By Peter Rudegeair and Dan Wilchins
NEW YORK (Reuters) - Bank of America Corp's balance sheet suffered from rising bond yields in the second quarter, suggesting that the second-largest U.S. bank may be more exposed to interest-rate risk than some of its major rivals.
The bank posted a profit for shareholders of $3.57 billion in the second quarter, but on its balance sheet the picture was not as good - its net worth fell by $6.26 billion as a result of investment losses. Rivals JPMorgan Chase & Co and Citigroup Inc both managed to increase their net worth as measured by their book value.
The unrealized losses bode ill for investors hoping Bank of America will increase share buybacks and dividends.
As bond yields - and eventually interest rates - rise, further losses in its portfolio could prevent it from building its net worth, making it hard to convince regulators the bank can return more capital to shareholders.
Bank of America appears to have used mortgage bonds in an investment portfolio to bet yields would stay stable and relatively low, say analysts who studied the size and composition of its holdings.
It lost that bet. U.S. bond yields surged after Federal Reserve Chairman Ben Bernanke said the bank would taper its latest bond buying programs. Bank of America booked some $5.73 billion of paper losses from these securities in the quarter, and still held about $170 billion as of June 30.
Those losses and others were in a portfolio, known as the "available-for-sale" book, which affects a bank's balance sheet but does not affect earnings.
The Charlotte, North Carolina-based bank also may have made similar, large bets about rates in the derivatives markets that will lead to more losses if yields rise, analysts said, based on the bank's prior disclosures.
"Every bank has their risk where they're willing to go out on a limb, and rate risk is what Bank of America is willing to go out on a limb for," said Charles Peabody, a partner at Portales Partners, an equity research and trading firm.
According to Peabody's estimates, Bank of America has a higher percentage of residential mortgage-backed securities in its available-for-sale portfolio than JPMorgan and Citigroup. Higher exposure to RMBS implies it has greater exposure to rising rates.
"They shine at taking rate risk over time, but it can come back to haunt them, too," Peabody said. He rates Bank of America an "underperform," and last month correctly predicted that the bank would generate billions of dollars of losses in its available-for-sale portfolio.
Bank of America spokesman Jerry Dubrowski declined to comment.
For this year, the bank already has approval from regulators to buy back up to $5 billion in common shares and redeem approximately $5.5 billion in preferred stock.
By some measures, the bank is building capital, and is ahead of rivals. For example, Bank of America boosted its capital levels under new international rules, known as Basel III, above those of JPMorgan. Regulators consider multiple measures of capital and leverage in assessing a bank.
GOOD AND BAD SCENARIOS
As of Wednesday, investors seem to be more pleased with the bank's lower operating expenses and higher revenues than worried about any decrease in tangible book value. Bank of America shares closed at $14.31, their highest level since March 2011.
Many investors also hope that bond yields have stabilized at higher levels. So far this month, the 10-year U.S. Treasury yield has remained relatively flat at 2.49 percent. It rose 0.87 percentage points to 2.49 percent between May 3 and the end of the second quarter.
In this scenario, Bank of America may be able avoid hits to its balance sheet from losses in its investment portfolio and deflect criticism from investors.
Continued growth in earnings would also offset those unrealized losses. Chief Financial Officer Bruce Thompson said it would likely take three years for net interest income to offset the decline in its securities portfolios due to the rise in yields.
"You're going to have earnings improving, which is what the markets are going to be looking at. It just takes a little time to get there," said Marty Mosby, an analyst at Guggenheim Securities.
But in a worst-case scenario, one of minimal economic growth coupled with rising bond yields, the bank's income could be squeezed and it could suffer further investment losses. Both of those factors would decrease bank capital.
Declines in the value of the bank's available-for-sale portfolio have another impact on its books: they prevent the bank from using tax benefits it has accumulated, known as "deferred tax assets."
Bank of America's rate risk has spooked some investors.
"Rising rates will not be a benefit for Bank of America or any big bank in the short-term. That's why we're staying away," said Malcolm Polley, chief investment officer at Stewart Capital Advisors, which has about $1.1 billion under management.
(Editing by Paritosh Bansal, Peter Henderson and Edwina Gibbs)