America's banks are sitting on $620bn of hidden losses

America's commercial banks are sitting on roughly $620 billion of unrealised losses on their securities portfolios, according to recent figures from the Federal Deposit Insurance Corporation (FDIC). The number should have worried every bank risk committee in the country. The hole equals nearly forty per cent of the sector's tangible common equity, and it stays out of sight thanks to regulatory accounting. By labelling hundreds of billions of dollars of long-dated Treasuries and mortgage-backed securities as "Held to Maturity" (HTM), banks are allowed to act as though the fastest bond sell-off in forty years never happened.

The HTM rule is simple. As long as a bank says it intends, and is able, to hold a bond until maturity, it need not show mark-to-market losses in its income statement or its regulatory capital.

Capital rules look the other way

The escape hatch is wider than HTM alone. Bonds classed as available for sale must be marked to market, but their losses pass through accumulated other comprehensive income rather than earnings. Under an opt-out that regulators extended in 2019 to banks with less than $700 billion of assets, most lenders may also leave those losses out of regulatory capital. For all but the very largest banks, the price of a bond starts to matter for capital only when it is sold.

Losses that exist only on paper

In the zero-rate years of 2020 and 2021, banks were flooded with trillions of dollars of pandemic deposits. With little loan demand, they put the cash into 10-year Treasuries and 30-year agency MBS yielding a meagre 1.5 to 2.0 per cent.

When government bond yields climbed toward 4 per cent, the market value of those fixed-rate assets fell by twenty to thirty per cent. Mortgage bonds suffer twice, because higher rates also slow refinancing and stretch the life of the bond just as its value falls. On paper the banks look well capitalised. Sold today, those portfolios would wipe out a large slice of their equity.

A squeeze even without a sale

The damage does not depend on a forced sale. A bank that locked in 1.5 to 2.0 per cent on its securities must now pay far more to keep its depositors, and the gap comes straight out of net interest margin. In the early stages of tightening, banks raised deposit rates slowly and enjoyed wider margins as loan rates rose. That phase is ending. As savers move money or demand more, funding costs catch up while the income from the bond book stays frozen at pandemic-era yields for years.

The numbers compound. A 10-year Treasury bought in 2021 will keep paying its low coupon until 2031, and the mortgage bonds bought alongside it will, if anything, last longer than planned because homeowners who locked in 3 per cent mortgages have no reason to refinance or move. Every quarter those assets remain on the books is a quarter in which the bank earns less than its cost of funds on part of its balance sheet.

Echoes of the thrift crisis

The savings and loan industry ran the same trade in the 1970s, funding fixed-rate mortgages with short-term deposits. When Paul Volcker drove rates up at the turn of the 1980s, much of the industry became insolvent on a market-value basis, and regulators answered with forbearance and looser accounting rather than closures. The losses grew while the books looked acceptable. The clean-up eventually required the Resolution Trust Corporation and a large bill for taxpayers.

Everything depends on depositors

The accounting holds up only as long as depositors leave their money where it is. With Treasury bills now yielding 4.75 per cent, depositors have good reason to move. Deposits across the system have been shrinking since the Fed started tightening, as savers shift into money market funds that pass on higher yields almost at once.

Silvergate shows how the sequence runs. The California lender to crypto firms lost a large share of its deposits late last year, sold securities at a loss to meet the withdrawals, and said this week that it would delay its annual report while it assessed whether it could continue as a going concern. Its problem was a concentrated, flighty deposit base, and it is not the only bank with one.

Defenders of the banks have a case. Most deposits are sticky, held by households and businesses that value convenience over yield, and insured balances rarely run. Banks can borrow from the Federal Home Loan Banks or the Fed's discount window against their securities, and every HTM bond pulls back to par as it nears maturity. That describes the average bank. The danger sits with lenders whose depositors are large, uninsured and closely connected to one another.

Who is most exposed

The largest banks are in better shape than the averages suggest. They face the strictest capital rules, including the requirement to count losses on available-for-sale securities, and their deposits are spread across millions of retail customers. The exposure concentrates in mid-sized and regional banks that grew fast in 2020 and 2021 on deposits from a single industry, whether technology start-ups, venture funds or crypto companies. Those depositors tend to hold balances far above the $250,000 insurance limit, talk to one another and move money quickly when they are nervous.

Borrowing from the Federal Home Loan Banks has risen sharply in recent months as lenders replaced departing deposits with wholesale funding. That buys time, but it is expensive, and it does nothing about the underlying mismatch between long, low-yielding assets and short, repricing liabilities.

If withdrawals force a bank to sell its HTM securities, the losses have to be recognised at once, which could erase regulatory capital and leave the bank insolvent. Selling even part of the book can taint the rest, obliging the bank to mark the whole portfolio. The weekly Federal Reserve data on bank deposits and the pace of borrowing from the Home Loan Banks will show where the pressure builds first. America's banks look solvent because of an accounting rule, and that rests on depositors who can now earn four times as much elsewhere. The first bank to face a serious run will show how thin the protection is, and it may not be long in coming.