US banks surrender profit for capital relief

 
NEW YORK — US banks are increasingly giving up the right to sell tens of billions of securities in their investment portfolios, a shift that helps them avoid the pain of weaker bond markets but will cut into future profits as interest rates rise.
 
Lenders ranging from large banks like US Bancorp to smaller banks like Cullen/Frost Bankers Inc. have been changing the way they account for investment securities, adopting a treatment that essentially forces them to hold onto bonds through thick and thin, instead of being able to sell them when markets tank. The accounting switch gives them near-term relief that helps them meet new capital and liquidity rules. 

The accounting shift is known as moving assets from “available-for-sale” treatment to “held-to-maturity,” a change that has been underway for several years.

US commercial banks’ held-to-maturity books increased 62% to $347.4 billion in the second quarter from $215 billion in the fourth quarter of 2010, according to SNL Financial. 

As bond markets weakened in the second quarter, the switch accelerated, with held-to-maturity accounts rising 8.7% from the first quarter. It was the biggest increase in nearly two years. 

One of the first big banks to make the shift was US Bancorp of Minneapolis, Minnesota, the sixth-largest US bank, with $353.4 billion in assets. The bank is a favorite of Warren Buffett, whose Berkshire Hathaway Inc. is one of its biggest shareholders. 

US Bancorp’s held-to-maturity securities book ballooned to $34.7 billion in the second quarter, or 46% of its investment portfolio, from just $1.5 billion at the end of 2010, with most of the change coming in 2011. 

But the bank is now saddled with tens of billions of dollars in low-yielding assets. The weighted average yield on US Bancorp’s held-to-maturity portfolio was 1.89% in the second quarter of 2013, compared with 2.72% for the available-for-sale portfolio.

As rates start to rise, the bank could earn less on some assets than it has to pay to fund itself, cutting into its income. 

To be sure, banks have some ways to mitigate that pain. For example, they can borrow against the held-to-maturity assets and invest the proceeds. And many bank loans carry floating rates, so rising rates will boost interest income.

But banks that go too far with a held-to-maturity strategy will not be able to free up as much of their balance sheet to make new loans if the economy improve in the coming months, said Johannes Palsson, managing director at Angel Oak Advisory, a risk management consulting firm. 

Those banks are “kind of stuck. There’s not much you can do” to take advantage of future loan growth, Mr. Palsson said. 

For available-for-sale assets, banks must record paper losses each quarter when the securities’ values fall. The paper losses do not hit earnings but reduce net worth, as measured by the book value of assets minus liabilities.

That happened to banks in the second quarter, when bond markets weakened amid talk of the US Federal Reserve cutting back on its bond buying program.

The $38 billion of unrealized investment gains they had reported at the start of the year swung to $13.1 billion of paper losses by the end of August, according to Fed data.

For a long time, regulators ignored changes in the value of available-for-sale books when assessing a bank’s capital strength.

But under the international framework known as Basel III, losses from available-for-sale assets will hit regulatory capital, and a bond market selloff could force US banks to boost their capital levels. 

Paper losses on held-to-maturity securities, however, would not subtract from banks’ capital levels.

This, along with new liquidity rules that pressured banks to increase their securities holdings, encouraged banks to park assets in their held-to-maturity bucket of their investment portfolios. — Reuters