U.S. banks surrender future profit for capital relief now

U.S. banks are increasingly giving up the right to sell tens of billions of securities in their investment portfolios, a shift that helps them avoid the pain of weaker bond markets but will cut into future profits as interest rates rise.

Lenders ranging from large banks like U.S. Bancorp to smaller banks like Cullen/Frost Bankers Inc have been changing the way they account for investment securities, adopting a treatment that essentially forces them to hold onto bonds through thick and thin, instead of being able to sell them when markets tank. The accounting switch gives them near-term relief that helps them meet new international capital and liquidity rules.

But analysts fear that as bond markets keep weakening, banks will be stuck with more turkeys in their portfolios, giving them less cash to invest or lend at higher rates.

The willingness of lenders to surrender future profits shows the pressures they face in an era of restrictive regulations, soft loan demand and historically low rates that are now poised to rise. The exposure of banks to rising interest rates threatens to undo much of the progress that lenders had made in building capital since the financial crisis, said David Hendler, an analyst at New York research firm CreditSights.

"You've got all these hurdles that banks have to jump over, and they get higher and higher," Hendler said, adding that the challenges are testing the acumen of bank treasury and finance departments. "A lot of these guys didn't train for this."

The accounting shift is known as moving assets from "available-for-sale" treatment to "held-to-maturity," a change that has been underway for several years. U.S. commercial banks' held-to-maturity books increased 62 percent to $347.4 billion in the second quarter from $215.0 billion in the fourth quarter of 2010, according to SNL Financial.

As bond markets weakened in the second quarter, the switch accelerated, with held-to-maturity accounts rising 8.7 percent from the first quarter, the biggest increase in nearly two years.

One of the first big banks to make the shift was U.S. Bancorp of Minneapolis, Minnesota, the sixth-largest U.S. bank, with $353.4 billion in assets. The bank is a favorite of Warren Buffett, whose Berkshire Hathaway Inc is one of its biggest shareholders.

U.S. Bancorp's held-to-maturity securities book ballooned to $34.7 billion at the end of the second quarter, or 46 percent of its investment portfolio, from just $1.5 billion at the end of 2010, with most of the change coming in 2011. In January 2012, U.S. Bancorp finance chief Andrew Cecere told analysts and investors the bank used the held-to-maturity book to help manage new regulatory requirements for liquidity and capital.

But the bank is now saddled with tens of billions of dollars in low-yielding assets. The weighted average yield on U.S. Bancorp's held-to-maturity portfolio was 1.89 percent in the second quarter of 2013, compared with 2.72 percent for the available-for-sale portfolio. As rates start to rise, the bank could earn less on some assets than it has to pay to fund itself, cutting into its income.

To be sure, banks have some ways to mitigate that pain. For example, they can borrow against the held-to-maturity assets and invest the proceeds. And many bank loans carry floating rates, so rising rates will boost interest income.

But banks that go too far with a held-to-maturity strategy will not be able to free up as much of their balance sheet to make new loans if the economy improve in the coming months, said Johannes Palsson, managing director at Angel Oak Advisory, a risk management consulting firm.

Those banks are "kind of stuck. There's not much you can do" to take advantage of future loan growth, Palsson said in an interview.

"ABSOLUTELY RIDICULOUS"

For available-for-sale assets, banks must record paper losses each quarter when the securities' values fall. The paper losses do not hit earnings but reduce net worth, as measured by the book value of assets minus liabilities. That happened to banks in the second quarter, when bond markets weakened amid talk of the Federal Reserve cutting back on its bond buying program.

The $38 billion of unrealized investment gains they had reported at the start of the year swung to $13.1 billion of paper losses by the end of August, according to Federal Reserve data.

For a long time, regulators ignored changes in the value of available-for-sale books when assessing a bank's capital strength. But under the framework known as Basel III that international regulators finalized in December 2010, losses from available-for-sale assets will hit regulatory capital, and a bond market selloff could force U.S. banks to boost their capital levels.

Paper losses on held-to-maturity securities, however, would not subtract from banks' capital levels. This, along with new liquidity rules that pressured banks to increase their securities holdings, encouraged banks to park assets in their held-to-maturity bucket of their investment portfolios.

Bank officials have argued that regulators are pulling them in too many directions without much consideration about how the new rules interact with each other. Hearing those complaints, earlier this year U.S. regulators exempted banks with less than $250 billion in assets from capital rules linked to available-for-sale books.

But for some that ruling came too late. For instance, Cullen/Frost, a San Antonio, Texas bank with $22.6 billion in assets, classified $2.6 billion of its municipal bond portfolio as held-to-maturity in last year's fourth quarter. It made the move because regulators seemed "incapable" of stripping out the requirement to subtract paper losses on securities from capital ratios, finance chief Phillip Green said on an earnings call with analysts at the time.

"That was absolutely ridiculous for a bank like ours" which is flush with liquidity and has never had a problem funding its securities portfolio, Cullen/Frost Chief Investment Officer Bill Sirakos said in an interview about the Fed's initial proposal.

But that transfer proved unnecessary when the bank was later exempted. Sirakos said the bank didn't have any big regrets about its use of the held-to-maturity account. "We gave up some flexibility, but we generally hold the stuff to maturity anyway," he said.

Though regulators can easily reverse course, under accounting rules banks cannot. If they chose to sell some securities out of the held-to-maturity portfolio, outside of few extreme circumstances ,the entire portfolio becomes "tainted."

Once that happens, all held-to-maturity securities ��� not just the ones the bank planned to sell ��� are transferred to banks' available-for-sale books where any unrealized loss immediately detracts from their net worth. Additionally, the bank would be prohibited from using hold-to-maturity portfolios for two years.

With that inflexibility, some banks, including JPMorgan Chase & Co have opted to accept the risk of rising rates clobbering their investment portfolios, and use held-to-maturity accounting for little-to-none of their investment securities.

(Reporting by Peter Rudegeair and Carrick Mollenkamp; Editing by Dan Wilchins, Leslie Gevirtz)