at worst disastrous.
Unfortunately for most of us there is nothing we can do other than watch this slow-motion train wreck as it comes down the track and try to find a “safe haven” for our money.
Over the past year there has been an uncomfortable rise in rates for mortgages, credit cards, and other loans. Then there is the positive side of rising rates of finally being paid a little more interest on your savings, assuming you have some left.
But the real time bomb is at the nexus of interest rates, bank accounting, the bond market, bank regulation, and bank management. Decades of artificially low rates left most asleep at the switch when inflation finally hit. Some of our major businesses and many agencies of Government are now run by people who have never seen anything but low inflation and low rates. This generation is ill equipped to handle the crisis and just keeps plodding along ignoring the problem.
The Genesis of the Problem
In 2008 when President Obama came to the White House he ushered in a feeling of good will and for many people some hope on the economic front. But he inherited a world where the 9/11 attack and later Middle Eastern conflicts had all but drained our treasury. This should also have ushered in a brief era of inflation, higher taxes, and reduced spending. However, Congress instead continued to spend, Obama did not bring the troops home, and the FED did all they could to keep the good times rolling.
Then when President Trump came to power, he discovered that the same issues that plagued his predecessor were now his. Raising taxes, cutting spending, and bringing the troops home just was not practical. Like President Obama he quickly learned that you cannot be reelected if you cut spending and raise taxes, so he began to use his position to “jawbone” the FED into leaving rates low. There was some justification for his criticism because of the pandemic, but a tougher leader would have explained it to the American people and done the difficult things needed.
Now comes President Biden with disastrous financial policies that encouraged even more spending going into the midterm elections. Some in Congress believed that Modern Monetary Theory was real, and they turned on the printing presses for two years. The flood of money from the pandemic, pork politics, and wars finally overcame the economy and proven economic principles came into play. The age-old definition of inflation (Too many dollars chasing too few goods.) finally started to work its black magic on us all. The FED had no choice but to begin to raise rates to try and slow inflation. Fifteen years of draining the Treasury and deficit spending finally hit home and inflation was here to stay.
Any rational person would stop the printing presses in Washington, but apparently rationality is not the currency of the day. Congress continues to spend on things like the Chips Act, green energy, and other infrastructure projects that feed the inflation beast. In the ultimate ostrich impression, they refuse to rescind spending bills and dump the problem on the FED and the American people.
Understanding The Banking Problem
For banks, the problem is rising rates and the mechanism by which banks make money. When you make a deposit, your bank must earn money to pay interest and to meet their expenses. Banks make money from two primary sources of interest: loans and bonds. The time bomb we are discussing lies in a part of that equation that relates to bonds and the FED’s actions to stop inflation. Banks are one of the primary purchasers of bonds from all sources within our economy and managing this risk is key to a healthy and stable banking system.
There is an inverse relationship between a bond’s value (price) and interest rates. As rates go up bond values come down. Individuals buy bonds in thousands or tens of thousands of dollars, so unrecognized losses are manageable. But imagine you are one of the largest banks in America and rather than having just one or two bonds you have billions or even hundreds of billions of dollars invested in bonds. Most if not all these bonds were bought when rates were lower than today, so most banks have massive losses in their bond portfolio. Normally you would need to report those losses on your income statement UNLESS you can use a little loophole allowed by the regulators.
The regulators allow the banks to delay or avoid reporting these losses under a special condition. Banks are allowed to divide their bonds into two broad categories. If the bonds are held as “Available for Sale,” (AFS) then losses must be recognized as they occur. But if you classify them as “Held to Maturity” (HTM) then losses are not recognized until the maturity or sale of the bond. Using this logic banks can, with some limited oversight, move bonds from one category to the other as it suits their circumstances. It is obviously to their advantage to have as many as is reasonable classified as HTM.
The Size of the Problem
To understand the size of this problem we must turn to several sources because banks have become quite adept at meeting the required reporting disclosures while obfuscating these figures. Many who are investigating this issue believe that the problem has risen to paper losses of $1.7 Trillion, with the top nine banks reporting paper losses of $232 Billion. Within the top nine banks two seem to be exceptional (Toronto Dominion and Capital One) with no HTM securities reported. The $232 Billion is worth following within just the remaining seven of the top nine banks. This is obviously a widespread problem with a total of $1.7 Trillion in losses, but these seven are more easily analyzed.
Given the size of these banks it is true that HTM bonds are a small part of their total assets, but that is not the issue. The issue is income, and how would their stocks be valued if they had to recognize the losses rather than delay them.
Bank of America and Wells Fargo top the list and deserve the most ongoing scrutiny because they are a systemic risk to the whole banking system. With Bank of America clearing the losses from their books would take almost half their accumulated capital or just over three years of net income. Wells Fargo is slightly better but still the losses would absorb twenty-five percent of their capital or just over two years’ net income.
Looking at the whole group to clear the losses would wipe out almost half the accumulated capital of Bank of America, and one quarter of the accumulated capital of Wells Fargo. Bank of American would not earn a dime for over three years to address their issues. Wells Fargo would need two years to do the same. US Bancorp, Truist, and Citibank are marginally better. The other two banks are in better shape, needing less than a year to move all their bonds from HTM to AFS.
One argument, and most are buying it, is that HTM bonds are no risk because the banks can just hold them until they mature. But this argument assumes the bonds were all purchased at par or less, that they pose no risk of default, and that rates will return to near zero. It seems unlikely that all three of these conditions can occur at once. In fact, we believe that we are looking at the new normal now and that for the sake of investors accounting changes need to be made. Bond defaults are rare so that risk is actually very low, but not zero. Like stocks there are agencies that rate the safety and soundness of bonds so banks can set up reserves against losses, and marking all the bonds to market value monthly is easy.
The Solution and The Pain
In an article that appeared on the web site GAAPdynamics.com on March 28, 2023, Mike Walworth makes an excellent case for the complete elimination of the HTM category, and I would agree! History shows us that when banks have the choice to report losses or defer them, they often take the path of least resistance. Stock prices and compensation are often tied to net earnings and deferring losses is in their best short-term interest. But the size of this problem makes that solution unworkable in the short term. The top nine banks here are only a fraction of the issue to the banking industry if the $1.7 Trillion is correct.
A more workable answer would be to phase in the elimination of the HTM category over a short period of time. In the interim regulators could require greater recognition of the risk with required reserves against losses. These can be managed by raising the reserve requirements until the HTM category is effectively 100% reserved, converting it to AFS through risk mitigation.
Addressing this problem now is also essential to the health of the overall banking system. We are nowhere near the end of the tightening cycle and no matter how bad the losses look now they are headed to a place that is worse. Smaller banks lack the capital and resilience to withstand more losses, even if they are only paper losses at this point.
The FED will most likely need to take rates up another 2% to stop inflation in its tracks, and the bond losses at that level will be massive. Knowing this, the FED has already created a facility to warehouse bonds when the banks need it for liquidity, but by doing this they are admitting that they are part of the problem, and there are darker days ahead.
Resources Used in This Article
Annual Reports of Banks, Banks Cited in this article as of December 31, 2022, and Quarterly reports of select banks as needed.
BankFind Suite, banks.data.fdic.gov, various searches for banks cited and others researched.
Bank of America nurses $100bn paper loss after big bet in bond market, by Stephen Gandel, Financial Times, ft.com, June 29, 2023.
Bank Runs Trash Long-Held Assumption on Deposits, By Jonathan Weil and Peter Rudegeair, The Wall Street Journal, May 22, 2023.
Banks’ Newest Fed Headache: Nonstop Instant Payments, by Eric Wallerstein, The Wall Street Journal, July 9, 2023.
Call Reports, Federal Financial Institutions Examination Council, March 31, 2023.
Commercial real estate woes weigh on New York City recovery, NY Fed says, by Michael S. Derby, reuters.com, April 13, 2023.
Consumer debt hits record $16.9 trillion as delinquencies also rise, by Jeff Cox, CNBC.com, February 16, 2023.
Historic Rate Increases Leave Some on Wall Street Wanting More, by Matt Grossman, The Wall Street Journal, July 11, 2023.
It’s Time to Accept That Higher Mortgage Rates Are Here to Stay, by Holden Lewis, nerdwallet.com, June 28, 2023.
OFF WITH THEIR HEADS!” TIME TO KILL THE HTM CATEGORY UNDER ASC 320, by Mike Walworth, CPA, GAAPdynamics.com, March 28, 2023.
Recharged Bond Rout Unnerves Investors, by Sam Goldfarb, The Wall Street Journal, July 9, 2023.
Understanding Bond Prices and Yields, by Barry Nielson, Investopedia.com, May 24, 2023.
U.S. Banks are sitting on $1.7 trillion in unrealized losses, research says. That’s not a problem—until it is, by Will Daniel , Yahoo Finance, March 23, 2023.
Volcker’s Announcement of Anti-Inflation Measures, October 1979, by Bill Medley, Federal Reserve Bank of Kansas City, Federal Reserve History, federalreservehistory.gov, November 22, 2013.