If you’ve been listening to our podcast, GAAP Chats, you know we’ve recently discussed the current state of the banking industry, including the issues involving Silicon Valley Bank and Credit Suisse, just to name a few. One of the points we made is that these banks were not holding risky investments, but rather U.S. government or government-agency bonds classified as either available for sale or held to maturity under ASC 320. Knowing I was on blog duty this week, I figured I would just write a “puff piece” on the rules surrounding held-to-maturity investments. You know…positive intent and ability…if you sell before maturity your portfolio is tainted…blah blah blah, but then I saw this headline for an article dated March 23, 2023, in Fortune magazine:

U.S. Banks are sitting on $1.7 million in unrealized losses, research says. That’s not a problem – until it is

Every time I read these accounting-related articles in business publications, I always come away a bit frustrated. This is because the authors never truly understand all the nuances of U.S. GAAP (or IFRS), and this article would be no different.

“Unrealized losses aren’t reflected on banks’ balance sheets due to an accounting practice where assets are held on banks’ books at the value at which they are bought, instead of their current market value.”

In my best English accent, channeling my inner Richard Stokes (my former business partner and co-founder of what would become GAAP Dynamics), “That is absolute rubbish!” Everyone knows the quote from the article only applies to investments in debt securities classified as held to maturity (HTM) in accordance with ASC 320. Unrealized losses on available-for-sale (AFS) debt securities are reflected in the balance sheet, albeit in other comprehensive income.

Which got me wondering, how have the unrealized losses on investments held by banks changed from prior year? What percentage of investments held by banks are classified as held to maturity as compared to available for sale? And have these percentages changed from prior year? Did they transfer substantial portions of their AFS portfolio to the HTM portfolio to “protect” their balance sheets from unrealized losses that were bound to manifest in a rising interest rate environment?

“But the “puff piece” blog would be easier,” my inner voice told me. “You have two audit storyboards due this week!”

I wonder which way I ought to go.

And down the rabbit hole I went!

If you don’t know where you’re going, any road will take you there.

As this was going to be a manual task that I couldn’t pawn off on anybody, I first had to narrow the population. I went with the top 25 banks in the U.S. based on consolidated assets as of December 31, 2022 as published by the Fed in its Federal Reserve Statistical Release.

For each of the banks, I downloaded and analyzed their most recent annual reports filed on Form 10-K (but in some instances on Forms 40-F or 20-F) to determine:

1. The unrealized losses on both their AFS (recorded in OCI) and HTM (only disclosed) portfolios and the increase in unrealized losses year over year;
2. The composition of their investments (i.e., AFS vs. HTM) and if that composition has changed compared to prior year; and
3. If the bank made transfers from their AFS portfolio to their HTM portfolio during the year.

Three of the banks on the list were foreign (TD Bank, BMO Harris, HSBC) with year-ends other than December 31, financial statements prepared in accordance with IFRS, and/or different reporting currencies. I don’t have time for that! I also combined Morgan Stanley Bank and Morgan Stanley Private Bank into one entity as it was combined in their Form 10-K. Great! Down to 21 banks. That’s my population.

I may be crazy, but all the best people are.

Unrealized losses

Just as a reminder the federal funds rate was 0.25% beginning in 2022 but the Fed began to raise rates in March 2022 to respond to inflation. In total, the Fed raised rates a total of 7 times during 2022 totaling a whopping 4.25% increase to 4.5% at year end. This had a devastating impact on the fair value of banks’ debt securities, so it comes as no surprise that every bank in the sample showed a substantial increase in unrealized losses on December 31, 2022, as compared to the prior year.

In total, the 21 banks in my sample had total unrealized losses of $399 billion, an increase of 830% over prior year, of which $288 billion (72%) was only disclosed in their financial statements as it related to their HTM portfolios. The banks with the largest total unrealized losses on December 31, 2022 were (% of loss related to HTM securities):

1. Bank of America – $113.4 billion (96%)
2. Wells Fargo – $49.8 billion (83%)
3. JPMorgan Chase – $48.0 billion (77%)
4. Citigroup – $31.9 billion (79%)
5. Truist – $22.2 billion (45%)
6. U.S. Bank – $19.4 billion (56%)
7. Silicon Valley Bank – $17.7 billion (86%)
8. Morgan Stanley – $16.2 billion (66%)
9. Bank of New York Mellon – $12.5 billion (50%)
10. Capital One – $10.3 billion (0%)

Honestly, I didn’t realize banks held so many held-to-maturity securities, especially given the severe restrictions on sale. Could it be that perhaps the percentage of HTM investments, as compared to AFS investments, has changed since prior year? Would we discover that the list of banks above had significant transfers from AFS to HTM during 2022? Let’s find out!

Curiouser and curiouser!

Use of the AFS and HTM classification

Overall, the 21 banks held a total of $3.8 trillion of investments on December 31, 2022 that they classified as either available for sale or held to maturity (for purposes of this analysis, I omitted the trading and equity securities categories). This represented approximately 21% of total assets and was broken out as follows:

• Available-for-sale debt securities – $1.5 trillion (40%)
• Held-to-maturity debt securities – $2.3 trillion (60%)

Did this breakout change since prior year? Well, let’s find out!

In total, the 21 banks held a total of $4.0 trillion of investments on December 31, 2012 that they classified as either available for sale or held to maturity. This represented approximately 17% of total assets and was broken out as follows:

• Available-for-sale debt securities – $2.1 trillion (53%)
• Held-to-maturity debt securities – $1.9 trillion (47%)

Well, isn’t that interesting?!

The banks with the highest percentage of held-to-maturity debt securities on December 31, 2022 were:

1. First Republic Bank (89%)
2. Silicon Valley Bank (78%)
3. Bank of America (73%)
4. Wells Fargo (72%)
5. PNC Bank (68%)
6. JPMorgan Chase (67%)
7. State Street Bank (61%)
8. M&T Bank (56%)
9. U.S. Bank (55%)
10. Goldman Sachs (51%)

The first two banks on the list certainly have been in the news recently! But where should I go from here?

That depends a good deal on where you want to get to!

Significant transfers from AFS to HTM

What I really wanted to find out was whether these banks, knowing rising interest rates were all but inevitable, made a conscious decision to transfer securities out of their AFS portfolio (where unrealized losses still show up in OCI) and into their HTM portfolio (where unrealized losses are only disclosed). Here’s what I found:

• Two banks on my list (Capital One and American Express) don’t even use the HTM category.
• Ally and Fifth Third only have a very small amount of HTM debt securities, and that amount remained consistent from prior year.
• Although high (78%), Silicon Valley Bank’s percentage remained consistent from prior year.

However, of the remaining 16 banks, all of them increased, many by substantial amounts, the percentage of investments in the HTM category. Here’s the list of the banks with the biggest increases in the percentage of HTM investments:

1. PNC Bank (68% up from 1% in 2021)
2. Truist (45% up from 1% in 2021)
3. Goldman Sachs (51% up from 9% in 2021)
4. U.S. Bank (55% up from 24% in 2021)
5. State Street (61% up from 37% in 2021)
6. Citizens Bank (29% up from 8% in 2021)
7. M&T Bank (56% up from 41% in 2021)
8. JPMorgan Chase (67% up from 54% in 2021)
9. Wells Fargo (72% up from 61% in 2021)
10. Huntington Bancshares (42% up from 30% in 2021)

PNC Bank, Wells Fargo, and Huntington Bancshares disclosed quantitative information about the transfers, but did not provide an explanation as to why they were made. That’s better than Goldman Sachs, Citizens Bank, and M&T Bank which did not include any information about transfers in their footnote. Here are the “explanations” given by the four remaining banks on the list:

• “…for capital management purposes.” (JPMorgan Chase)
• “…to reflect its new intent for these securities.” (U.S. Bank)
• “…reflect our intent to hold these securities until their maturity.” (State Street)
• “…as the Company continues to execute upon its asset-liability management strategies.” (Truist)

Execute. That’s a funny word!

That's enough! Off with their heads!

Conclusion: Eliminate the HTM classification

Just to be clear, I am not calling for the execution of banks, which are inanimate objects, or anyone or anything for that matter. However, it is my opinion that the FASB should eliminate, or at the very least put significant restrictions on, use of the held-to-maturity category within ASC 320 as it is crystal clear that banks are “gaming” the system. When it is convenient and beneficial or them, they have no problem classifying debt securities as available for sale and reporting unrealized gains/losses in OCI, which probably makes sense as that gives the bank the most flexibility as such securities can be sold without repercussions. However, once the environment gets a little hairy, they run like scared, little children to the safety of the HTM category, eliminating the possibility of unrealized losses showing up in their balance sheet, unless there is a credit loss impairment under ASC 326, which for the securities they hold is highly unlikely). Instead unrealized losses are hidden away deep in the recesses of the footnotes.

At the very least, if I were in charge, which thankfully I am not, I would require classification of debt securities as held to maturity only on initial acquisition, and eliminate any transfers into or out of the held to maturity category. Furthermore, I would severely limit (even more than it is now), the ability to sell securities that have been classified as held to maturity and, if an entity sold a security out the HTM category, that category would be tainted forever. Banks would think twice before using the category and we’d stop all these shenanigans!

I have an excellent idea! Let’s change the subject.

Thanks for going down the rabbit hole with me! What do you think? Am I being unreasonable? Not thinking it all the way through? Let me know your thoughts in the comments.

I’ll leave you with this sage advice from the Mad Hatter from Lewis Caroll’s novel Alice’s Adventures in Wonderland:

The secret, Alice, is to surround yourself with people who make your heart smile. It’s then, only then, that you’ll find Wonderland!

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