Tuesday, January 14, 2025

Bonds Gone Bad

Bank earnings remained below par for 2024 due to continued net interest margin pressures. As a result, many financial institutions amplified their misery by turning unrealized losses in their relatively low-yielding bond portfolios into actual losses by selling their underperforming bonds.

In my book, Squared Away-How Bankers Can Succeed as Economic First Responders, I referred to the phenomenon of further impairing already impaired earnings by making strategic investments in your bank as "pulling into the pits." The difference between what I recommended in the book versus what has transpired is that I was referring to strategic investments in technology, products, lines of business and people to build a financial institution that is relevant, even important to its constituencies. If macroeconomic factors, such as the interest rate environment, led to a suboptimal ROA, why not make it an even less optimal ROA by investing in the bank's future?

Overcoming bad balance sheet decisions in a zero-rate environment was not exactly what I had in mind unless, and I hope my conjecture is correct, some of the increased interest income generated by higher-yielding bonds leads to strategic investments needed to build an enduring financial institution. I suspect, however, it's just to have better earnings in 2025. Not better capital, mind you, but the promise of better earnings. 

Some may take exception to me calling bond-buying decisions made during the pandemic era as bad. And I will admit, I do not sell bonds nor consider myself a bond expert. I leave that to your fixed-income advisors. With a particular shout-out to those who did not advise clients to "go long" in a zero-rate environment or at least hedge if they went long. Special mention to those who admitted to making a bad call if they advised clients to go long.

In hindsight, buying long-term bonds in a historically low interest rate environment doesn't sound like a great strategy though what were the alternatives given such excessive liquidity? One alternative would have been to stay on the shorter end of the curve as short-term yields moved in tandem with rising rates. But according to the below tables and charts, it looks like we didn't do that. The below charts, courtesy of S&P Capital IQ are from all banks between $1B-$10B in total assets where the information is available. I went through the list and eliminated some specialty banks like Charles Schwab Bank, etc. It yielded 600 banks and savings banks. In the table, one column is when rates were zero (pandemic era), and the second column is when the Fed tightened.










During the period when rates plummeted to zero as a result of the pandemic, and liquidity rushed into financial institutions as a result of government stimulus and a flight to safety and liquidity for consumers and businesses, bank securities portfolios grew 83%.

What did they do with the money? Bought long-term bonds, as each maturity/repricing bucket grew more in the over one year and beyond bucket than the 0-12 months buckets. The greatest growth was in the 3-5 year bucket. Over five years grew 192%. This bond buying might result from "present bias", which Gemini AI defined as the tendency to overvalue present rewards without considering future consequences. Such as, I don't know, selling a lot of those bonds at a loss that will take three years to earn back and, in many cases, raising capital causing shareholder dilution. It requires an assumption that current conditions, good or bad, will continue indefinitely.  Present bias is the only rationale I could conjure for Silicon Valley Bank's unhedged bond portfolio. 

In the rate runup from 2Q22 to 3Q23, securities portfolios declined 7.8%. One reason is we thought customers would stick with us through thick and thin. Maybe through thin, but not through thick. FDIC-insured financial institutions hemorrhaged $1 trillion in deposits while money market mutual fund assets grew by the same amount. Now we needed the securities portfolio for liquidity. This time also included the high-profile failures of three banks. One had the signatory of the Dodd-Frank Act on its board. 

That fact is irrelevant to this article but I like to bring it up whenever the opportunity presents itself.

Although the overall securities portfolio declined, bonds with maturities or reprices in less than three years grew. Long-term bonds declined to help us meet liquidity needs. We ran off long-term bonds and bought short-term ones. This makes sense to me because the interest rate environment was so unpredictable. We had an inverted yield curve during this time. It would have been nice, however, if we bought long-term bonds at peak interest rates, not trough. But this is Monday morning quarterbacking.  

My point is that if we are elevating rates over liquidity in our bond portfolio, remember Covid! If we thought we had loyal customers that don't demand competitive deposit rates, remember post-Covid Fed tightening!

In terms of making hypothetical losses into actual losses and prioritizing rate over liquidity in our bond portfolios, this chart visualizes consequences.














In a couple of weeks I will be heading off to Bank Director's Acquire or Be Acquired conference. There will be plenty of presenters with snappy looking charts describing how loss-sales make sense. And in some cases these transactions may make sense. I had a BOLI person extoll the virtues of taking an exit fee hit to trade for higher paying BOLI. I got off the call thinking "let's sell off some BOLI!" Note: I don't have BOLI. Sometimes critical thinking skills take a back seat to the compulsion to act, thinking if everyone else is doing it perhaps we should too.

If we are selling off assets at a loss, we must perform a post-mortem to create long-term institutional knowledge as to what happened to lead to it and how can we learn from it to apply to future situations. Let's not waste an "ahh crap" moment. Let's make us smarter, and our bank better.


~ Jeff



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