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The 2008 financial crisis exposed numerous flaws in America’s financial system, such as the inherent danger of America’s largest banks being overleveraged. Significant dangers remain despite a slate of reforms designed to keep banks on sound financial footing going forward. A recent article in Cryptopolitan magazine revealed that American banks’ potential loss exposure on real estate-related securities skyrocketed to $750 billion in Q3 2024.
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This is raising concerns for many reasons. First, the estimated $750 billion is roughly seven times more than banks held in 2008. Second, many unrealized losses are concentrated in portfolios that are crucial to bank profits. The most at-risk portfolios are:
· AFS-Available for sale
· HTM-Held to maturity
One deeply troubling aspect of the potential $750 billion in losses is that so much is tied to residential mortgage-backed securities (RMBS). Banks loaded up on these when interest rates were lower. The easy credit made it easier for banks to acquire larger debt tranches and the underlying assets were also easier to sell. Making such heavy investments in RMBS now threatens to boomerang back on banks and investors in a big way.
Many of those HTM portfolio loans are approaching maturity dates and high interest rates are slowing sales down in the AFS portfolios. That’s why the potential losses are beginning to stack up. Increased financing costs are consuming massive chunks of what used to be profit and Investors are wary of buying RMBS in the current environment.
This decreases the value of bank-held RMBS while increasing the potential losses on the underlying assets. Being upside down on large AFS or HTM portfolios has taken banks down. In 2023, unrealized losses on First Republic Bank’s commercial loan portfolios were a major contributor to the bank’s eventual collapse and takeover by JP Morgan Chase.
Banks may have been able to carry these balances in years past, but one of the major reforms instituted after 2008 is making that much more difficult. U.S. banks must submit to periodic “stress tests” where their liquidity is weighed against outstanding debt and liabilities. If those numbers are out of line, the bank could be forced to close or make major markdowns.
If that wasn’t enough, banks have more potential for major losses in other areas, specifically in treasury and corporate bonds. Cryptopolitan cited Bank of America’s recent admission that it lost $85 billion in its bond portfolio this year. Worse still, Bank of America has taken a $116 billion hit to its HTM portfolio in the last three years. They are not alone.
According to Cryptopolitan’s research and public filings, 47 of the 1,027 American banks with assets over $1 billion have potential liabilities and losses on their books totaling more than 50% of the bank’s capital equity. At the moment, it’s important to stress that these are unrealized losses, which means that the banks holding the paper aren’t necessarily going to lose it, but that they could.
If the worst-case scenario came to pass, the banking industry and the economy would be in crisis. That said, the future is difficult to predict and much of what happens next will depend on what the Federal Reserve does with interest rates going forward. If rates remain steady or continue falling, some analysts believe that banks may be able to cut their unrealized losses by up to 25%.
That would knock billions of these unrealized losses off the books. On the other hand, if interest rates go back up, the long-term outlook could change for the worse very rapidly. In either case, anyone invested in RMBS or big bank shares should watch this sector carefully over the next 18 months. They could be in for a very bumpy ride.
The current interest rate environment has created an incredible opportunity for income-seeking investors to earn massive yields, but not through publicly-traded REITs.
