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The rise in bond yields in the United States over the past couple of months has put larger commercial banks in a bind. "Bond instruments now comprise nearly 99 percent of the $1,159 trillion investment portfolios held by the top four banks, according to Charlottesville, Virginia, data provider SNL Financial," writes Dan Fitzpatrick and Shayndi Raice in the Wall Street Journal.

For the banking system as a whole, Treasury and Agency securities, in the banking week ending July 17, made up just under 70 percent of the security holdings of domestically chartered commercial banks according to Federal Reserve data.

The article mentioned above continues, "Banks in recent years piled into bonds in search of returns to make up for lackluster loan demand and billions in annual income lost to new U. S. regulations."

The problem arises, as usual for financial institutions, because expectations were broken. Up until early May, the financial markets seemed to expect that the yields on longer-term US Treasury issues would remain at relatively low levels. The 10-year US Treasury notes yielded around 1.60 percent on the first of May.

Then, however, large amounts of money from Europe that had sought a safe haven in the United States began to return to the continent. (See my post of May 28.) The 10-year US Treasury inflation-protected bonds went from a negative 70 basis point yield in early May to a positive yield of almost 60 basis points in late June.

Over the same period of time the yield on the regular 10-year Treasury bond went from just above a 1.60 percent yield to around 2.60 percent, a full 100 basis point rise into the end of June.

And, yields have stayed near these levels through July, with the yields on the 10-year TIPS trading around a positive 40 basis points and the 10-year Treasury note staying around 2.60 percent. A major reason for this is that the flows of funds out of the US market into the European market have remained high.

Even though the Federal Reserve has modestly backed-off its statements about "tapering" it's monthly purchases of open market securities, bond prices have not recovered from the losses that have occurred over the past two months. And, on this Thursday morning, bond prices remain firm.

Fitzpatrick and Raice write

JPMorgan Chase & Co. (NYSE:JPM), Bank of America Corp. (NYSE:BAC), Citigroup Inc. (NYSE:C) and Wells Fargo & Co. (NYSE:WFC) saw a measure of the paper value of these holdings fall by more than $13 billion during the second quarter…

The second-quarter losses didn't affect banks' earnings because of a quirk in accounting rules that allows institutions to keep any paper losses on long-term bonds out of the profit-and-loss equation…

But analysts said the unrealized accounting losses, which result from a quarterly evaluation by the banks of how much the securities are worth, could hurt banks in the long run…

A Keefe, Bruyette & Woods presentation, Fitzpatrick and Raice report, showed that data from the Federal Reserve showed that "From early May through July 17, more than $37 billion in unrealized accounting gains vanished, leaving paper losses of more than $3 billion (to the banking system…"

In addition, Fitzpatrick and Raice report on a presentation made by Zions Bancorp, a bank that holds $54 billion in assets that asserted "the amount of capital held by the (banking) industry would drop by $200 billion to $250 billion if long-term rates were to rise by three percentage points. That would result in $2 trillion of reduced lending capacity."

I believe that this information highlights the fragility of the domestic banking system when facing the potential "tapering" of Federal Reserve security purchases.

The Federal Reserve is trying to tell us that "tapering" is nothing more than a driver who had been driving very fast easing up on the gas pedal. They argue that the car will continue to race along…but just at a slightly slower speed.

In my view, participants in financial markets build up expectations of what will be taking place in the future and take actions accordingly. The Fed has indicated in the past that it would continue to buy $85 billion in securities every month and keep short-term interest rates at very low levels for "an extended period of time."

Participants in financial markets, including banks, took the Fed at its word and built a portfolio based on these expectations.

As a consequence, Federal Reserve "tapering" is seen as a tightening up of monetary policy and implies higher interest rates in the future.

Add this on top of the movement of funds from the United States back to Europe and you have a scenario for longer-term interest rates going higher and staying there. I have tried to capture this in a recent post.

One potential side effect of a rise in interest rates that would impact the balance sheets of commercial banks is that it would make the banks more reluctant to lend. This would just add further constraint on improving economic growth because bank lending is seen as a necessary ingredient for a more robust economic performance. Even now, bank profits have not been a result of core bank business.

So, we continue along into the future but only modestly. Economic growth continues, but major firms and industries continue to be "wounded" and not in not complete health and are still facing uncertainty about the future of governmental economic policies.

The uncertainty, I believe, also extends to our policymakers. The officials at the Federal Reserve must be totally on edge these days. They have helped to create the environment we are now in…and must…somehow…get us out of the situation without causing other, major dislocations in the economy.

Source: Banks And Bonds