Rate Cuts Encourage U.S. Banks to Reposition Investments

By Saeed Azhar

(Reuters) – Rate cuts and easing bond yields are encouraging some U.S. banks to minimize losses from low-yielding investment securities. They are reallocating those funds into higher-yielding instruments to enhance returns and liquidity.

Such actions are expected to increase as additional Federal Reserve interest-rate reductions unfold into 2025.

Declining rates provide relief by reducing banks' paper losses that peaked two years ago, contributing to regional banking distress.

Banks invest in securities like Treasuries and mortgage-backed securities to drive earnings and maintain liquidity, yet these investments carry interest-rate risks.

When the Fed raised interest rates in 2022, unrealized losses for U.S. banks reached a staggering $690 billion, but this figure has since declined to $513 billion as of the second quarter, according to the Federal Deposit Insurance Corp.

With these losses decreasing and the Fed reducing rates in September, major banks such as Wells Fargo and regional institutions such as KeyCorp sold low-rate securities to acquire those yielding higher returns.

The Federal Reserve decreased interest rates by half a percentage point to a new range of 4.75%-5.0%, with some policymakers indicating support for further reductions.

"Banks have concluded that the immediate loss from selling low-value securities is justifiable compared to the long-term benefits of purchasing higher-yielding securities," remarked Wes West, chief analytics officer at Nomis Solutions, which offers loan and deposit-pricing software to banks.

In the past, lenders retained low-yielding securities because selling them at a significant loss, while rates were elevated, would necessitate setting aside funds to meet regulatory capital requirements, analysts indicated.

Low-yielding investments were marked down among available-for-sale securities, which are categorized as such since the bank has the option to sell them before they mature.

Wells Fargo took significant action this quarter by selling around $16 billion in securities, incurring a one-time hit of $447 million, and reinvesting in vehicles with yields 130 basis points higher.

Wells did not provide further comments beyond this disclosure.

These bank actions appear opportunistic in locking in higher coupon rates to enhance reported profitability, especially given expectations of additional rate cuts in subsequent quarters, according to Megan Fox, vice president at Moody's Ratings.

Smaller lenders have also engaged in similar repositioning.

On Tuesday, Banc of California, which acquired PacWest last year, reported a repositioning of $742 million in securities at a weighted average yield of 2.94%, resulting in a pre-tax loss of $60 million. It procured securities with an average yield of 5.65%.

Regional lender KeyCorp sold approximately $7 billion of lower-yield mortgage-backed securities, reinvesting the proceeds into higher-yielding investments, as noted in its third-quarter earnings statement. It reported a $737-million after-tax charge due to the loss on these securities.

KeyCorp stated via email that the securities sold had an average yield of around 2.3%, while the newly purchased securities boast an average yield of 4.9%.

Some lenders have also capitalized on one-time gains, such as those from asset sales, to offset the immediate impact of selling these securities. Truist Financial Corp sold its insurance division in May to reallocate part of its available-for-sale investment securities portfolio.

PNC executed a similar strategic move in the second quarter when it recorded a gain from the exchange of shares in Visa, the credit card company.

The banks did not elaborate further than their official disclosures.

Bank of America performed a similar repositioning on its available-for-sale securities last year and is now reinvesting cash from maturing securities into higher-yielding paper. Bank of America did not provide additional comments beyond its announcement.

Banks utilize the held-to-maturity designation to invest in lower-risk securities that offer downside protection, even though in a rising interest-rate climate, upside potential is limited.

Warren Kornfeld, senior vice president at Moody's Ratings, noted that banks' liquidity has improved due to more securities trading at par, while they are likely reallocating investments into papers with shorter durations.

UNREALIZED LOSSES DECLINE

As interest rates decline, banks observe a reduction in unrealized losses within their securities portfolios.

The rapid collapse of Silicon Valley Bank earlier in 2023 was attributed to its failure to manage a sudden and extensive withdrawal by depositors, leading to tens of billions of dollars' worth of withdrawals within hours.

The chain of events also included selling U.S. Treasuries to stabilize funding costs, resulting in a staggering $1.8 billion loss alongside a failed stock sale.

"The banking system has learned how rapidly situations can deteriorate when facing spikes or swift increases in rates," stated Jon Curran, head of investment-grade credit at Principal Asset Management. "Currently, declining or stable rates are decidedly more favorable."