4/13/2022 - By Joshua Jackson, CPA
Over the last three months, unrealized losses in available-for-sale (AFS) securities portfolios have accelerated at a staggering rate. The graph below illustrates the remarkable downward trend in valuations since January 2022.
Unrealized losses in AFS portfolios across the banking industry are at their highest levels since July 2009, and likely from even earlier, as shown below.
Of course, smaller institutions can make the “AOCI opt-out” election for calculating regulatory capital ratios, but let’s be honest, nobody likes to see a large and growing debit balance sitting in their equity accounts. As a community banker recently asked, “How can we stop the bleeding?” One option being explored more frequently today is the transfer of AFS securities into the held-to-maturity (“HTM”) category. Of course, this option does not immediately eliminate the other comprehensive income (“OCI”) component of unrealized losses from equity, but it does “stop the bleeding”, so to speak. A simplified example of such a transfer follows below, which assumes a remaining maturity term of five years on securities transferred and no principal paydowns.
Essentially, unrealized losses formerly recorded as fair value adjustments to amortized cost are transferred to and netted against the unamortized purchase premiums (or discounts) at the time of transfer resulting in a new premium (or discount) balance, consistent with ASC 320-10-35-10. In addition, the deferred tax assets arising from unrealized losses, as well as the OCI component in equity, become frozen at the time securities are transferred. These items, along with the new amount recorded as purchase premiums, are amortized over the remaining lives of transferred securities in a manner consistent with the amortization of any premium or discount. Keep in mind that amortization will not necessarily be on a straight-line basis for certain asset-backed securities with principal paydowns, as prepayment speeds, interest rates and other factors affecting asset lives can change rapidly.
Below are examples of journal entries that would be made in Year 1 of the transfer scenario presented above:
As previously mentioned, this topic is gaining traction in management discussions and strategic sessions at many institutions. If this type of classification change is an option your team is currently evaluating, a few quick summary points to consider include the following:
At Saltmarsh, we understand the strategic challenges currently facing the financial institutions industry and our team stands ready to assist you in navigating these uncertain times. If you have any specific needs, or simply need to use us as a sounding board, please do not hesitate to contact a member of our Financial Institutions team.
About the Author | Josh Jackson, CPA
Josh is a senior manager in the Financial Institution Advisory Group of Saltmarsh, Cleaveland & Gund. He has over 18 years of public accounting and financial services experience, primarily serving financial institutions. Josh has extensive experience in delivering accounting services, external audits, directors’ examinations and agreed-upon procedures, loan and credit quality reviews, internal audits, due diligence projects related to mergers and acquisitions, and other consulting services. Prior to rejoining Saltmarsh in 2020, Josh served in various management roles in private industry, including the role of Chief Financial Officer.