In the wake of regional bank failures earlier this year, the U.S. banking sector has grappled with substantial challenges, which include customer deposit deficits, rising deposit costs, sluggish loan growth, and diminishing profit margins. Yet, it demonstrated resilience later.
This ostensible resurgence became evident as the Federal Reserve propelled benchmark interest rates to the highest in over two decades, a trend expected to reverse in the forthcoming year. Amplified interest rates produce gains for banks due to elevated net interest income.
Despite this, the U.S. banking sector continues to bleed deposits. Throughout the second quarter alone, FDIC-insured banks experienced an almost $100 billion downward deposit shift. The industry's net income was diminished by $9 billion to $70.80 billion in the second quarter, with the average net interest margin contracting by three basis points to 3.28%.
Moreover, Federal Reserve Economic Data reveals a stunning $100 billion diminution in U.S. commercial banking deposits in just three weeks. Deposits plummeted from $17.38 trillion on September 27 to a disconcerting $17.28 trillion by October 18.
Furthermore, according to Moody's assessment, U.S. banks could struggle with at least $650 billion in unrealized losses in their securities portfolios, a 15% increase from the $558 billion losses experienced at the second quarter's end. This comes after expectations of extended higher interest rates led to a bond market collapse in the third quarter.
The share performance of the nation's second-largest financial institution, Bank of America Corporation (BAC), has languished alongside other bank stocks given these circumstances. BAC reported $131.60 billion in unrealized losses in its securities portfolio for the fiscal third quarter that ended September 30, 2023.
BAC continues to weather a period of economic volatility despite a 14% year-to-date decrease in its share values. However, investors are increasingly concerned about the bank's diversified investment portfolio status during long-standing escalated interest rates.
BAC’s early pandemic decision to allot billions into long-term Treasury bonds and mortgage bonds during a time of increased new deposits has now become a significant financial burden.
An influx of deposits accelerated by federal aid significantly outpaced the growth of loans during this period. The acting CFO at the time, Paul Donofrio, divided the surplus funds between long-term fixed-income products, with the remainder placed in short-term and floating-rate debt. This strategy was intended to safeguard the bank's net interest margin if rates stagnated or fell.
Over the years, BAC's CEO, Brian Moynihan, has consistently underscored that the bank stands to make significant gains when interest rates rise, backed by a solid deposit base ready for financial expansion following a strategic pivot by the Fed. However, amid the current high-interest rate climate, BAC has lagged among America's banking heavyweights.
Low-yielding investments and a decrease in the value of holdings upon the Fed's increased rates imply reduced earnings from its investments for BAC. Its investment holdings presently display considerable unrealized losses, missing competitive rates since 2007. As of June 30, 2023, these holdings show paper losses on those debt securities exceeding $109 billion, which increased to $136.22 billion by the third quarter's end.
With approximately $603.37 billion tied up in held-to-maturity securities, the bank's considerable holdings in these low-yield assets restrict its potential to maximize profits from cash investments in money markets or higher-return assets. The bank's comparatively lower overall yields on its securities book are projected to persist for some time. Analysts do not anticipate the bank needing to liquidate these holdings and incur a loss.
BAC’s securities portfolio is the largest and the least-yielding, heavily weighted with debt that matures after a decade. Should the Fed act upon another prospective rate increase, the valuation of these holdings may depreciate further.
Moreover, for the fiscal third quarter of 2023, BAC’s net interest income rose 4.5% year-over-year, surpassing the analyst's estimate, but it remains below its peers. JP Morgan’s NII grew about 30% year-over-year, while Wells Fargo’s NII climbed 8.3% year-over-year.
However, executives remain optimistic that the financial climate could ameliorate each quarter as the portfolio contracts and the remaining bonds decrease in duration. Even if rates stay where they are, interest income is poised to bolster as approximately $10 billion of holdings mature every quarter, the proceeds of which can be reinvested at more favorable rates.
Chief Financial Officer Alastair Borthwick indicates that these funds could go into cash where attractive yields are achievable or possibly for long-term investments, now offering superior coupons. More than a quarter of the bank's reserve remains frozen in debt securities, yielding roughly 2.4% in a market environment offering around 5%. As it stands mid-year, the accounted value of these securities has plummeted by close to $110 billion.
There were also signs from BAC that some of its customers are encountering problems as borrowing costs rise. Its net charge-offs were $931 million, up 79% from the year-ago quarter.
BAC, indeed, pays less than 2% on its significant deposit base. This allows it to maintain profitability through its loan and investment ventures, unlike smaller banks that face financial strain due to their new deposits costing more than what their older assets yield.
A potential shift in investor perspective may also benefit BAC. As investors shift their focus from bond losses and increasing deposit costs to credit and capital, BAC could surpass expectations and enjoy improved performance.
Bottom Line
Recent decisions by financial institutions have underscored the precarity of the contemporary banking landscape. The alarming revelation that the second-largest lending bank in the U.S. has unrealized losses of $131.6 billion on securities is exceedingly concerning, even with government assurances in place.
Prominent lending organizations have experienced setbacks in their bond holdings; however, BAC is particularly notable due to its size and impact. Possessing over $3 trillion in assets and $1.9 trillion in deposits as of September 30, 2023, the bank has considerable fiscal security to endure this turbulent period. It is anticipated that BAC will successfully navigate these rough waters.
CEO Moynihan has long championed a strategy of "responsible growth," which calls for the pursuit of profit without exposing the bank to unnecessary risk – a methodology instituted in 2014. However, some insiders argue that this cautious approach might neglect potential growth opportunities.
While unrealized losses do not generally affect the average bank customer, they may concern investors. This factor, combined with the massive scale of insured consumer deposits, construes BAC as less vulnerable to the type of deposit flight that sank regional banks.
Should interest rates stabilize and gradually decrease, it could trigger a rise in share prices since the long-term securities the bank holds are likely to gain in value.
Moreover, the unrealized losses may bear less significance for long-term investors focused on gaining from the bank's consistently escalating dividend payments. BAC boasts a solid balance sheet underpinned by sturdy profitability, and it currently offers an appealing dividend yield of 3.38% on the current share price. Investors can benefit from this by retaining the shares and waiting for potential capital appreciation.
While BAC's disproportionate portfolio does not create an immediate existential crisis, it significantly affects both the bank's earnings and investor interest. Even though it currently trades slightly above the 50-day moving average, considering prevailing circumstances, it may be prudent for investors to wait for a better entry point in the stock.
