The Blubber

A particularly alarming aspect of the potential $750 billion in losses is how much is tied to residential mortgage-backed securities (RMBS). Banks heavily invested in RMBS when interest rates were lower, as easy credit made it simpler to acquire large debt tranches and sell the underlying assets. However, these investments now pose a significant risk, threatening to backfire on banks and investors.

Many of the held-to-maturity (HTM) portfolio loans are nearing their maturity dates, while high interest rates are slowing sales in the available-for-sale (AFS) portfolios. This is why potential losses are mounting. Rising financing costs are cutting into what used to be profit, and investors are increasingly hesitant to buy RMBS in the current market.

This devalues the RMBS held by banks and raises the potential for losses on the underlying assets. When banks find themselves upside down on large AFS or HTM portfolios, it can lead to collapse, as was the case with First Republic Bank in 2023. The bank's unrealized losses in its commercial loan portfolios were a major factor in its downfall and subsequent acquisition by JP Morgan Chase.

Banks once carried these balances more easily, but post-2008 reforms have made it harder. U.S. banks now undergo periodic "stress tests" to assess their liquidity against debt and liabilities. If a bank's numbers are misaligned, it may be forced to close or significantly mark down its assets.

The risks don’t stop there. Banks also face potential major losses in treasury and corporate bonds. Cryptopolitan recently reported that Bank of America lost $85 billion in its bond portfolio this year, and over the past three years, its HTM portfolio has taken a $116 billion hit. They’re not alone. Public filings and research indicate that 47 out of 1,027 American banks with assets over $1 billion have potential liabilities and losses exceeding 50% of their capital equity. These are still unrealized losses, meaning the banks holding these assets haven’t necessarily lost money yet, but they could if conditions worsen.

If the worst-case scenario unfolds, the banking industry and economy could face a crisis. However, the future is uncertain, and much depends on the Federal Reserve's actions regarding interest rates. If rates stabilize or fall, some analysts believe banks could reduce their unrealized losses by as much as 25%, easing some of the pressure. On the other hand, if rates rise again, the long-term outlook could quickly deteriorate.

For anyone invested in RMBS or major bank stocks, this is a sector to monitor closely over the next 18 months, as it could be a turbulent period.