Losses on Swaps Threaten to Swamp Bank of America's Balance Sheet

The big bank could be vulnerable if volatility continues.
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Bank of America (BAC) - Get Report is showing large paper losses in its bond and derivatives portfolios that could end up hurting earnings at the nation's second-largest bank, according to one banking analyst.

Due to rising interest rates, Bank of America had an unrealized $2.4 billion loss at the end of June on $76 billion of securities classified as "available for sale," which are bonds and equities that are not held for trading purposes or long-term investment. That's a steep decline from a $400 million unrealized gain on available-for-sale securities at the end of last year, according to the bank.

Losses or gains on available-for-sale securities are not included in banks' income statements and thus do not effect profits, according to banking regulations. They only have an impact on earnings when the securities are sold or reach maturity.

However, if the size of paper losses increase to a level that creates nervousness in the market, banks have been known to book the loss, even though it hurts profits, just to clear the air.

Bank One

(ONE) - Get Report

did this in 1994, after rising interest rates clobbered the bank's securities portfolio.

"I expect them to realize the losses in the fourth quarter," says Charles Peabody, analyst at

Mitchell Securities

in New York, which has no underwriting relationship with Bank of America.

Also at the end of June, Bank of America's swaps portfolio was showing an unrealized loss of $811 million, down sharply from an unrealized gain of $942 million at the end of 1998, according to the bank. (Swaps usually take the form of an agreement between two counter-parties to exchange a fixed-interest payment for a floating-rate one.)

"Generally, these are never realized," says a Bank of America spokesman, referring to the unrealized losses registered by the securities and swaps. Because the securities and swaps are being used to hedge other parts of the bank's business, the losses are, to a large extent, offset by gains elsewhere, he adds.

For example, there was a $240 million unrealized loss at the end of June on the swaps used to hedge both the prepayment risk on mortgages and the value of mortgage servicing rights (essentially the present value of future mortgage payments). And that $240 million shortfall was dwarfed by the $1.16 billion increase in the value of mortgage servicing rights since the beginning of the year, according to the bank's second-quarter 10-Q filing with the

Securities and Exchange Commission

released earlier this week.

That is the only offsetting gain that Bank of America chose to specify.

On the subject of the remaining $571 million of swaps losses and the $2.4 billion of securities losses, the spokesman says that they have probably been balanced by a rise in the value of the bank's loans, resulting from the higher interest rates. "The offset is the value of the loan portfolio, which has probably increased," he says.

Peabody says he thinks the losses in the available-for-sale securities account are rising at a pace that suggests Bank of America is holding securities that are considerably more volatile than government bonds, which usually make up the vast majority of a commercial bank's securities portfolio.

Peabody calculates that the available-for-sale portfolio showed a $1.08 billion unrealized loss in the first quarter of this year, followed by an unrealized $1.63 billion shortfall in the second quarter. He says that these declines are suspiciously steep in comparison with the drops that took place in the Treasury market in the same periods.

"I don't think this company is being entirely honest in characterizing the nature of this bond portfolio as plain vanilla. It looks more like nuclear waste," says Peabody.

Bank of America said its debt securities had a duration (which measures sensitivity to interest-rate movements) of just over four years at the end of June. A bond index with a similar duration -- the

Merrill Lynch Treasuries/Agencies 5 to 7 Year Index

-- registered a negative total return of 2.09% in the first half of this year.

Bank of America's financial statements do not provide enough information to enable the calculation of the total return on the bank's available-for-sale bonds over the same period as the Merrill index.

The Bank of America spokesman says that the bond portfolio does not contain instruments that could be considered dangerously volatile.

In comparison with competitor banks, Bank of America's losses look large.

Chase

(CMB)

, for example, showed an unrealized loss of $1.3 billion on its available-for-sale securities, against an unrealized gain of $600 million at year-end 1998.

Certain investors are keeping a close eye on the unrealized losses, but are not prepared to make a negative judgment at this stage. "These losses are something to watch. But they did address this in a recent conference call," says Lisa Welch, an analyst for the

John Hancock

financial funds, which own Bank of America.

Bank of America may choose to realize the losses, but much depends on the strength of the bank's other businesses over the coming quarters and whether it believes the market would react badly to such a move, says Adam Levy, a financial services analyst for

Invesco

funds, which do not hold Bank of America.

Peabody warns that the losses could even limit the impact of Bank of America's plan to buy back a hefty 130 million shares, worth $8.3 billion at Friday's share price of 64 5/8, over the next two years. This is because the unrealized losses have to be factored into capital calculations. If the losses grow further, the bank may have to reduce the size of stock repurchases in order to maintain legal capital levels.