Banks Lose $17 Billion as Mortgage Market Shifts

Wells Fargo & Co. reported a profit of more than $3 billion in the third quarter, thanks in part to higher interest rates. However, those same rates also reduced the company's capital by nearly three-quarters.

While rising interest rates are good for the country's largest banks in terms of revenue, in the short term they also force the banks to write down the value of assets they hold on their balance sheets. This exacerbates the capital squeeze that's prompted most of the banks to halt share buybacks. For example, at Wells Fargo, an additional $2.4 billion in unrealized losses on mortgage-backed securities and other bonds weighed on shareholder equity in the third quarter.

Wells Fargo's three biggest rivals have all seen similar losses. According to company filings, the four banks have racked up a combined $17 billion in unrealized losses on mortgage-backed securities alone.

In a speech last month, Wells Fargo CEO Charlie Scharf warned that the bank needs to be very careful about managing its capital in light of risks such as fluctuations in the value of its investment portfolio and geopolitical risks. He said that given the current environment, it is more important to be conservative on capital rather than less conservative.

The unrealized losses don't appear on the firms' income statement, but they still affect the banks' balance sheets under accounting rules. This affects something called accumulated other comprehensive income, or AOCI. The four largest banks in the country - JPMorgan Chase & Co., Citigroup Inc., Bank of America Corp. and Wells Fargo - reported a $16 billion drop in AOCI for the third quarter in their company filings. Because AOCI can swing shareholder equity, the drop has weighed on key capital ratios.

This year, many of the biggest US banks saw a surge in AOCI losses.

The writedowns come at a tough time for banks, which are trying to increase their capital levels to meet new, higher regulatory requirements. They’re just one of a number of factors weighing on capital ratios. Others include new accounting rules that say banks must set aside even more in reserves as a result of rising inflation that’s threatening the overall economic outlook. And with markets on edge over the Federal Reserve’s rate hikes, banks have also been battling back an increase in risk-weighted assets, which are used to determine minimum capital levels.

"Banks are generally taking steps to maintain strong financial profiles in spite of a weakening economy, though this is becoming increasingly difficult," said Julie Solar, who tracks North American financial institutions at Fitch Ratings, in an interview. She went on to say that it is likely that "share repurchases will be reduced or suspended altogether as banks work to meet their capital requirements."

Wells Fargo's capital ratios not only exceed regulatory minimums, but they are also higher than the buffers set by the bank's management. However, the company and its rivals are still looking to their portfolios of mortgage-backed securities as they prepare for the shift in interest rates.

Many firms have moved billions of dollars of assets into their so-called held-to-maturity portfolios in order to boost capital. The value of such securities has surged to $802 billion from $495 billion at the start of the pandemic at the country’s four largest banks, according to company filings. For bonds in that pile, the recent softening of the mortgage and broader markets won’t affect capital ratios.

According to Greg Hertrich, head of US depository strategies at Nomura, banks have reacted quickly to the recent market volatility and have been utilizing held-to-maturity securities much more actively. He noted that while the market movement has been swift, banks were prepared for it and have been able to pivot accordingly.

Despite this, the country's four biggest banks are still holding onto $157 billion of mortgage-backed securities that they have marked as being available for sale.

However, the paper losses on these assets have been increasing rapidly in recent quarters, which is hampering efforts to raise capital.

Mortgage-bond losses have increased in available-for-sale portfolios.

Citigroup is hoping to increase its CET1 ratio to 13% by the middle of next year, up from 12.3% in the third quarter. In June, the company transferred $21.5 billion of agency residential mortgage-backed securities to its held-to-maturity portfolio. This has helped cut unrealized losses on such securities by almost half.

At JPMorgan, unrealized losses on mortgage-backed securities in the available-for-sale portfolio reached $7.4 billion in the most recent quarter. That’s after the firm transferred $73.2 billion of investment securities from available-for-sale to held-to-maturity in the second quarter, citing capital management as the reason.JPMorgan's decision to transfer $73.2 billion of investment securities from available-for-sale to held-to-maturity in the second quarter led to $7.4 billion in unrealized losses on mortgage-backed securities in the available-for-sale portfolio in the most recent quarter. The firm cited capital management as the reason for the transfer.

Jamie Dimon, CEO of JP Morgan Chase, prefers to keep investment securities available for sale rather than holding them to maturity. This provides greater flexibility to buy and sell securities when the bank wants to, according to people familiar with his thinking.

In the third quarter, investors got a taste of the potential cost of the preference for long-term assets when JPMorgan reported a $959 million loss from selling some of its available-for-sale US Treasuries and mortgage-backed securities. Even so, the CEO said he still expects his firm to reach a Common Equity Tier 1 ratio of 13% in the first quarter. The firm ended the most recent period with a ratio of 12.5%.

Dimon said that they don't want to be locked into something that they think will get worse, and that they would rather take a chance on something that they think will get better.