Tucson-area banks grapple with falling bond values

Like banks and credit unions across the nation, Tucson-area institutions are coping with a major challenge that contributed to the failure of three banks in March — potential losses on their bond investment portfolios due to rapidly rising interest rates.

Overall, financial institutions serving the Tucson region continue to meet regulatory capital requirements, despite significant paper losses on their bond holdings in some cases.

Banks are taking steps to boost liquidity — the ability to quickly access cash to cover their obligations — without having to sell off bond assets at a steep loss.

Most banks and credit unions have seen the value of their bond portfolios plunge as the Federal Reserve Board has rapidly raised the interest rates it charges banks since March 2022, in a bid to tame rampant inflation.

That’s because as interest rates rise, the value of existing bonds tends to fall.

By the end of 2022, the Fed’s aggressive interest-rate increases — totaling 4.5 percentage points — had resulted in unrealized losses on debt securities totaling $620 billion across the federal banking system, regulators say.

And while those losses aren’t realized until the bonds are sold, the huge potential losses on a bank’s balance sheet can spook investors and depositors, said Christopher Lamoureux, Diamond Professor of Finance at the University of Arizona’s Eller College of Management.

“They’re holding long-dated U.S. Treasury securities, so there’s no default risk,” Lamoureux said. “However, they do have what we call duration exposure, when rates go up, and their value can come down and depositors or lenders observe this and they’re fearful that others are doing the same. Then they may feel that it makes sense to jump ship before they’re left holding the bag.”

Run on the bank

That happened to Silicon Valley Bank, which failed in early March after accumulating unrealized losses on its bond portfolio of about $15 billion — nearly equaling its total capital reserves.

After announcing a loss of nearly $2 billion on a sale of government and mortgage-backed bonds on March 8, SVB suffered a “bank run” in which more than $40 billion was withdrawn in a day.

SVB catered to tech startups and venture capitalists and had a relatively small number of very large depositors, exacerbating fears over the safety of uninsured deposits.

A couple of days later, Silicon Valley Bank was seized by regulators and placed in receivership under the Federal Deposit Insurance Corp. Fearing a contagion of bank runs, regulators later decided to cover deposits beyond the $250,000 limit per account. SVB’s banking business was acquired by North Carolina-based First Citizens BancShares in late March.

Unrealized losses are just that — unrealized, until the underlying assets are sold — and banks can hold things like Treasury bonds until maturity and recover the principal amount.

But if banks need money fast, they may be forced to sell their devalued bonds at a loss.

That happened to California-based Silvergate Bank, which catered to cryptocurrency firms.

In the wake of the bankruptcy of crypto exchange operator FTX in November, Silvergate was hit with a bank run and sold off debt securities to cover deposits, taking a $718 million loss on $5 billion in sales. In early March, the bank announced it would voluntarily liquidate and return remaining deposits.

A third bank that failed in March, New York-based Signature Bank, was also heavily dependent on cryptocurrency customers, though its unrealized bond losses were relatively modest.

To help banks avoid runs by depositors, federal regulators have launched new loan programs to assure banks can get the cash they need to avoid selling off assets at huge losses.

Meanwhile, several national and large regional banks are under review by major credit raters, due partly to their significant paper losses on bond investments, including Zions Bancorp, which owns National Bank of Arizona and Western Alliance Bancorporation, which operates as Alliance Bank of Arizona.

The UA’s Lamoureux said bank executives should have had ample time as the Fed raised rates to adjust their bond portfolios to limit their risk.

He likened the situation to the savings and loan crisis of the 1980s, when interest rates rose rapidly and S&Ls saw the value of their long-term, fixed-rate mortgages plummet.

“It’s quite shocking to me that any bank would have put so much into long term Treasurys. Why would you buy a 10-year note yielding 3% or a 30-year bond yielding less than 3½ percent?” he said, adding that the Fed was “quite transparent” about its intention to raise interest rates amid spiraling inflation.

Local banks respond

The leaders of two Tucson-based community banks that recovered from major financial challenges in the aftermath of the Great Recession say the banks remain financially strong despite their unrealized bond losses.

Commerce Bank of Arizona reported about $5.9 million in unrealized losses on debt securities available for sale at year-end 2022.

Paul Tees, Tucson market president for Commerce Bank, said the bank remains well-capitalized, with a key regulatory measure called Tier 1 leverage capital ratio of 10.31% at the end of 2022, easily meeting a minimum required 5% ratio.

Banks with total assets of $250 billion or less — most U.S. banks — can opt out of counting their unrealized losses on debt securities like bonds against the regulatory capital reserves, though they must report them.

Commerce’s bond portfolio is largely made up of agency-guaranteed mortgage bonds, which carry no credit or principal risk, and provide principal payments every month, Tees said, in contrast to long-dated “bullet” bonds or Treasury bonds that don’t pay back the principal until their final maturity date.

The gain or loss on the portfolio fluctuates as bond yields, or returns, move up or down and has no bearing on the bank recovering its principal amount, he said.

“There is no projected need to sell anything at a loss,” Tees said. “We are confident in this because the bank has abundant alternative sources of liquidity from various sources.”

He cited the Fed’s new $25 billion Bank Term Funding Program, created to provide liquidity at fixed rates secured by bank bond portfolios.

Commerce, which raised additional capital under a regulatory order in 2013, has maintained its five-star, or “superior” rating from Bauer Financial in the Florida-based rating agency’s most recent ratings.

Cash reserves

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Tucson’s other locally-based bank, Canyon Community Bank, also is in good position to weather any future bond losses, president and CEO Bo Hughes said.

Canyon, which has $197 million in assets, reported $963,000 in unrealized losses on bond assets available for sale at the end of 2022.

Hughes said the bank cut its unrealized bond losses to about $800,000 in the first quarter and that represents just 2% of Canyon’s overall capital.

Once locally-owned, Canyon raised $9.5 million from a Texas-based investment holding company in 2015 for a controlling stake in the bank, satisfying a 2013 order by federal regulators to raise its capital resources.

Since then, Canyon is one of the state’s most highly capitalized banks, and any future bond losses won’t change that, Hughes said.

Canyon’s leverage ratio, a key measure of capital reserves, was 11.6% at the end of 2022, while banks are generally required to maintain a leverage capital ratio of at least 4%.

The bank maintains extraordinary liquidity, with more than $40 million in cash, and had a strong first quarter, Hughes said.

“We are extremely well capitalized and finished the quarter in a strong liquidity position thanks to the deep relationships we have with our clients,” Hughes said.

Like many banks, Canyon has reached out to depositors and employees to assure them the bank is safe, Hughes said.

In a message to employees, Hughes noted that SVB and Signature Bank had exposure to the crypto/tech sector, large bond portfolios and concentrated deposit bases that exposed them to catastrophic trouble as interest rates rose.

Credit unions cope

Credit unions aren’t immune from the interest-rate risk.

Tucson Old Pueblo Credit Union reported $7.8 million in unrealized bond losses at the end of 2022, more than half of its equity capital of about $15 million.

The credit union has about 18,000 members and had total assets of about $223 million at the end of 2022.

Vernon Babilon, Tucson Old Pueblo’s president and CEO, said the credit union remains in the “well-capitalized” regulatory category and it is carefully managing its bond portfolio.

Babilon noted that its available-for-sale bond holdings are safe, short-term investments backed by the federal government either through Fannie Mae, the government-charted mortgage lender, or the Federal Deposit Insurance Corp.

“These funds are available for sale if TOPCU needs the liquidity to fund loans or meet withdrawal needs,” he said, adding that the credit union has not needed to do so.

TOPCU also has $49 million in available lines of credit for short-term borrowing, Babilon said.

“The utilization of the lines of credit allows for investments to pay off at maturity with no realized market loss, while adequately meeting loan demand,” he said. “There will be no realized loss to the credit union or the members as long as investments are held to maturity, which we have prudently managed.”

Babilon said TOPCU remains operationally strong, with healthy growth in deposits and loans and a higher-than-average net interest margin, the spread between the average yield on loans and investments and the average cost for deposits and borrowings.

For 2022, TOPCU outperformed an Arizona peer group of credit unions from $100 million in assets to $300 million in assets in many areas including deposit retention and growth, loan growth and operating revenue to operating expense ratios, Babilon said.

Unneeded angst?

Hughes and other bank executives say that while concerns remain, banks are capable of managing their bond losses.

“I think as a general statement, Arizona banks are strong, and I don’t think this is the same as the 2008 crisis, because the fundamentals are totally different,” Hughes said. “Sometimes, our big media, you know, CNN, Fox, can spin things up in a way that creates more angst than is necessary.”

That angst has hit many banks hard.

Western Alliance, which operates two Alliance Bank of Arizona branches in Tucson, saw its stock price plunge and an outflow of deposits after the bank failures, prompting a review by credit-rating agencies.

The bank holding company saw its stock price fall from around $72 per share to around $26 in mid-March as SVB collapsed, before stabilizing in the $30-$32 range last week.

In an April 4 update, Western Alliance said that its deposits had stabilized after an outflow of 11% and that it had arranged more than enough liquidity to cover any bond losses.

Protecting your money

Even when a bank fails, depositors are protected by FDIC insurance up to $250,000 per account. Credit union deposit accounts also are insured up to $250,000 by the National Credit Union Share Insurance Fund, operated by the National Credit Union Association.

“Let’s say you might have $500,000 in a bank,” the UA’s Lamoureux said. “It would make sense to split that across the couple of banks so that you don’t have more than $250,000 in any one institution. In terms of the institution itself, if it’s a member of the FDIC, then you’re safe.”

Banks have made it easier to stay under the insurance limits by setting up networks where individual investors can seamlessly place deposits at different banks.

Commerce Bank’s Tees said the bank is part of the Certificate Deposit Account Registry Service, or CDARS, which can place up to $50 million in certificates of deposit under the insurance limits in different banks, and the Insured Cash Sweep program, which operates similarly with money-market accounts.

“The client can take a million dollars and then what we do is we break it off into smaller $250,000 pieces and send them to other banks,” Tees said. “Essentially, it still stays in our portfolio but it allows you to get the full FDIC insurance.”

The FDIC also offers the online Electronic Deposit Insurance Estimator or EDIE (edie.fdic.gov), that calculates on a per-bank basis how the insurance rules and limits apply to a depositor’s specific group of deposit accounts — what’s insured and what portion (if any) exceeds coverage limits at that bank.