How US banks can wiggle out of the $650 billion balance-sheet bomb hanging over them

• US banks are sitting on an estimated $650 billion in unrealized losses on their bond holdings.
• The surge in interest rates over the past 18 months drove bond prices lower, leading to bank failures earlier this year.
• Here's why banks have flexibility in making sure that their $650 billion balance sheet bomb is defused.

US banks have a ticking time bomb sitting on their balance sheets to the collective tune of at least $650 billion, but it will likely be defused rather than explode.

The banking sector, which has been rocked by five bank failures this year, has to grapple with the ramifications of buying trillions of dollars worth of low-yielding Treasury bonds prior to the start of the Federal Reserve's aggressive interest rate hiking cycle. Because bond prices fall as yields rise, the value of these holdings has plummeted since the Fed started hiking rates.

But banks have flexibility in ensuring that massive unrealized losses sitting on their balance sheets don't become realized, like they did for Silicon Valley Bank, First Republic Bank, and Signature Bank, which all failed earlier this year, partly as a result of tanking fixed income portfolios.

Here's how banks got into their $650 billion mess, and how they can maneuver avoid another financial catastrophe.

What happened?

A perfect storm brewed for banks after the outbreak of the pandemic, as consumers were flush with cash from the combination of stimulus checks and spending less money during the COVID-19 lockdowns.

Consumers poured their excess savings into US bank deposits, and the banks invested those deposits in low-yielding government debt. By the end of 2021, US banks held more than $4 trillion in government debt that yielded less than 2%.

Then interest rates started to surge, with the 10-year US Treasury yield tripling to more than 4.5% in less than two years. That sudden interest rate shock sent bond prices plunging, leading to a spate of bank failure and eventually to one of the biggest market crashes market history.

That plunge in bond prices was bad news for US banks with sizable fixed income portfolios, as the market values of their assets cratered. The bond crash culminated in an estimated $650 billion in unrealized losses held by banks, according to Moody's.

Bank of America alone had $131.6 billion in unrealized losses sitting on its balance sheet at the end of the third-quarter, which is more than half the value of the company's $218 billion market capitalization.

How banks can defuse their balance sheet bomb

Despite the massive unrealized losses, banks are looking at three scenarios that could help ensure losses aren't realized.

First, banks could simply hold onto their low-yielding debt until it matures and not realize any losses at all. Unlike Silicon Valley Bank, many firms won't be forced to sell in order to cover deposits that are rapidly being pulled by customers.

"The question is how many banks invested too far out on the Treasury yield curve? Most banks likely kept their duration risk under three years, so I suspect that those losses might be overstated," market expert Louis Navellier told Insider.

Second, banks can sell some or all of their low-yielding debt and reinvest the proceeds in today's higher yielding bonds if they determine that interest earned from the higher-yielding debt would outweigh the losses realized on the bond sales.

"It puts them in a difficult situation because if they sell the asset, they have to book the loss which hurts their earnings and could require a potential recapitalization of the balance sheet," AlphasFuture founder Geetu Sharma told Insider. "On the other hand, if they continue to hold the asset to maturity, that capital is blocked and cannot be invested into higher return opportunities as available today in the market, impacting their future earnings."

Third, banks could see the value of their bond assets increase and their unrealized losses decrease if interest rates move lower from current levels, like they have over the past two weeks.

"If interest rates have peaked as markets are currently implying, banks could be seeing a reduction in some of these losses going forward," Sharma said.

Finally, any resurgence of risks in the banking sector will be closely monitored by the Federal Reserve, and emergency funding arrangements could once again be offered to prevent another banking crisis from spiraling out of control.

"The Fed is likely to be on top of it, will protect customers and save the bank, as the Fed Put exists," Sharma said, referring to the idea that the central bank would likely step in to stem any extreme turmoil in across markets out of fear that it could destabilize the economy.

What it means for the banking sector

Banks are in a tricky spot as they manage their multi-trillion dollar pile of low-yielding debt, but barring another crisis of confidence in the banking sector, they should be able to escape this period without realizing any losses.

But it's the money that they could have been making had they not piled into such low-yielding debt that will weigh on investor sentiment in the sector going forward.

This is reflected in the stock performance of the banking sector, and it's showing no signs of recovering anytime soon, even as interest rates edge lower in recent weeks.

The SPDR S&P Bank ETF is down about 20% year-to-date, while the SPDR S&P Regional Bank ETF is down 30% over the same time period.

"Banks are exposed to lower earnings whether they realize it or not, markets may be pricing that in," Sharma said.