Navigating Market Value Changes in a Rising Interest Rate Environment

After years of relatively low and stable interest rates coming off of the Great Recession, the Federal Reserve has recently become more aggressive in its efforts to cool the economy and fight the highest inflation rates seen in decades. As a result, the prime rate has increased seven times so far in 2022, more than doubling from 3.25% to 7.50%, with indications that rate increases may continue into 2023. Increases in the Federal Reserve’s benchmark interest rate have been much more aggressive than any action taken by the Federal Reserve in recent years and the speed in which they are being made is requiring financial institutions to adapt at a similar pace. While higher yields in loan portfolios may be a refreshing change of pace, there are other financial implications of this interest rate environment for financial institutions to be mindful of.

Rising interest rates have a negative impact on the market value of fixed income securities such as bonds. Many investment portfolios are filled with bonds that were purchased prior to 2022 in a relatively low and stagnant interest rate environment. Under the current rising interest rate environment, previously acquired lower rate bonds are forced to compete with the newer bonds issued at higher market rates. This drives the market value of the bonds down to increase the effective yield of their lower rate coupons. For financial institutions with significant investments in fixed income securities, this is quickly resulting in substantial unrealized losses in investment portfolios unlike anything seen recently. Under generally accepted accounting principles (GAAP), fixed income securities that are classified as available-for-sale (AFS) must reflect their related unrealized loss in accumulated other comprehensive income (AOCI). The silver lining is that these potentially significant unrealized losses have no impact on net income if the financial institution can support that they have no plans to sell the investments prior to recovery of their cost basis or until maturity, and that they can demonstrate an ability to fund operations without needing to liquidate debt securities within their investment portfolio. The bonds will continue paying interest and no unrealized loss will be recognized upon maturity. One caveat is that the decline in market value must also be assessed and determined to be related to overall market conditions and not a deterioration of the creditworthiness of the related individual bond issuers. Any declines in market value related to credit deterioration will need to be evaluated for other-than-temporary impairment and possibly recorded through the income statement.

While AOCI is included within total book capital on the financial statements, many community banks have taken advantage of the revised Basel III capital rules allowing them to opt out of including AOCI as a component of their regulatory capital ratios.  However, while regulatory capital ratios may not be impacted for most, there are other considerations for carrying large unrealized losses in book capital. From a tax planning perspective, these bonds present a possible tool for offsetting gains and lowering taxable income should a financial institution decide to chip away at the unrealized losses in AOCI on their financial statements through sales while offsetting income in a particularly strong year. In addition, mergers and acquisitions in the banking industry have been widespread in recent years, but declines in book capital due to high unrealized losses have the potential to derail or delay these deals. Mergers in process prior to the aggressive actions taken by the Federal Reserve may look a lot different on paper in 2022 with some large fluctuations in valuations occurring before the deal formally closes. Financial institutions considering exploring mergers and acquisitions in this interest rate environment will need to determine whether the timing makes strategic sense for the institution and if they have the flexibility and willingness to move forward with fluid valuations as rates continue to rise. Another important consideration is the ability to borrow from the Federal Home Loan Bank (FHLB). While the Basel III opt-out mentioned earlier allows banks to remove AOCI from their capital ratios for regulatory capital purposes, the FHLB’s regulator, the Federal Housing Finance Agency (FHFA), has not yet adopted a similar regulation for its definition of tangible capital, which includes those unrealized losses. Per FHFA regulations, any member with a negative tangible capital ratio is not eligible to take new borrowings unless their primary regulator submits a waiver to the FHLB on its behalf. Members with a negative tangible capital ratio but sufficient collateral may renew maturing advances for a term of no more than 30 days.  Institutions should monitor communications from the FHLB closely on this issue to avoid an unexpected liquidity crunch.

Alternatively, a financial institution may consider reclassifying their AFS fixed income portfolio (or a portion thereof) to one that is formally classified as held-to-maturity (HTM).  Securities classified as HTM are held at amortized cost with no fair market value adjustments impacting their carrying value. That may sound like a tempting proposition, but there are complexities to consider before making formal classification changes.  Importantly, the unrealized holding gain or loss at the date of transfer continues to be reported in AOCI. However, in this instance, the unrealized holding gain or loss related to the transferred security reported in AOCI is amortized to income by the interest method. Fair value at the date of transfer is the new cost basis of the debt security. The unrealized holding gain or loss included in the new cost basis of the debt security represents a premium or discount that is amortized by the interest method as a yield adjustment over the remaining life of the security. This amortization offsets the effect on interest income from the amortization of the unrealized holding gain or loss included in AOCI. Thereafter, the debt security should be accounted for like any other debt security classified as held-to-maturity.  The amortization of AOCI, together with the reversal of the related tax effect, would be offset by the amortization of the debt security’s fair value adjustment, leaving no effect on net income.

As financial institutions are working to implement the new Current Expected Credit Losses (CECL) standard, it’s important to note that HTM securities are impacted by that standard. Financial institutions will need to assess whether an allowance for credit losses will be needed for their HTM securities at the date of adoption, likely impacting net income prospectively and adding an additional layer of complexity to an already strenuous adoption process. Also, if a security is classified as HTM, the financial institution loses the flexibility to sell the security. While liquidity has been strong in recent years, this classification will limit your options for boosting liquidity in the future.

Further, should an institution decide to take a proactive approach to fair value fluctuations, they have the option of entering into a fair value hedge against their fixed income securities. With a fair value hedge in place, as the value of the underlying hedged securities decreases with rising interest rates, the fair value of the hedge increases. For fair value hedges of available-for-sale debt securities, GAAP requires that the basis adjustment be recognized in earnings, rather than through other comprehensive income, to offset the gain or loss on the hedging instrument.  Also note that the notion of hedging the interest rate risk in a security classified as held-to-maturity is inconsistent with the held-to-maturity classification under GAAP, which requires the financial institution to hold the security until maturity regardless of changes in market interest rates. For this reason, GAAP indicates that interest rate risk may not be the hedged risk in a fair value hedge of held-to-maturity debt securities. However, hedging credit risk is permitted.  Institutions inexperienced with hedge accounting may also be put off by the accounting complexities of having derivatives on their books.

The banking industry is no stranger to uncertainty, especially after dealing with the impacts of the COVID-19 pandemic while at the same time developing its CECL models. High inflation, rapidly rising interest rates, and the looming threat of an economic recession present new challenges and opportunities moving forward that are much different than those of the recent past. While high unrealized losses in fixed income security portfolios can be concerning for some users of financial statements, putting these unrealized losses in the proper context is important for presenting an accurate picture of a financial institution’s financial position and easing users’ concerns. The industry as a whole has demonstrated continued strength and resilience despite these drastic shifts in market value and the volatility within the markets in general.

Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, investment, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.

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