“This isn’t Big Banks preparing for higher rates! This is Big Banks using a loophole in GAAP accounting to “window dress” future financial statements. How so? As a result of a self-identified “held for investment” designation on certain loans/securities, as rates inevitably rise future economic losses will likely be hidden from shareholders and others…

…Preparing for higher rates involves hedging the duration mis-match between long-duration, fixed-rate, loans and securities and short-term and/or variable rate deposits or just frankly selling these assets before rates rise.”, Mike Perry

March 9, 2016, Aaron Back, The Wall Street Journal

Markets
Heard on the Street

How Big Banks Have Prepared for Higher Rates

The biggest U.S. banks have been actively preparing for higher interest rates, but yields haven’t played along

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The Federal Reserve’s tightening of short-term rates hasn’t translated to increases in long-term yields. PHOTO: ANDREW HARNIK/ASSOCIATED PRESS

By Aaron Back

What if they build it and the Federal Reserve doesn’t come?

Big U.S. banks have continued to construct balance sheets that are ready for a rising interest-rate environment. So far, though, to little avail.

The four biggest banks— J.P. Morgan Chase, Bank of America, Citigroup and Wells Fargo —all substantially increased the portion of their securities that are classified as “held to maturity” in 2015. This seemingly arcane technical adjustment is essentially a way to protect against the downside to their massive bondholdings that could result from higher rates.

The big four designated an average 18.1% of their securities holdings as held to maturity at the end of 2015. That was up from 14.2% the previous year, according to regulatory data.

The biggest jump was at Wells Fargo, where held-to-maturity securities rose to 23% from 17.7% at the end of 2014. Just a few years ago, Wells Fargo had no held-to-maturity debt.

The significance of designating holdings as held to maturity is that it insulates a firm from short-term changes in their value. If, on the other hand, bonds are classified as being “available for sale,” gains or losses flow through to shareholders equity. Although this doesn’t affect earnings, it does impact book values and capital.

The downside of designating more bonds as being held is that banks lock themselves into holding this debt. They can’t generally take advantage of price gains should yields fall instead of rise. Should a bank decide to sell some of this held-to-maturity debt, the whole portfolio would have to be reclassified as available for sale. That would subject banks to a wider range of price volatility.

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Apparently, the risk of being locked in is one the banks have judged worth taking. Ironically, though, rates overall have moved lower since the end of 2015. The Fed’s tightening of short-term rates hasn’t translated to increases in long-term yields. Indeed, so far this year the yield on 10-year Treasurys has fallen steeply, from 2.3% to less than 1.9%.

That likely means many available-for-sale securities have risen in value. Banks won’t gain from that, at least from holdings now designated as being held to maturity.

Still, caution is warranted. Banks have worked hard to bring their capital cushions in line with the new, stricter regulatory environment. They would hardly want capital and book value to be eroded by upward interest-rate moves when yields are at such low levels.

Bond yields have flummoxed traders the world over for some time now. For big banks backed by deposit insurance, and ultimately, taxpayers, there is no shame in holding to a better-safe-than-sorry approach.

Posted on March 16, 2016, in Postings. Bookmark the permalink. Leave a comment.

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