How High Interest Rates Turn ‘Paper Losses’ Into Real Ones

If you borrowed money to invest in bonds, waiting for them to mature will cost a bundle.

Published in The Wall Street Journal with Paul H. Kupiec.

Thanks to a sharp rise in interest rates since March 2022, the financial system is facing eye-popping mark-to-market losses on its fixed-rate assets. These include more than $1 trillion of market-value losses on the Federal Reserve’s portfolio of bonds and mortgage securities—and according to some estimates, a $2 trillion market-value loss on the fixed-rate securities and loans of the banking system.

Central-bank officials suggest that we needn’t worry, because these unrealized “paper” losses won’t translate to cash losses if the underwater investments are held to maturity. Though the market price is down today, the thinking goes, an institution will receive 100 cents on the dollar if it holds its security to maturity and thus won’t incur a loss.

The argument is appealing yet superficial. The notion that these are “simply paper losses” doesn’t hold up in the real banking world, where investments are financed with short-term borrowing. Even when underwater investments are held to maturity, a mark-to-market loss is a forecast of future high cash interest costs on the funds borrowed to finance the investment.

Suppose that in 2021, when the Fed had kept short-term interest rates near zero, you borrowed money to buy a seven-year $10,000 U.S. Treasury note yielding 2%. In 2023, when the note had five years remaining, the central bank raises the interest rate to 5%. The market price of your note drops from $10,000 to about $8,700, for an unrealized loss of $1,300 and a 13% decline in market value. This is about the same as the year-end mark-to-market discount the Fed has disclosed on its long-term investments.

Like the Fed, you may believe this $1,300 unrealized loss is merely a paper loss since the note will be held to maturity, when it will pay $10,000. But that neglects that you, like the Fed, funded the note with short-term borrowing that must be continually renewed at a cost of 5%.

If interest rates stay at 5% for the next five years, you will receive a 2% yield—or $200 a year in interest—but will pay 5%, or $500 a year, in interest on your debt. Holding the note costs 3% of $10,000, or $300 a year. Over the next five years, the total cash loss to carry this note to maturity will be $1,500, or a loss of 15% of your original investment, even though you never sold your Treasury note and it matured at par. This is a net cash loss with the cash gone forever.

This example is no doubt simplified by assuming a flat yield curve and ignoring fluctuating interest rates. But it nevertheless correctly demonstrates the economics of large mark-to-market losses on leveraged fixed-rate assets held by the Fed and many banks. The soaring costs of financing underwater held-to-maturity investments will generate large operating losses on these investments. If short-term interest rates continue to rise, the loss will be larger. Lower rates would stem the bleeding, but as long as they exceed 2%, holding the note in our example will generate a cash operating loss.

For the Fed and commercial banks, there are some funding sources that impose no or minimal interest costs. The central bank can issue paper currency that bears no interest but in amounts limited by the public’s demand for paper money. Banks can fund some of their investments with transaction deposits, which pay little or no interest to the account holder but impose deposit insurance and other operating costs on the bank. In both cases, though, these funding sources reduce the cost of carrying an underwater asset.

Now, let’s apply this analysis to the Fed’s investments in Treasury and mortgage securities, which totaled about $8.4 trillion as of year-end 2022. These investments have an average yield of about 2%. About $7.2 trillion have a remaining maturity of more than one year, $4 trillion of which have remaining maturities of over 10 years. These long-term securities account for most of the Fed’s reported $1 trillion in mark-to-market losses.

On the liability side, the Fed has about $2.3 trillion in outstanding currency—i.e., dollar bills—that can be used to fund part of the $7.2 trillion in long-maturity assets. The remaining $4.9 trillion are financed with floating rate deposits and reverse-repurchase-agreement borrowings on which the Fed now pays about a 4.9% interest rate.

The zero-interest-bearing paper currency that funds the $2.3 trillion of these 2% fixed-rate assets generates about $46 billion in annual net interest income for the Fed. The remaining $4.9 trillion in assets also yield 2%, but this income is more than offset by the 4.9% cost of financing these assets and, on balance, cost the Fed $142 billion. Combined, its fixed-rate held-to-maturity investments cost the central bank $96 billion annually. Adding its $9 billion in noninterest expenses, the Fed can expect an annual operating loss of about $105 billion.

A $105 billion annual loss equates to an average monthly loss of $8.7 billion. This estimate mirrors reality. The Fed’s actual net loss year-to-date through March 30 has averaged $8.7 billion per month.

If any institution, including the central bank, borrows short-term to finance long-term fixed-rate investments, large mark-to-market losses aren’t merely “paper” losses. They’re a forecast that holding investments to maturity is going to be extremely expensive.