In the most recent discussion of “available for sale securities” (AFS) in the Chemical Financial Corporation case study, a heavy emphasis was placed on the analysis of the accounts and the criteria in which an investment security was classified as available for sale. The AFS securities in the case included US Treasuries, mortgage-backed securities and other conventional debt and equity securities on the balance sheet of the Chemical Financial Corp. Interestingly and surprisingly enough, the balance sheet of CHFC did not list stand-alone mortgages as available for sale investment securities, a common trend within the banking industry today.

In an article written for DailyFinance.com, Jordan Wathen of The Motely Fool, discusses the strategic implications of a bank treating its mortgages as “held to maturity” rather than “available for sale,” which, at first blush seems to be a subtle if not irrelevant  accounting quirk.  Of course, the devil is always in the details, and a bank shifting its loans to “held to maturity” from “available for sale” creates additional risk for the bank (and its investors), because the banks must hold these loans to maturity in an economic environment, marked by, if nothing else, rising interest rates. Rising interest rates could have calamitous effects on the net interest margin of these banks.

The available for sale account allows for banks to hedge interest rate risks by allowing them to sell securities with low yields.  The objective with this strategy would not be to capture return, as loans would likely have to be sold at a discount, but rather to limit losses.  Why would a bank allocate (and hold captive, for that matter) capital with a return of 4%, when its competitors are lending capital at 6%? The held-to-maturity account facilitates that type of strategic blunder, especially in today’s extremely sensitive interest rate environment.

In a somewhat puzzling comparison, JPMorgan Chase smartly holds nearly “all of its investment portfolio as available for sale” while its contemporary, Bank of America Corp, had over $55B in held-to-maturity investments, putting them in a vulnerable position if interest rates do rise. US Bank is following suit with BAC, adopting similar accounting practices, holding nearly 10% of its total assets in held to maturity.  In these bank’s defense, Wathen states that moving assets to held-to-maturity relieves some of the strain of capital requirements, and losses on the accounts are not covered under the jurisdiction of the Basel III regulations.

Whatever the case, these accounts must be analyzed with caution, and banks (and by association, its shareholders) must consider the implications of its accounting decisions relative not just to its own balance sheet and financial statements, but also to the economic climate surrounding its business.  Indeed, there had better be a very good reason why a bank would choose to hand-cuff itself by placing a liquid enough asset into a seemingly restricted held-to-maturity account.

Article: http://www.dailyfinance.com/2013/10/10/1-thing-bank-investors-should-watch-this-quarter/