Almost all U.S. banks hold some amount of securities on their books at any given time. But how they report the value of those securities can make a big difference on the bank’s book equity capital… but not necessarily on its regulatory capital.
Reporting securities as “available-for-sale” (as opposed to “held-to-maturity”) provides the bank flexibility to buy and sell when it chooses to do so. When interest rates are flat, that is a reasonable way to go. And, as we all know very well, rates were flat for a very long time.
But here’s where it gets tricky. When rates rise, the value of those securities fluctuates, and not generally in the direction the bank would like. So, let’s say you’re a bank with a book value of $1 million in securities but rates have risen rapidly and you find the market value of those securities is now just half that.
Since the bank decided to report the securities as “available-for-sale” (AFS), this half a million must be booked as an unrealized loss. That doesn’t sound so bad, right? It is an unrealized loss. Many of us have seen similar unrealized losses in our 401k accounts. It only really matters if you sell when you’re down. If you have patience and wait until the market comes back up, or until the securities mature, that’s all the losses will ever be: unrealized.
The problem for banks (aside from the Big Boys) is that deciding to report these securities as AFS also means that, according to Generally Accepted Accounting Principles (GAAP), the losses, realized or not, must be reflected on the balance sheet. The assumption being, if they are AFS, they must be reported at the price the bank could fetch for them right now.
The rapid pace at which the Federal Reserve has been raising interest rates has negatively impacted the market value of securities mercilessly, but these AFS securities are bringing down bank equity as well ...on paper.
Even though it is just a paper loss, if for whatever reason, the bank found it really did have to sell the securities, the paper loss could materialize into a “real” loss.
Conversely, had the bank reported the securities as “held-to-maturity” (HTM) instead of AFS, accounting rules would keep the whole mess away from the net worth equation. That’s why we say, timing is everything. And, that’s why Bauer monitors bank financials for you.
These paper losses notwithstanding, the banking industry is still in very good shape and if any issues do arise from AFS securities, you can rest assured that Bauer is out in front of it.