U.S. banks seen taking capital hit from bond market selloff

Wed Jul 3, 2013 11:04am EDT

(Reuters) - The selloff in the bond market over the past eight weeks is likely to have caused a multi-billion-dollar dent in the capital levels of some of the biggest U.S. banks, including Wells Fargo & Co (WFC.N) and JPMorgan Chase & Co (JPM.N), analysts said.

Indeed, the portfolios of securities that the banks invest in, known as "available for sale" books, may be the worst affected, they said. These assets can be sold before they mature, unlike many loans, but are not used for short-term trading purposes.

As they report results later this month, individual banks will disclose just how much of a hit they took in the second quarter.

When asset prices in these portfolios drop, banks' earnings are not affected, but under a new global regulatory framework known as Basel III, capital levels are, the analysts said.

Still, the capital drag is not likely to be severe enough to force banks to issue more equity, said Marty Mosby, an analyst at investment bank Guggenheim Securities.

While the hits to capital are immediate, over time, rising bond yields will help lift bank income by boosting what they earn on new investments.

If longer-term yields keep rising, banks could face real headwinds in augmenting their capital under new rules.

Wells Fargo and Bank of America currently exceed the proposed new capital levels, but Citigroup and JPMorgan fall short on the requirements for the biggest banks, according to a June 25 research report from Morgan Stanley.

Sluggish global economic growth has made it a challenge for many banks to build capital by boosting their earnings, and many have, instead, opted to shrink their assets.

The capital losses by banks could run into billions of dollars, analysts said, and are already evident in weekly Federal Reserve reports on bank balance sheets.

The net unrealized gains on available-for-sale securities, the reports show, have more than halved since bond yields began rising just a few weeks ago, falling to $14.8 billion in the week ended June 19, from $32.3 billion in May. The 10-year Treasury yield stood at 2.45 percent on Wednesday, up from 1.62 percent on May 3.

The markdowns that banks record could be particularly painful because of the way the bond market sold off. Longer-term yields, for example on 10-year Treasury bonds, rose by more than 0.6 of a percentage point, which is expected to cut into the market value of most bonds.

In comparison, shorter-term rates barely budged. Most of a bank's floating-rate assets, such as loans to companies, are tied to short-term rates, which remain at low levels. So banks will not get much more interest income from existing loans.

In early June, before it was clear where the 10-year yield would settle, analysts at investment bank Guggenheim Securities looked at how banks' available-for-sale portfolios would be affected if longer-term bond yields rose by 1 percentage point while short-term rates stayed stable. They found JPMorgan's would face a pre-tax markdown of $10.1 billion, with pre-tax markdowns of $8.3 billion at Wells Fargo, $9.9 billion at Bank of America Corp (BAC.N) and $7.8 billion at Citigroup Inc (C.N).

Those drops could be enough to wipe out much of the gains some banks have made recently in the securities.

Wells Fargo's net unrealized gains in the first quarter were nearly $7 billion, equal to 6 percent of its tangible common equity, and JPMorgan's were $6.2 billion, equal to 4.2 percent of its tangible common equity.

The treatment of unrealized gains on banks' securities portfolios was incorporated into Basel III standards in order to better reflect institutions' actual ability to absorb losses. The Federal Reserve voted to adopt global Basel III capital rules on Tuesday for U.S. banks.

To be sure, rising bond yields will also bring some benefits to banks' securities portfolios.

Banks will be able to buy bonds at higher yields, which will eventually earn them more interest income. At an investor conference on June 5, Tim Sloan, Wells Fargo's chief financial officer, said the increase in bond yields made it attractive to add securities to its investment portfolios at a quicker pace.

But these benefits will take time to offset capital hits. For instance, it would take two-and-a-half to three years for Bank of America to earn enough net interest income to offset the fall in its capital from a percentage point increase in short-term and long-term interest rates, the bank's chief financial officer, Bruce Thompson, told investors at a June 11 conference.

For now, bank investors seem to be focusing more on the positives, and shrugging off the impact of higher long-term yields on capital.

Shares of JPMorgan and Wells Fargo are up around 10 percent and 9 percent, respectively, since May 3.

"Right now, most investors are in the growth camp and believe economic growth will follow the higher rates. If it doesn't, most banks will give up these gains," said Paul Miller, analyst at investment bank FBR.

(Editing by Alden Bentley and Bernadette Baum)

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