Thanks to higher interest rates, banks’ unrealized losses jumped by a third at the end of last year

There’s a hard and fast rule about bonds that you may notice every day when Marketplace does the numbers and talks about the 10-year Treasury note: bond prices and bond yields — the interest rates they pay — move in opposite directions. That means if interest rates go up, the value of existing bonds automatically goes down.

That was a big factor behind the collapse of Silicon Valley Bank two years ago. Interest rates rose and so the value of the bonds the bank was holding as assets tumbled.

Banks are still holding on to plenty of exactly those kinds of losses, according to a new report from the Federal Deposit Insurance Corporation. In fact, those unrealized losses jumped last quarter by a third as interest rates rose.

When trillions of dollars of government relief aid went out early in the pandemic, a lot of it ended up being deposited in banks across the country. Banks then had to figure out what to do with that money.

“We sat on our deposits for quite a while, and then ultimately decided that well, the money’s sticking around, it’s a little bit stickier than we thought it was going to be, let’s put it to work,” said Chris Duncan, chief lending officer at La Salle State Bank in Illinois.

Duncan said there wasn’t much demand for loans at the time, so the bank decided to invest a big chunk of those deposits in five- to 10-year government bonds, which at the time were paying next to nothing in interest.

But then, the Federal Reserve started raising interest rates. All of the sudden, those low-interest bonds the bank owned were worth less.

“You can imagine there is no one out in the market that is looking to purchase that very low interest rate-bearing security, when they could now go out on the market and buy a security that’s earning them a much higher interest rate,” Duncan said.

Duncan said he had hoped that interest rates might come down a bit more than they have. But they haven’t.

“We have not seen our unrealized loss position in our securities portfolio reduce as much as maybe we would have anticipated a year ago,” Duncan said.

If a bank needs to sell off any of those securities to scrounge up some cash, for instance, it’d have to do so at a loss, and take a chunk out of its profits.

“Your shareholders are upset, maybe it costs you more to borrow, maybe it’s harder for you to provide loans to your customers,” said Julie Hill, dean at the University of Wyoming College of Law.

But Hill emphasizes that’s only an issue if banks need to sell off their bonds. And right now, most of them are holding on to what they own.

“At some point, some of those securities are going to hit maturity and go away, and they won’t have been sold,” Hill said.

Once those bonds mature, the bank gets back the full amount that it invested.

Banks can afford to do that when they have plenty of excess capital they can use as a cushion.

Quentin Leighty, chief financial officer of First National Bank Colorado, said his bank has plenty of extra capital sitting around, in large part because he said his borrowers are paying back their loans just fine.

“That really is a driver for an environment where you’re building capital over time, because you’re not needing to put more aside for potential loan losses,” Leighty said.

Leighty said it also helps that most of the bank’s assets are invested in loans, rather than bonds. That’s because loans tend to have shorter terms and often allow banks to increase the interest rate.

“We get to experience the rising rate environment quicker with those,” Leighty said.

La Salle State Bank’s Chris Duncan said one strategy is to make more loans, in order to take advantage of today’s elevated interest rates. Another is to sell off some of its old low-interest bonds: taking the hit, and re-investing in new bonds with better yields.

“We feel, in five to 10 years, when rates have come down, those investments will still be earning much higher rates,” Duncan said. “And therefore, those securities will have value.” 

Hope is, Duncan said, that in five to 10 years, we’ll be talking less about unrealized losses, and more about unrealized gains.