Treasury Downgrade Might Chip Away At Banks' Capital

A decline in the value of Treasury securities due to a downgrade in the U.S. credit rating could lower critical capital ratios at banks large and small.

While declining Treasury prices wouldn't put any major banks in regulatory intensive care, they would chip away at the cushions that are a key barometer of bank health. Such sizable banks as Bank of New York Mellon Corp. (BK) and Bank of America Corp. (BAC) could, in an extreme case where Treasury prices fall by 10%, have a key measure of capital decline by about one percentage point and nearly 0.9 percentage point, respectively, according to a study Thursday by Macquarie Equity Research.

The average bank holds 10% of its assets in Treasury bonds and notes and bonds issued by government agencies like Fannie Mae (FNMA) and Freddie Mac (FMCC), according to Macquarie. The holdings are sizable because banks like securities commonly believed to be among the safest investments.

Macquarie gauges in the report how much banks' capital would decline if bond values fall--and for some banks, it could be an unpleasant hit. The cost of hedging derivatives and interest-rate risk could also rise, and revenue in the mortgage business could fall, the firm said.

The tier 1 common capital ratio of Bank of New York Mellon, for example, could slip more than a percentage point if the value of Treasury and other agency securities on its books could decline by 10%, according to Macquarie the worst case scenario.

Tier 1 common capital has become one of the most important ratios to evaluate a bank's health, and is closely watched by regulators, even though tier 1 capital is still the benchmark for a bank to be considered "well capitalized," the critical regulatory seal of approval. Tier 1 capital includes certain intangible assets stripped off tier 1 common ratios, and is measured as a percentage of assets.

Ratings agencies have warned they could strip U.S. government bonds of their triple A rating if the government can't agree on how to handle the nation's fiscal deficit. Bonds ratings tied to Fannie and Freddie could also fall in lock step. It is unclear what impact a downgrade of such securities might have on their value; the Macquarie report looked at the effect of market value declines in U.S. debt bonds of 3%, 6% and 10%.

Bank of America, the nation's largest bank by assets, wouldn't lose as much of its tier 1 common capital as some other banks if Treasurys declined. Under Macquarie's worst-case scenario, its tier 1 common ratio could slip 88 basis points to 7.76%.

But some smaller banks Macquarie follows might get hit much harder. The tier 1 common ratio of CoBiz Financial Corp. (COBZ), a small regional bank in Denver, would decline 153 basis points, to a rather thin 4.81% tier 1 common capital ratio. Regulators required 4% tier 1 common in recent stress tests for large banks.

SVB Financial Group (SIVB), a healthy bank focusing on banking start-ups and their venture capitalists, could see its tier 1 common ratio slip by 336 basis points, to 9.5%--still healthy, particularly for a bank too small to be considered systemically important by regulators.

None of the banks mentioned were immediately able to comment on the impact of a downgrade of Treasurys on their capital ratios.

Macquarie analyst Thomas Alonso considers the numbers in its report good news for investors. "For the past two years, the industry has been in capital rebuild mode; there is a whole lot of capital in the industry," so any hit from falling bond prices wouldn't hit banks at the worst time, he said.

The impact on derivatives is harder to gauge, but investors should keep it in mind, Alonso said. Banks don't disclose exactly how they hedge risk.

The impact on the mortgage business also remains uncertain--mortgage rates remain at historic lows and will rise eventually anyway, but an expedited cooling of the mortgage business by rising rates might hurt fragile housing values, which could boost banks' losses from defaulting mortgages, Alonso said.

-By Matthias Rieker, Dow Jones Newswires; 212-416-2471; matthias.rieker@dowjones.com

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