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Rising Rates Gnawing at Banks' Loan Books

As the Fed toughens its interest-rate policy, banks' balance sheets are coming under a lot more strain than the markets may realize, according to a research firm that focuses on financial institutions.

It's well known that higher interest rates have eaten deep paper losses in securities portfolios at several large financial institutions, including Washington Mutual (WM), Bank of America (BAC) and Golden State Bancorp (GSB).

But, contrary to common wisdom, these losses aren't being offset by reported gains elsewhere on the institutions' balance sheets, says SNL Securities, based in Charlottesville, Va. SNL arrived at this conclusion after assembling data from a number of thrifts' 1999 annual reports, published over the past couple of months. Under SNL's methodology, Bank of America also shows a significant overall shortfall.

The failure to achieve offsetting gains raises a number of questions for investors. It suggests that the banks are struggling to manage interest-rate risk in their balance sheets, which will become more of an issue if the Fed continues to raise interest rates. In addition, banks' equity is reduced by these paper, or unrealized, securities losses. This hurts particularly the thrifts, because investors are more likely to apply book value-based valuations to this sector. And observers predict that some banks will choose to sell the underwater securities, producing losses that have to be subtracted from earnings.

The financial institutions that commented for this article said that the losses are nothing to worry about and insisted that data included in annual reports, as well as SNL's methodology, give too narrow a picture of their balance sheets.

Startling Realization

This issue centers on losses in banks' portfolios of so-called available-for-sale, or AFS, securities. At many thrifts, these securities, almost always bonds, are bought with borrowed money to help boost growth -- a strategy called leverage. The bonds are a source of interest income and -- when above water -- they can be sold to obtain capital gains that boost earnings. They are also placed on the balance sheet to help protect banks against interest swings.

As interest rates have risen, many of these bonds are showing paper, or unrealized losses, which are reported and deducted from equity each quarter. The AFS losses aren't pretty. At the end of 1999, Bank of America had a $3.84 billion shortfall, while Washington Mutual, Astoria Financial (ASFC) and Golden State were showing year-end AFS deficits of $667 million, $344 million and $275 million, respectively.

The Cost of Higher Rates
In millions of dollars, as of year-end 1999
Company AFS loss* Balance-sheet adjustment Loss plus adjustment
Above Water
Chase (CMB:NYSE) (2,495) 2,534 39
Downey (DSL:NYSE) (2) 147 145
Under Water
Bank of America (BAC:NYSE) (3,838) 1,875 (1,963)
Washington Mutual (WM:NYSE) (667) (401) (1,068)
Astoria Financial (ASFC:Nasdaq) (344) (28) (373)
Golden State Bancorp (GSB:NYSE) (275) (66) (209)
People's Bank (PBCT:Nasdaq) (79) (42) (121)
*Loss on available-for-sale securities. Figures in parentheses denote losses. Sources: SNL Securities, FreeEdgar and

For most of last year, the banks said that the AFS declines didn't really matter. They argued that the higher interest rates were boosting other asset values on their balance sheets as well as decreasing liabilities (remember that a falling liability is a positive for a firm).

The impression was given that these shifts would likely produce a gain that exceeded the AFS loss. It was hard to argue with this, since the data needed to test the assertion don't come out regularly; they are only in annual reports.

But SNL examined recent annual report data to see whether compensating gains actually materialized. Often, they didn't. In the case of Washington Mutual and Astoria, SNL shows that there was actually a negative net change in assets and liabilities elsewhere on the balance sheet at year-end -- to the tune of $401 million and $28.5 million, respectively (see table).

Bank of America and Golden State managed to achieve gains -- of $1.88 billion and $65.7 million, respectively -- but neither were enough to make good the AFS loss.

Differing Views

The banks bristle at SNL's approach. Their main beef is that accounting rules don't allow the banks to include a revaluation of their demand, or noninterest-bearing deposits. Higher rates would cause these to be worth more to a bank, since the bank isn't paying interest on them. "The deposits demand a premium that is not recognized in annual report disclosure," says Bill Longbrake, finance chief at Washington Mutual. "You're misusing the accounting rules," says Bob Stickler, a spokesman for Bank of America. Stickler says that if a 10% premium were applied to his bank's $92 billion of deposits, then that $9 billion would easily offset its $2 billion balance-sheet loss.

James Record, head of bank research at SNL, responds that leverage-using thrifts aren't funding their operations primarily with noninterest-bearing deposits. Instead, they use the borrowed funds to buy AFS bonds. Therefore, a bank ideally wants the value of these borrowings to show a decline that offsets the losses on the AFS bonds.

But Washington Mutual's liabilities fell by only $290 million, which is not even half the year-end loss on its AFS securities. That said, Golden State's liabilities did decline by an amount ($645 million) that far exceeded its AFS loss ($245 million).

The AFS loss is already subtracted from equity, but the other balance-sheet movements should also be factored in to get a sharper picture of book value, says Record. If that's done for Washington Mutual, then subtracting the net $401 million adjustment would have made equity around 4.4% lower at year-end -- not an insignificant reduction.

The Good News

Naturally, against a backdrop of rising interest rates, investors will be searching out thrifts that don't have these balance-sheet mismatches. One, says Record, is Downey (DSL). Its AFS loss was a mere $1.6 million at year-end, and that was made up for many times over by a $147 million gain in other balance-sheet components.

Thrifts that have above-water balance sheets "are the ones to buy," says David Harvey, a manager of Everest Partners, a Gardnerville, Nev.-based financial services hedge fund. Harvey expects some thrifts to sell out of these underwater bonds and book a loss against earnings. They'd take this pain so that they could invest in higher-yielding bonds and take the tax benefit. But the market could react badly, nevertheless.

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