Silicon Valley Bank was not the only institution that loaded up on bonds at precisely the wrong time.
Dozens of other banks — most of them quite small — are deeply underwater on their bond investments and could hit trouble if they were unexpectedly forced to liquidate the investments. That's according to an American Banker analysis of regulatory filings by the country's more than 4,700 banks.
Many experts say there is very little risk that those unrealized losses could ever turn into a problem, given the many options available to banks and regulators' focus on avoiding that type of scenario. The losses, a result of banks' bonds losing their value when interest rates rose, remain "unrealized" and only theoretical. They would only cause trouble if a bank needed cash and was forced to sell the bonds early for less than it bought them, thus making the losses real.
Several bankers contacted for this story pushed back on any concern that they'd ever need to get rid of the bonds to raise cash. Those bankers said they have plenty of cash available, and that if they ever need more, they could easily borrow from the Federal Reserve and elsewhere. The Fed launched a new program this month
The banks in question — many of them tiny, with just a few branches — are also wildly different from Silicon Valley Bank, whose rapid failure this month has prompted jitters over whether other banks could be next. Silicon Valley Bank sat on a uniquely explosive powder keg, namely a massive amount of deposits from tech companies and their investors, the vast majority of which surpassed the federal insurance limit of $250,000. With most of their money uninsured, depositors got spooked and pulled out their cash at the first sign of trouble.
In contrast, most community bank deposits are under $250,000 and therefore insured, guaranteeing the safety of those customers' money and encouraging them to keep it at their existing bank. Bankers say their local customers' trust in them is deep-rooted.
Still, the review of call report data reveals how some banks appear to have misplanned for a scenario in which interest rates rose sharply. They effectively took the same position as Silicon Valley Bank, where executives thought interest rates would stay ultralow for years after the pandemic and were caught by surprise when the Fed raised rates aggressively.
"It was risk management 101," said Cliff Rossi, a University of Maryland professor and former chief risk officer of Citigroup's consumer lending division. "They need to be all over that."
The risk buildup happened under regulators' watch, raising questions about whether the government should toughen its monitoring of banks' interest rate vulnerabilities. American Banker's analysis shows that unrealized bond losses, if they ever became real, would either wipe out or come dangerously close to eliminating the capital of roughly 90 banks. Collectively, those institutions represent just under 2% of the country's banks.
Across the entire industry, unrealized losses on bond portfolios totaled some $620 billion at the end of last year, according to the Federal Deposit Insurance Corp. In addition to the roughly 90 banks that American Banker identified, the analysis found that more than 200 other banks would see their capital drop to somewhat concerning levels in a scenario where they were forced to sell their underwater bonds. The vast majority of the industry would see far more modest or tiny losses.
The FDIC, whose chairman has warned about unrealized bond losses across the industry
Bank lobbying groups, as well as several of the banks in question, said American Banker's analysis is incomplete and paints an inaccurate picture of those banks' health.
The Independent Community Bankers of America, which represents small banks across the country, said in a statement that it "stands behind the nation's community banks and denounces any attempts to categorize them in the same manner as the large, risky financial institutions that have made headlines recently."
"Any attempt to characterize any community bank as unsafe, unsound or a threat to any depositor based purely on a hypothetical set of facts that don't exist in reality and with a newly contrived financial ratio not consistent with existing regulatory calculations is egregiously misleading," the group said.
Hugh Carney, a top executive at the American Bankers Association, said a single metric such as unrealized bond losses "does not accurately capture the risks or health of an individual bank."
"It would be irresponsible to draw conclusions from data that don't tell a full and complete story of bank health," Carney, the group's senior vice president of prudential regulation, said in an emailed statement.
Rossi, the University of Maryland professor and former banker, agreed that looking at one metric never tells the full story. But he said it's an "irrefutable fact" that a decent number of banks took on far more interest rate risk than they should have.
'Boggles the mind'
Bert Ely, a bank consultant, said it "boggles the mind" that banks took on the same type of interest rate risk that brought down hundreds of savings and loan companies starting in the 1980s. Ely, who predicted what became the S&L crisis, said American Banker's analysis shows a need for regulators to take a stricter approach on the issue.
"It just absolutely astounds me that they can be in compliance with the regulations" but take on such large interest rate risks, Ely said.
The analysis does not include the impact of taxes, nor of any hedging instruments that banks may or may not buy to protect themselves in case interest rates turn against them. It also does not account for any additional income that banks are collecting as a result of floating-rate loans resetting to higher rates. The analysis is far less detailed than those regulators undertake, since they have more granular information on individual bonds and also take into account how loans and deposits factor into any interest rate risk equations.
And the analysis is based on year-end data, the latest available, meaning the benefit that banks have gotten from this year's decrease in long-term rates is not reflected. It's also the case that if interest rates fall sharply again, today's unrealized bond losses could evaporate or turn into unrealized gains.
The analysis "appears to completely ignore the realities of the current bank regulatory capital framework for community banks," Philip K. Smith, a lawyer for ICBA, wrote in a letter to American Banker.
When regulators evaluate a bank's capital standing, the key metrics they consider generally do not include the impact of unrealized bond losses. Supporters of that approach argue that it helps limit the type of volatility in banks' capital levels that would otherwise occur if quarter-by-quarter swings in bond markets were included. Others say it shields banks from having to fully grapple with the impacts that interest rates have on their assets.
In one of their capital measures, which compares banks' tangible equity with their assets, regulators use a 2% threshold to determine whether a bank is "critically undercapitalized." Banks that are at or below that mark undergo what's essentially the strictest form of regulatory probation.
American Banker used the same threshold for its analysis, except it included the impact of unrealized losses in the unlikely case that they did occur. Unrealized losses on bonds that banks classify as "available for sale" are already factored into the capital on banks' balance sheets. Bonds that banks label as "held to maturity" are not, so American Banker analyzed what their capital would look like if their plans to hold the bonds didn't pan out and they needed to sell them.
The analysis showed roughly 90 banks would fall under the 2% threshold of capital health, with some of them having negative equity. For simplicity, American Banker used banks' total equity instead of tangible equity, which excludes intangible assets such as the value of "goodwill" tied to bank acquisitions.
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The researchers, whose analysis included banks' real estate loans, found that banks' assets would be $2 trillion lower than their balance sheets currently suggest. The co-authors are from Northwestern University, the University of Southern California, Columbia University and Stanford University.
Last year, the Federal Housing Finance Agency used a similar but looser approach to the measure used in American Banker's analysis. At the time, a handful of banks' unrealized losses had resulted in negative tangible capital, effectively blocking them from borrowing from a key quasi-government funding source, the Federal Home Loan Bank System. ICBA
An FHFA spokesperson said the agency did not change its policies on the issue, which prohibits banks with negative tangible capital from borrowing from the Home Loan banks. One banker contacted for this story said he's still blocked from tapping that borrowing source, though he noted that his bank has plenty of cash and that the Fed is available for borrowing if needed.
'Where they couldn't make loans … they bought bonds'
In normal times, the bonds at issue are extremely safe and even boring. There is little risk that they won't be paid back, unlike the toxic financial instruments based on shoddy mortgages that blew up the financial system in 2008.
The risks for those bonds show up when interest rates rise quickly. That happened last year as the Fed battled decades-high inflation by jacking up the cost of borrowing, which slows economic growth.
Bond investors suffer when interest rates go up, because the value of the existing bonds they hold falls. If, for example, a bank bought a fixed-rate bond that periodically pays a 2% interest rate, that rate stays the same for the entire contract, which varies in length depending on the bond. After rates rise, banks can sell that 2% bond to someone else, but since that buyer could now buy a similar bond that pays 4%, the older, lower-paying bond becomes less valuable. To find a willing buyer, the seller would have to accept a lower price.
At the time the banks bought many of these bonds — after the pandemic hit but before the Fed's rate hikes started in March 2022 — banks were struggling to make loans and were looking for extra income. Buying safe bonds that offered a small but reliable 2% or so yield was an attractive alternative.
"Where they couldn't make loans because of the lockdowns, they bought bonds," said John Toohig, head of whole loan trading at Raymond James.
Banks had a tough time making loans because relatively few businesses or consumers needed them for much of the pandemic. Many bank customers were flush with cash, thanks in part to the money that the federal government and Fed pumped into the economy to avert a lengthy recession. Customers parked that cash at their bank, along with any savings that many accumulated from staying at home, leading to a spike in bank deposits.
In short, banks had too many deposits and too few loans, and bonds gave them some extra income.
The strategy backfired once inflation proved to be hotter than many expected, prompting the Fed to ditch its forecast that inflation would be "transitory." The central bank has since raised interest rates at its fastest pace in decades, hiking rates from effectively 0% to nearly 5% in just one year.
Even if they were caught off guard, there is "zero excuse" for banks to have failed to adequately gauge their exposure to a drastic interest rate shock, said Mayra Rodríguez Valladares, a bank consultant and managing principal of MRV Associates.
"You can blame the Fed all you want, you can blame the European Central Bank, the other central banks around the world that have been raising rates," Rodríguez Valladares said. "At the end of the day, it's the responsibility of banks to be managing their interest rate risks."
'It's business as usual'
Bankers contacted for this story, who are all among the dozens with the biggest potential hits to their equity, said they are on sound financial footing and that the vast majority of their deposits are FDIC-insured. They said they have ample cash to meet depositor needs, an ability to borrow if needed and periodic interest payments coming in from the bonds they bought and loans they made.
Many small banks pushed back against the outsize focus over the past two weeks on banks' unrealized bond losses, which have rocked the stock prices of several of their larger peers as investors look for institutions with Silicon Valley Bank-like vulnerabilities.
"The more these geniuses on TV harp about it, the more people are going to say: 'Well, what am I missing?'" said Patrick Reilly, president and CEO of Mauch Chunk Trust Company, a $610 million-asset bank in Jim Thorpe, Pennsylvania.
"Our liquidity is very strong," he added. "It's business as usual with us. And the issue of unrealized losses, I think, is being overdone."
Jack Hopkins, the president of the $358-million-asset Community Bank of Raymore in Missouri, said accounting rules are causing a "distortion" in his bank's value.
Most of the bank's assets are bonds, which are easy to sell since investors buy and sell them every day. Since their prices are easy to discern, accounting rules require banks to disclose the historical and current value of their bonds. But loans generally don't face the same treatment. They also involve more repayment risk than bonds and aren't as easy to sell, which means a forced sale may come at a steep discount.
"Our bank may be a whole lot safer than a bank" whose assets are mostly in loans, Hopkins said. "Their loan portfolio is not as liquid and … they'd have larger losses than we might."
First State Bank of Randolph County, based in Cuthbert, Georgia, is another bank that has more bonds on its balance sheet than loans. The rural county of less than 7,000 people has lower loan demand than other more populated areas, said CEO Scott Curry.
Rather than go out of its way to take on risky loans, the $90 million-asset bank prefers buying highly rated bonds that pay less. That strategy, Curry said, paid off during the 2008 crash as its bond investments held up, while other banks got in trouble for buying chunks of loans in markets they didn't understand.
Curry, a fifth-generation banker, said the unrealized losses will work themselves out over time and that the bank has always ensured its liquidity is strong.
"Even in the worst-case scenario, we would never be at the point of having to sell any securities at a loss," Curry said. "We've never done that, and our bank's 123 years old."
'We don't intend to sell our bonds'
Industry Bancshares, a $5 billion-asset company in Texas that had multiple subsidiaries show up in American Banker's analysis, said in a statement that the six banks it runs "have capital levels that significantly exceed the required regulatory levels, are financially strong and well positioned in the current environment to continue to serve our customers." The bank said it has strong liquidity levels on its balance sheet, and it boosted its position further in the last two weeks due to the uncertainty facing the industry.
Meanwhile, a spokesman for the $6 billion-asset Republic First Bank in Philadelphia said the bank continues "to prudently manage our risk profile to ensure ample liquidity and the security of customers' assets."
The only two big banks with similarly large exposures are the bank operations of Charles Schwab, a trading platform whose stock has fallen due to some investors' worries over its unrealized losses; and USAA Federal Savings Bank, an $111 billion-asset bank focused on military members and veterans that is not publicly traded.
In a statement, a Schwab spokesperson said its approach to managing its assets is "quite different than traditional banks." The company said it makes far fewer loans than other banks and invests in high-quality and liquid securities.
When the bonds mature, they will return to their original value and any past unrealized losses will never occur, the spokesperson noted. There is also "very little chance that we'd need to sell them" prematurely given the bank's wide access to other liquidity sources.
The bank also noted that looking only at unrealized bond losses does not factor in any potential losses in other loan-focused bank portfolios. "The analysis penalizes firms like Schwab that in fact have a higher quality, more liquid, and more transparent balance sheet," the company said.
USAA, meanwhile, said it is "a fundamentally different bank than those that have struggled over the past few weeks." The consumer-based bank said 93% of its deposits are FDIC-insured, and that since it has a relatively lower share of loans, bonds make up a larger part of its portfolio, so "investment fluctuations are more noticeable."
"Not all banks and not all investment portfolios are the same," the company said. "Unrealized bond losses do not create excess risk in institutions with a stable base of customers, a strong capital position, the ability to hold such bonds to maturity and access to the liquidity necessary to meet their depositors' and borrowers' needs."
At Spur Security Bank in Texas, CEO Kevin Bass said the $69 million-asset bank has "substantial liquidity" to cover its depositors' needs and can borrow from other sources if it needs to.
"We don't intend to sell our bonds, nor do we have to," Bass said.
Many of the bank's bonds, he added, were bought by the bank's previous owners before March 2021. "Rates moved against us so quickly and so fast that we got upside down," he said.
He also said his bank is nothing like Silicon Valley Bank, whose large pool of uninsured depositors played a key role in its downfall. The community bank's deposits are about as normal as they can be, he said, noting that the bank doesn't even tap the brokered deposit market where banks can buy deposits if they need them.
"I don't have any brokered deposits. It's all organic. It's all people in my community," Bass said. "So my deposits aren't exotic or anything."
Reilly, the CEO of Pennsylvania-based Mauch Chunk Trust Company, said that his bank also has a strong, stable deposit base.
But he acknowledged that he'd "love a do-over" on the bond purchases. In reviews of the bank's risk management, the FDIC and Pennsylvania banking regulators "took us to task" for its interest rate risk, he added.
"They've been ahead of this situation, as far as I'm concerned — with us anyway," Reilly said. "As a result of their comments, we've substantially stepped up our game, and we did that almost a year ago."
The bank wasn't previously hedging its bond portfolio, which would have protected it from changes in interest rates. Now it is, but Reilly said it's avoiding overdoing it because "when rates come down, the hedging will work to our detriment."
Asked to reflect on the bank's bond purchases, Reilly said they were made at a time when the bank "couldn't make loans as fast as we were taking in deposits." He noted interest rates were at rock bottom — much like they were for the aftermath of the 2008 financial crisis — and the Fed seemed in little hurry to raise rates, predicting that inflation would be "transitory."
"You make a decision with the facts that you have, and in hindsight, it turns out to be a bad decision or a bad choice," Reilly said. "You didn't set out to take excessive risk, but that ends up being where you are."
