U.S. banks, who had little choice in recent years but to use deposits to buy super safe mortgage bonds, are now getting an unpleasant taste of the risks.
On Wednesday, Tulsa, Oklahoma-based BOK Financial (BOKF.O), which had nearly a third of its $27.5 billion in assets invested in mortgage bonds earlier this year, saw paper profits from the portfolio drop.
It said net unrealized gains on agency mortgage bonds fell 66 percent to $70 million in the second quarter compared to the previous three month period. A BOK spokeswoman wasn't immediately available to comment further.
BOK is just the latest bank to be hit by losses after the U.S. Federal Reserve set off a sharp bond market selloff in May and June when it indicated it might taper its massive bond buying program, known as quantitative easing.
U.S. banks currently have $1.2 trillion of agency securities investments that are tallied as gains or losses. Banks' bets on bonds, including pools of loans that carry the backing of government-sponsored finance agencies such as Fannie Mae, have resulted in sharp swings and net unrealized losses.
For the week ending July 10, for example, net losses totaled $7.5 billion. A slight rebound decreased that loss to $3.3 billion as of July 17. In total, bank portfolios have lost more than $36 billion of their value since the end of the first quarter, according to Fed data.
The losses highlight the challenges banks have faced in a low interest-rate environment and a weak U.S. economy. They increased holdings of agency mortgages over the past two years as they struggled to profitably put their flood of deposits to work amid a dearth of loan demand.
Agency securities appeared to be a safe alternative at the time. But as fixed-income markets weakened in the second quarter, mortgage bonds lost value and many of the unrealized gains banks previously generated from the securities evaporated or turned into unrealized losses.
"You've been in an environment where you've got massive inflows on the deposit side, and you've got nothing to do with it on the asset side," said John Moran, a bank analyst at Macquarie Capital in New York.
Because of accounting rules, losses on mortgage bonds that banks hold in their securities portfolios do not affect their quarterly profits but do subtract from their net worth and shareholder equity.
Over time, most bank stock prices are more correlated with the institution's net worth than with its earnings.
The paper losses deserve close attention "even if some managements and investors wish to sweep it under the carpet," said Chris Marinac, managing principal and director of research at FIG Partners LLC in Atlanta.
Swings in bond prices could continue and with that the uncertainty around banks' balance sheets. The Fed said on Wednesday that it will continue to buy bonds for now. The central bank is currently buying about $40 billion of agency securities a month.
The banks' bets on bonds have also paid off over the past few years, as the Fed's demand for securities drove up prices.
The losses could also have been worse. Banks steadily increased their agency securities investments from $1.09 trillion in the first quarter of 2011 to $1.3 trillion in the first quarter of last year. But then they curtailed investments beginning in 2012, according to SNL Financial.
The speed of the selloff and swings in bond prices in the second quarter, however, caught many banks by surprise.
Since May 1, the price of a 30-year Fannie Mae bond that pays a 3.5 percent coupon has fallen 5.3 percent to 100.9 cents on the dollar from 106.6. Prices fall when yields rise.
In mid-July, Bank of America Corp (BAC.N) became one of the first banks to report second-quarter losses on its agency mortgage portfolio due to the rise in yields. The second-largest U.S. bank by assets reported $5.7 billion in paper losses tied to the bank's holdings of the securities.
In a swing that reflects the turmoil in the market, the Charlotte, North Carolina bank in the first quarter reported a net unrealized gain of $3.4 billion on the securities. That holding swung to a net unrealized loss of $2.3 billion by the second quarter.
"The selloff was not unexpected but it definitely happened over a much shorter time frame than expected," said Sandipan Deb, an agency mortgage securities strategist at Barclays Plc in New York.
The situation may have been made worse because of the concentration of banks' holdings in agency bonds.
Historically, a one percentage point increase in yields would result in a $16.7 billion unrealized loss in large U.S. banks' investment portfolios, Nomura Securities wrote in a recent note.
But in this case, an increase that was half as large - yields on Fannie Mae securities with a 4 percent coupon rose half a percentage point from June 7 to July 19 - seem to have triggered a $30 billion hit to these portfolios over that time frame.
That suggests that banks' crowding into mortgage bonds has amplified the paper losses across the industry, Nomura added.
The sudden surge in yields were "a much needed wake-up call" for institutions that haven't paid attention to the impact that rising rates could have, said Jeff Caughron, associate partner at the Baker Group, an Oklahoma City, Oklahoma, firm that advises community banks on how to handle interest-rate risk.
(Editing by Paritosh Bansal and Miral Fahmy)