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Banks Realize Securities Are Like a Box of Chocolates


You never know what you're going to get -- in both loan and investment portfolios.

Editor's Note: This article was originally published on the Buzz & Banter. It's being reposted here for the benefit of the Minyanville community.

This morning's Wall Street Journal has an article raising questions about what's in bank securities portfolios.

A couple of quick thoughts:

First, the whole notion behind bank investment portfolios is liquidity risk management. In theory, the investment portfolio is there to provide a liquidity cushion because loans aren't liquid. But needless to say, in our recent credit bubble, bank treasurers, like bank loan officers, had to take more, not less risk, in order to make a decent return. And because most bank treasurers don't have a credit background, I expect that most relied heavily on the rating agencies for "approval."

Second, during the past 12 months, as market values plummeted on the various securities held in bank investment portfolios, banks chose to move a significant portion of their portfolios from "available for sale" (marked to market) to "held to maturity" for accounting purposes, believing that the underlying cash flows of the securities were far superior to what the market values would suggest. Effectively securities became loans -- both for liquidity purposes and for gain/loss purposes. Once "held to maturity," they must (in theory) really be held to maturity -- so a significant portion of the liquidity protection was reduced. But the transformation to "held to maturity" also means that most losses will be forthcoming.

Third, and probably most important, beyond the obvious issues of uncertainty, the disconnect between market values and held-to-maturity values creates a huge problem for the FDIC. When a bank fails, the only "value" that matters is market value -- as the FDIC seeks to find a new buyer for the assets. No buyer that I know is going to pay the "held to maturity" value for bank investment portfolios, but is instead going to demand a discount to the current market value. And that difference becomes a cost to the FDIC.

With the huge losses taken by the FDIC, it appears that the FDIC now understands that they have valuation risk in both loan portfolios and investment portfolios. And I believe that with or without Congress' approval, the FDIC is looking harder and harder at market values versus reported values. And the net result is likely to mean more, not less capital required for most banks across the country until the 2 figures better align.
Positions in SPY and JPM.
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