With the Federal Reserve raising interest rates seven times in 2022, making the year the worst year ever for U.S. bonds, many of the largest banks in the U.S. used a simple accounting strategy to prevent billions of losses from accumulating on their books.
Instead of selling the bonds for a loss, the banks held onto these assets until maturity and relabeled them on their books. By doing this, the bonds were frozen at the rates at which they were purchased, despite their current plummeting market values.
The disparity between a bank’s stated and actual market values leads to concerns that many banks’ balance sheets are deceptive.
Six large U.S. banks used this maneuver, including Charles Schwab and PNC Financial Services Group, both of which switched the classifications on over $500 billion of their bond investments in 2022, according to The Wall Street Journal (WSJ).
The move enabled the banks to exclude unrealized losses on their balance sheets and instead allowed them to report healthy levels of capital despite the banks’ current assets being valued at much less.
According to current rules, the value of a bank’s asset is tied to what the bank intends to do with the asset.
Current rules also allow banks to change their intentions on these assets, which can vastly change how balance sheets appear to investors.
If a bank holds the assets as “available for sale,” the assets are subject to current market prices, which can produce billions in losses. By labeling the bonds as “held to maturity,” the losses are not realized. As a result, the daily fluctuations that bond markets experience do not affect previously purchased bonds that the banks do not intend to sell.
Many banks are using this technique as bond prices fall due to rate hikes. At the end of 2022, roughly 48% of the securities held by U.S. banks were classified as held to maturity, a huge jump –more than 40% — from the 34% classified as held to maturity in 2021, according to FDIC data, per the WSJ.
This reclassification has boosted the banks’ held-to-maturity values to $1.14 trillion as of December 31, nearly twice the amount year-over-year, according to the WSJ.
By declaring the bonds as held to maturity, the banks’ balance sheets were 12% higher than current fair-market values for the bonds than if they had been deemed “available for sale,” the WSJ reported.
When interest rates were low in 2021, Charles Schwab did not hold any bonds labeled held for maturity. Since then, Charles Schwab has transferred $188.6 billion of securities from available for sale to this classification.
Similarly, PNC transferred $82.7 billion of bonds to held-to-maturity from available-for-sale. JPMorgan Chase & Co did so to the tune of $78.3 billion. Trust Financial Corp transferred $59.4 billion, while Wells Fargo and U.S. Bancorp transferred $50.1 billion and $45.1 billion, respectively.
Still, the reclassification does not change the current value of the bonds.
“This is an artificial accounting construct, not an economic measure of the value of the assets,” Sandy Peters, head of financial reporting policy for the CFA Institute, told the WSJ.
“The value of a bond doesn’t change based upon how management decides to classify it. It’s worth what it’s worth.”
Ken Kuttner, an economics professor at Williams College, told The Dallas Express, “The trend over the years has been to get banks to report the market value of their assets (so-called “mark-to-market” accounting) on the grounds that it more accurately reflected their financial health. This is going in the opposite direction, one could say artificially inflating the value of the bonds. This is a bad precedent, in my opinion.”
“Some people might say that this is OK because if the bonds were held to maturity, they would earn the full return. For example, if a bank bought a 10-year bond when its market yield was 2%, it would earn the full 2% if held for the entire 10 years. This is a fallacy. The problem is that if the market interest rate goes up from 0% to 5%, what had been a positive 2% net return becomes a negative 3% return. The bond’s loss of value is just the capitalized value of that return reduction.”