Bank of America's Latent Bond Losses Swell as Interest Rates Rise
Inside Bank of America.

They are the losses that no bank CEO likes to talk about.

Wells Fargo & Co. (WFC) , Bank of America Corp. (BAC) and Citigroup Inc. (C) have quietly racked up billions of dollars of losses that, under the vagaries of U.S. accounting rules, they've been able to avoid recognizing in quarterly earnings reports. Citigroup is a holding in Action Alerts PLUS.

The losses are due to rising U.S. interest rates, which has eroded the value of hundreds of billions of dollars of Treasury bonds, mortgage-backed securities and other assets that banks hold as investments, alongside their portfolios of loans. It's the basic tenet of bond math: When yields go up, prices go down.

Accounting rules allow banks to avoid recognizing the losses through net income, helping executives report higher headline profits on a quarterly basis. But the losses have to be deducted from capital -- the extra money that regulators require banks to keep on hand to withstand a big economic downturn. Capital is also used to support new loans or make payouts to shareholders in the form of dividends or stock buybacks.

The bond losses show how rising interest rates, which many investors speculated would lead to fat profits for big banks, can be a double-edged sword. The biggest U.S. firms hold hundreds of billions of dollars of the securities, which could be prone to even bigger losses as the Federal Reserve pushes rates higher amid an accelerating economy.

"If you take a cold, hard look at it, the rise in interest rates has caused them massive problems," said Richard Bove, a money manager at Garden City, New York-based Hilton Capital Management.

It's a new phenomenon, since banks weren't required to deduct the securities losses from capital until earlier this decade, when regulators imposed new rules in the wake of the 2008 financial crisis. The losses are recorded in an account known as "other comprehensive income," or OCI, and they accumulate until the bank disposes of the securities, effectively realizing the erosion in their market value, or until their maturity date. 

Details on the securities losses are buried deep in the press releases that banks issue each quarter on their financial results. Bank of America, based in Charlotte, North Carolina, recorded about $4 billion of losses in OCI during the first quarter. Had the losses been recorded in net income, its reported profit of $6.49 billion would have been almost two-thirds lower.

"The reduction you're seeing is just a function of long-term rates going up," Bank of America CFO Paul Donofrio said on a conference call with investors earlier this month. "It's just an accounting construct that all banks have to deal with."

A Bank of America spokesman declined to comment further.  

San Francisco-based Wells Fargo reported a $2.66 billion loss in its OCI account, while New York-based Citigroup recorded $1.9 billion of losses on investment securities. New York-based JPMorgan Chase & Co. (JPM) , the biggest U.S. bank, said its accumulated OCI increased by $944 million from the prior quarter. JPMorgan is a holding in Action Alerts PLUS.

With unemployment at a 17-year low and inflation rising, most economists expect the Fed to continue raising interest rates for the foreseeable future -- implying losses on the securities could swell. That leaves the banks with two options, neither of them good.

They can hold the securities until maturity, at which point they would get their investments back, and the losses would be reversed. But doing so would delay their ability to reinvest the money in new securities priced at higher yields.

Or they could sell the securities, swallow the losses, and immediately begin collecting higher yields on new securities.

Marty Mosby, a former bank CFO who now works as an analyst at the brokerage firm Vining Sparks in Memphis, Tennessee, thinks they should choose the latter option.

"You will get the benefit of having the higher-yielding security on the books," Mosby said. "You literally have already taken it out of your capital, so there's no additional impact on your capital. So now you would just get credit in your earnings going forward."

There are a few reasons banks might resist such a move. There are probably costs associated with sorting through the hundreds of billions of securities on banks' books and then trading out of them, Mosby said. Then there would be costs to locate new bonds to buy.

Another possibility is that banks are so eager to show higher profits as rates rise that they're reluctant to highlight the securities losses by recognizing them in closely-scrutinized earnings-per-share headlines.

Or maybe they just haven't really thought about it.

"We haven't had rates move higher meaningfully since we've had these new rules, and it's really not something they've thought about in the past, or thought about in this way," Mosby said.

David Hendler, a bank analyst at Viola Risk Advisors in Montebello, New York, said banks should be able to recoup the losses on the securities through new loans, made at higher interest rates.

But the losses serve as a reminder that it's "not going to be easy and pain-free" for banks as the Fed reverses its post-crisis policies of keeping rates at historically low levels, Hendler said.

"They don't want to disappoint the stock analysts," Hendler said. "The analysts are always looking for progressive earnings-per-share growth, and they're not as concerned with the balance sheet."

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