The recent bond market crash has left big banks with $650 billion of unrealized losses, according to an estimate from Moody's. This is a significant increase from the $558 billion of losses that banks were sitting on at the end of the second quarter of 2023.
The brutal Treasury-market meltdown has hit some of the largest financial institutions hard, dragging down the share prices of big names like Bank of America, and fueling fears that the turmoil triggered by SVB’s bankruptcy might not be over just yet.
The losses are due to the sharp rise in interest rates, which has caused the value of existing bonds to decline. Banks hold large portfolios of bonds, so they are particularly vulnerable to interest rate movements. But also to the Federal Reserve applying quantitative tightening since 2022.
The Federal Reserve is raising interest rates in an effort to combat inflation. This is making new bonds more attractive to investors, as they offer higher yields. As a result, investors are selling their older bonds, which have lower yields, in order to buy new bonds. This is driving down the prices of older bonds. The Fed is also engaged in quantitative tightening, which is the process of selling bonds from its own portfolio in order to reduce its balance sheet. Selling these Treasuries affects their price even deeper because now there are too many bonds overflowing the market, which drives the price of existing bonds down since there are more sellers than buyers. And private banks, mainly commercial banks, are the holders of these bonds.
The ghost of Silicon Valley Bank (SVB) continues to haunt Wall Street, as its collapse in March 2023 was partly due to its large holdings of underwater bonds. SVB's sale of these bonds at a loss raised concerns about the health of other banks with similar portfolios.
The bond market crash is also impacting banks' unrealized losses by making it more difficult for them to sell their bonds. This is because investors are less willing to buy bonds when they are expecting interest rates to continue rising.
While the unrealized losses are not currently impacting big bank profits, they could become a problem if the bond market continues to decline. If banks are forced to sell their bonds at a loss, it could hurt their capital levels and make it more difficult for them to lend.
Some analysts are concerned that the unrealized losses could lead to a credit crunch, similar to the one that occurred during the 2008 financial crisis. However, others believe that the banks are well-capitalized and that the losses are manageable.
As we know, the rise of interest rates will continue to affect the cost of borrowing for businesses and consumers. More importantly, if banks become risk-averse, they may reduce lending, which could also hurt economic growth. And lastly, if the unrealized losses at big banks become realized, it could lead to a credit crunch and financial instability. As a result, banks may be forced to hold on to their bonds for longer, which means that their unrealized losses could continue to grow.