| Over the last year, many banks entered into “long-term relationships” with their securities portfolios, a phrase coined by The Wall Street Journal. The newspaper said large banks in particular “promised” that hundreds of billions of dollars of bonds would not be sold.
The amount of securities in the held-to-maturity category (HTM) rose last year by 61 percent, to $492.3 billion. J.P. Morgan Chase increased the amount of its HTM securities by nearly $20 billion in last year’s fourth quarter alone.
When securities are classified as HTM, they are carried at their original cost, and declines in market values hit neither book value nor earnings. Their value is written down only if they are considered to be permanently impaired. It’s no coincidence, many observers believe, that the shift occurred as long-term interest rates started rising.
As an example, the yield on the 10-year Treasury surged 150 basis points last year, reaching 3.04 percent on Dec. 31. The 5-year note rose 120 basis points, hitting 1.85 percent in September. After a brief dip in October, the yield had approached 1.80 percent by the start of 2014. During that time period, the level of unrealized gains in bank portfolios disappeared and, in many cases, turned into unrealized losses.
At this time, most securities on bank balance sheets are still designated as “available for sale” (AFS). The share was recently 84 percent, according to the FDIC. In this situation, bonds are marked to market prices, and the change runs through shareholders equity as accumulated other comprehensive income (AOCI). While earnings aren’t affected, book values in the form of tangible common equity are.
For the larger banks, the turn to HTM is a reaction to changing capital and liquidity regulations.
Starting in 2015, banks with more than $250 billion of assets will be required to collectively hold about $2 trillion of liquid assets. With additional securities on their balance sheets for the new liquidity requirements, volatility is likely to bring fluctuations in capital ratios. Putting assets into HTM helps mitigate that impact.
Small Banks Muscle In
Smaller banks have also gotten into the act. According to SNL, banks with between $1 billion and $5 billion in assets increased the size of their HTM portfolios in the first quarter of 2014 (the most recently available data) by 6.3 percent from the linked quarter, adding to the 12.2 percent increase reported in the fourth quarter. Banks under $1 billion grew their HTM portfolios by 13.3 percent in the first quarter, while the AFS category fell 2.3 percent. Most of the increase in securities portfolios came from the addition of Treasuries, longer-term municipal bonds and mortgage-backed securities. Bankers say they’d rather hold these bonds in HTM instead of AFS to avoid the negative impact that rising rates would have on their tangible common equity ratios.
For an institution transferring a security from AFS to HTM, the unrealized loss at the date of transfer is reported in AOCI and is amortized over the remaining life of the security. At the effective date, the bank records the security at fair value, which becomes the security’s amortized cost. The subsequent book yield is adjusted upward, reflecting the change in the book value of the security. Going forward, the security is reported at amortized cost, while future changes in market value do not impact AOCI.
Given the end of the Federal Reserve’s bond purchase program in October and the prospect of a higher Fed Funds rate this time next year, this trend is likely to continue. With that in mind, here are some factors to consider for those institutions wishing to utilize the HTM category:
Benefits:
- Avoid build-up of unrealized losses in AOCI in a rising rate environment, which could reduce capital.
- Reduce capital volatility.
- Securities may continue to be pledged for borrowing.
Disadvantages:
- Securities in HTM may generally not be sold without tainting the portfolio, limiting the bank’s flexibility to proactively manage the balance sheet or control credit risk.
- At the transfer date, the adjustment to AOCI is locked in, eliminating potential mark-to-market benefits should interest rates decline.
For institutions unlikely to sell longer-dated assets, it may be worthwhile to shift a portion of its securities (or allocate new purchases) to HTM in order to minimize the impact on capital in a rising rate environment. Institutions may wish to consider securities with the largest potential price sensitivity for this category. They could also perform stress tests to make sure that net unrealized losses for a certain shock in interest rates preserves the capital ratio to a minimum target level.
Bankers are always worried about higher interest rates. As we’ve witnessed, rates can go lower when least expected. For those institutions making the move to HTM, timing is likely to play an important role.
Robert B. Segal is president of Atlantic Capital Strategies Inc., an investment advisor located in Bedford. He can be reached at bob@atlanticcapitalstrategies.com.
