Unrealized gains evaporate in Q2

By Nathan Stovall & Salman Aleem Khan, SNL Financial staff writers

The recent and rapid increase in long-term interest rates has caused unrealized gains in banks' investment portfolios to plummet.

The bond market has come under considerable pressure since early May and sold off heavily after the Federal Reserve signaled that tapering of its asset purchases in the market could come around the end of 2013.

The corresponding rise in long-term rates ate through unrealized gains sitting in banks' investment portfolios in the second quarter, as those gains dropped 72.5% from the end of the first quarter, according to the Federal Reserve's latest H.8 report.

Bank advisers believe it is unlikely that banks simply cashed in on gains because institutions have been so reliant on their investment portfolios for income as loan growth has remained challenged. Unrealized gains have dropped drastically from the level reported at the end of January, when the banking industry's gains stood at $40.5 billion, and at $32.5 billion among the nation's top 25 banks.

Since then, and in particular in the month of June, the tide has turned, with unrealized gains for all commercial banks falling to $9.8 billion from $34.4 billion at the end of May. During that period, the yields on the five-year and 10-year Treasury each rose 36 basis points, building on the significant increases already witnessed off the most recent lows in late April. 

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Price of standing still

The substantial decline in unrealized gains has likely come from changes in the value of banks' bond portfolios rather than institutions realizing gains.

"I don't think we're seeing a lot of evidence that there have been a significant amount of gains taken," said F. Greg Hertrich, managing director and head of U.S. depository strategies at Nomura Securities. "I think this moved much more quickly than many banks are usually prepared for, and partially as a result of that, we end up with a scenario where banks sort of realized that these market events were having a greater impact than might have otherwise been anticipated."

Now that banks have fewer gains in their bond portfolio, they have one less bullet in the gun.

"The risk of not having this bullet is probably far greater than the market is anticipating," Hertrich said.

Tangible book value also impacted

Banks will also face hits to tangible book value. While most analysts on the Street agree that the capital impact will be manageable, the hits to tangible book value might impact bank stock valuations, particularly since the bank group has risen more than 20% this year.

Robert W. Baird analyst David George noted in a recent report that most banks will incur a 2% to 3% hit to tangible value, which he believes will offset earnings accretion during the quarter. He said banks with higher concentrations of pass-through MBS such as Regions Financial Corp., Bank of America Corp., PrivateBancorp Inc., and SunTrust Banks Inc. are more exposed to swings in other comprehensive income--or OCI, which captures unrealized gains and losses--due to extension risk.

"While interest rate hedging or outright securities sales may have mitigated the valuation impact from higher rates, we expect most banks to report unfavorable [quarter-over-quarter] swings in OCI accounts," George wrote in a July 8 report. "Given excess capital/liquidity positions and lower reinvestment risk, investors have viewed the net impacts from the steepening yield curve favorably. Sentiment and valuation multiples for regional banks look extended ... and we believe investors will be able to buy these stocks at lower prices as the rising short-term interest rate scenario fails to materialize."

Hits to tangible book and tangible capital could create other challenges for banks. Even though those measures are not regulatory capital ratios, Sandler O'Neill & Partners LP analyst Frank Schiraldi noted in a recent report that regulators do consider them. He said that a reduction in tangible common equity levels could limit a bank's capital return strategies and flexibility when it comes to acquisitions. He also noted that tangible book value remains an important valuation metric to investors.

"If push comes to shove, there are of course many ways that banks can mitigate these issues, including adding hedges in the form of derivatives or by moving balances to held-to-maturity in order to protect tangible book," Schiraldi wrote in a June 26 report.

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What banks have done thus far

Some banks moved securities to the held-to-maturity bucket in past quarters to avoid volatility in interest rates, and others could follow in the coming quarters, given the recent swing in long-term rates.

Since the end of the second quarter, the yield on the five-year Treasury has increased close to 15 basis points, while the yield on the 10-year Treasury has risen roughly 20 basis points. If rates hold or increase further, what unrealized gains banks have left in their bond books just might disappear completely.

"Bank securities portfolios will still be in an aggregate gain position at June 30, 2013," said Fitch Ratings in a July 8 release. "However, as rates inch up higher, these gains will likely ultimately revert to losses."