At the Atlantic Economy Summit in Washington last month, Sheila Bair fielded a question about the just-released results of the latest bank stress tests. The former FDIC chief took pains to point out that they were an improvement over earlier iterations by virtue of keying off a truly dire economic scenario, but then ticked off a number of ways in which they fell short. One was in that they focused solely on credit risk, when historically, adverse interest rate moves have proven very effective in decimating the banking sector. Witness phase one of the savings and loan crisis, in which hasty deregulation and gimmickry in the early 1980s set up the crisis later in the decade, or the derivatives wipeout of 1994, in which an unexpected 25 basis point Fed funds increase created bigger losses than the 1987 crash, or the losses on US bond portfolios in 1997 and 1998, which among other things nearly wiped out Lehman.
The perils of interest rate risk have largely receded from memory since the US has been in a long-term disinflationary trend since 1983. But with rates at zero, we have nowhere to go but up from here.
Chris Whalen, in his latest newsletter, argues that this risk is even nastier than it might appear. One way of mitigating interest rate risk is by holding shorter-dated instruments. The reason is that the more back-weighted your payments are, the more exposure you have to changes in interest rates.
Investors measure this sensitivity via duration. There are somewhat different ways to measure it. One is the weighted average of payments. That gives you a result than under most circumstances is very close to the price sensitivity of a bond to interest rate changes. At “normal” interest rates, a current coupon bond of just under 10 years will have a 10% sensitivity to interest rate changes.
But, as Whalen points out, this all goes haywire when interest rates are super low. So much of the value is in the repayment of principal and so little in the intervening interest payments that it pushes duration out and increases interest rate risk disproportionately. That effect may be further compounded by the fact that banks are desperate for yield and with the yield curve flatish, they are likely to be extending the maturity of their assets.’And of course, anyone holding mortgages will see them extend, since refis will halt and home sales will probably be depressed, since higher interest rates mean more expensive mortgages, which all other things being equal, means lower home prices.
Whalen sets forth his concerns:
For a number of years now, US banks have been loading up on low yielding paper that is a function of the Fed’s efforts to reflate the US economy. Since many Americans are not able to refinance their home mortgage, the Fed’s efforts are not particularly effective, but we are not supposed to talk about housing. Banks and corporations have been able to refinance their debts, lowering interest expenses but also increasing the volatility – that is, the duration — of bonds and related swaps and options.
The trouble with low interest rates is that as coupons fall, the duration on a given bond lengthens exponentially. Whereas the duration on a Fannie Mae 5 or 6 can be measured and managed using traditional interest rate risk management tools, in a low or zero rate environments the effective duration on low or no coupon securities becomes so long and so difficult to manage that hedging becomes problematic.
Keep in mind that most banks today are seeking to maximize net interest margins on an interest rate book where the effective yield is falling. There is little incentive to lend cash or securities to other banks given that rates are zero, so banks simply place their excess cash into government and agency debt that has little cash flow yield and essentially infinite duration risk – risk that cannot be hedged.
“Of course, the banks also own a lot of duration…1.35 trillion of GSE MBS, notes one of the members of our mortgage finance discussion thread. “The Chinese had to sell to someone.” But such levity aside, the fact is that most banks are not even trying to hedge their interest rate books because cash flows on earning assets are so paltry. Thus as and when interest rates do rise, many larger banks that fund themselves in the markets will come under immediate pressure.
Now banks may be able to cover some of this up for a while. They may be able to put these low-yielding assets in a hold to maturity book (as they did in when similarly caught in the 1990s) which will spare them taking mark to market losses. But they’ll still lose money on an ongoing basis if they have assets that yield 3% that they are now funding at 5%.
A reader added another cheery thought via e-mail:
There is also a coming problem for HELOC borrowers – these loans will reset from interest only payments to principal and interest payments in the not too distant future. The HELOC interest only period was typically around 10 years, so that would put the reset dates in 2-3 years for a big chunk of bank portfolio HELOCs. Wells Fargo, in particular, also did a huge amount of convertible HELOCs – in a rising environment, borrowers could convert to fixed rate HELOCs, at the current market rate. This would have the effect of making the par valued variable rate loans convert to below par fixed rate loans for Wells, if rates rise significantly. If it happens at the same time that many of the same loans are also experiencing payment shock due to a conversion to P&I payments, that could get really ugly for Wells with big step ups in both duration and credit risk. Something to look forward to!
Indeed. Of course, if we’ve zombified our economy as well as Japan has, this day of reckoning may be very long in the making. And given the consequences to banks of leaving ZIRP, perennial zombification may be a feature rather than a bug.
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Yves: Check me out, here. Back in the 90s, I think it was, there was hole in the regs for money market funds that allowed them to game the duration rules: they could legally use the first call date as the term length. So, of course, they could go out a lot further than a year because the first call date at a year was within specs but the final due date might be much beyond that. Professional investors chase rates, too. Interest rate changes caused several MMs to break the buck and there was a flurry of alarm. Subsided when the problem with reg language was (so the regulators said) fixed and the firms behind the MMs made good.
However, regulators were moving away from regulating in any investor meaningful way and as time went on, the chiseling and cheating got worse and brazenly open. I remember reading about investor overcharges at several funds that were swept away by the SEC with cavalier unconcern.
What a ridiculous monetary arrangement we have. It forces so many to spend so much of their speculating on interest rates and shifting money in order to preserve their capital.
One way to solve this is to modify the system so the central bank deals directly with the public not the banking system when conducting monetary policy in a non debt based system. Heres a proposal if interested:
internationalmonetary.wordpress.com
@danny:
I could rephrase: Why exactly is our currency provided in a public private partnership in this manner? Why do we use commercial bank money as legal tender, if the benefit those institutions bring to allocating capital and identifying risk has essentially disappeared via TBTF.
I have this dread that the next Minsky moment is going to blow the system apart and ruin a lot of people through a hard reset.
Its ridiculous that profit oriented banks can create money. Its obvious if they do this they will grow to dominate the economy, create imbalances through misguided lending practises and exacerbate business cycles.
Not so ridiculous if you consider the banking system as a mechanism for economic control of the masses. Once the 1% had acquired 80% of all global wealth, it wasn’t really about profit any longer.. there arose a need to store the loot in a fashion which wasn’t subject to the whims of a free market.
no offense, folks,
but all that was predicted in mid-70’s poly-sci classes…
Interesting. This may actually mean that an extended period of ZIRP combined with flat curve automatically creates ZIRP (and flat curve) forever, because any deviation from FC ZIRP would sink the whole banking system.
So ZIRP becomes an absorbing barrier. I wonder whether Krugman would argue then that the banking system doesn’t matter in an economy.. .
At one point there is no reason to work, productivity and output tank.
That’s when inflation takes off.
Regulators are focused on Credit risk which was the bogeyman in 2008 and are telling the banks to keep their money in GSE MBS(contrary to what you may hear). I agree that duration risk is important and it may not be a current focus, but banks do pay attention to it, and it is possible that some of this is hedged via interest rate swaps and other hedges.
Whalen is certainly correct in warning about new bubbles being created by the Fed. Bernanke is doing exactly what Greenspan did in 2001 and he should know, he was Greenspan’s sous chef. And Whalen is certainly correct that continued deficit spending and Fed bubble making are not a recipe for future economic growth.
There is no spare capacity to create more bubbles, ZIRP does not mean necessarily more credit, just the possibility of it, which is prevented by both expectations on the economy and falling incomes.
Total credit stands below 2008 highs, only major propeller has been student debt but in aggregate that’s very low compared to real estate collateralized credit issued in the last decade. It only has served to push a bit debt.
Yes, deficit spending is the great elephant, and its creating a “bubble”… in corporate profits, because that’s where all the money is flowing to (and that helped reflate stock markets too). But in reality these deficits are barely keeping the deflationary trends of the economy from getting through. If it weren’t for commodity speculation in the last few months inflation would be flat, in some places (European periphery) there is outright deflation.
More so if you account for real estate. Problem with this is that liabilities don’t go away, so even if prices fall, this does not translate to households so there is an antisymmetric relation between inflation experienced by households depending on their equity position and leverage.
Overall, if the bubble on corporate profits deflate then the bogeyman of falling rate of profits will make its appearance, because then is when the trouble comes and the system implodes. All the efforts of central bankers and governments are to avoid this problem, which would pose a tremendous problem to the stability of the system, given its leveraged nature and the net of liabilities depending on given (sometimes rising) asset prices. Awful positive feedback loop.
As was written about here, simply by replacing treasuries on with cash on banks balance sheet, no new credit is created, but it does cause risk assets to increase in price and commodities can be a risk asset. The Fed is engineering a bubble by forcing up the price of stocks, high yield debt etc. Bernanke is just another guise of Greenspan.
But it’s all about expectations…
Well, you may get a temporary increase in financial credit (more leverage) , but these are very short lived (months) and respond rapidly to market actions.
The ‘reflating’ effect is not run on an increase in financial assets (including the ‘money’ asset class), just on very short lived expectations of ‘money printing’, ‘QE’ etc. However this does not change the long term trends and price structures, including for risky assets!
So the only thing the FED is accomplishing with this ‘expectation management’ is to create volatility in financial markets, but real business activity and household financial situation is not changing much. In this front the only thing helping corporate profits are big deficits, but monetary policy is helpless (actually, is removing income via the interest income channel, as the FED is ‘crowding out’ the private sector from debt government securities, in its effort to drive market participants to risky assets and reflate the hopeless debt past the peak credit we reached back in 2007 in most of the developed world).
A moderate rise in short term rates, but actually be good for banks as some of the benefits of current ZIRP policy has worn off for the banks hurting their net interest margin. A moderate rise in Fed Funds may help return NIM opportunities. Lastly some banks make money lendin out securities but can’t do so as long as the Fed makes this business a non-business.
ISTR that imperfect hedging of interest rate risk heavily affected Fannie and Freddy when the fed dropped rates lower than anyone imagined possible after the dot com bust. My vague reccolection was that Fannie became “technically insolvent” (as if there’s any other kind) and Freddy had an embarassment of riches that led them to try and “smooth” earnings.
I’ve had humongous concerns about this ever since the Fed first did ZIRP and I was trying to think thru the consequences.
Glad someone else is worried too. Too bad it does not seem to be the Fed that is worried (at least publicly). But maybe Janet thinks she will backstop the banks with ZIRP and QEX, when the day comes?
Course there are the optimistic folks that point out how well this has worked for Japan, and we will be happy zombies too.
But I’m not so sure zombiefication works the same in the US economy as it did in Japan. I think a analysis awhile back by Wolf Richter pointed out some differences where it may not.
We could turn into unhappy zombies!
So, while we are all waiting around for all hell to break loose, and it wiill happen when the FED can no longer recycle their fraud, Bloomberg news talking about fraudclosures and how there has been somewhat of a moratorium on fraudclosures? The question was posed have the banks now “fixed” their paperwork and will there now be a bunch of empty houses? They pretty much danced around the answer and ended up talking about the stuff that’s already been fraudclosed on. So, I guess the answer is no. The truth is that there is no legal or monetary fix for a quadrillion dollars in fraud committed by the FED banks.
Stien’s Law is coming. The absurdities of the last several years will continue until they stop as a result of the math. When it stops all the pain that has been put off will come to fruition.
Currently about 86% of single family mortgages outstanding are fixed rate.
$1.5 trillion ARMs
$8.9 trillion fixed rate
$10.4 trillion total
Per: FHFA http://www.fhfa.gov/Default.aspx?Page=70
The GSEs actively manage their duration gap, which is published monthly.
The problem is disproportionately concentrated in simultaneous 2nd liens and HELOCS, many of which should have been written down by the banks much earlier.
Excellent data, I was wondering precisely about the ARMs. That said, I don’t trust the ARM number is quite so benign even if it’s only 14%. My understanding is that there is a strong correlation of ARM and “Sand State” (ie, California, Nevada, Florida, Arizona) location so the ARM risk is not dispersed. Second, I personally know real estate investors sitting on dozens of underwater investment properties that they’d walk away from in a heartbeat if interest rates rise more than a few points. So far we’ve been spared the “Great ARM Reset Default” wave of foreclosures so many of us feared back in 2008/2009 precisely because of the ZIRP; in fact, one would-be real-estate mogul told me his mortgages payments all went down after the resets in 2010, 2011 etc rather than up since they were pegged to LIBOR or its equivalent, and rates are so low right now.
In addition to ARM-driven defaults, my other great worry is the swap market. One thing that should be clear to anyone post-AIG: all the mathematical models used by the rocket scientists are vulnerable to ‘black swan’ events that can destroy the solvency of the traders in a flash (so to speak ;-). If interest rate swaps have a Lehman-type event that causes massive losses to counterparties, and with Washington unable/unwilling to backstop the markets as they did after Lehman/AIG (and let’s not forget LTCM) then it’s all over except for the bankruptcy lawyers spending billions picking over the carcasses. We may have discovered what really killed the dynosaurs, and it wasn’t an asteroid.
Phichibe
A couple of things. I certainly would’t characterize the $1.4 trillion as “benign,” and I believe that number does not include 2nd lien debt.
I agree that plummeting interest rates have helped forestall an even worse crisis on interest reset dates for ARMs. But, low interest rates by themselves are just pushing a string.
The primary issue is that there is no honest actor in charge of managing loan workouts for distressed mortgages. The banks and servicers are, at best, conflicted and-based on a mountain of evidence-crooked. Because the government is fearful of cries of “socialism!” it refuses to take over and sort out the mess. Any solution to the mortgage crisis that doe not squarely address past and current fraud is half-baked. I believe that’s the primary issue with your friend’s properties and with the mortgage markets overall.
As for derivatives, I would be cautious about equating AIG and Lehman with the current interest rate environment. Credit default swaps are not really swaps or even derivatives, which are based on real cash market prices. They are insurance policies on individual entities, e.g. CDOs. AIG and Lehman took naked long positions because they believed they could not lose money on a AAA bond. I don’t know about hedge funds taking hyper-leveraged positions in interest rate spreads the way LTCM did.
Sometimes I wonder whether every mass extinction event, which has ever occurred, wasn’t actually caused by a species achieving sapience, i.e. the mass extinction of our era is the rule, not a novelty.
Consider that a brief few thousand years of sapient life would be nearly invisible, geologically speaking, some tens of millions of years later. Hence a given mass extinction event occurring due to an outbreak of sapience, would be marked only by the disappearance of many species from the fossil record, rather than through any artifact of the briefly phenomenal sapients themselves.
Thus the Permian extinction was caused by a particularly exceptional, although wretchedly incompetent, bunch of trilobites. And some saurian or another broke the intelligence barrier, only to result in the Late Cretaceous Epic Fail.
One other point I neglected to make, which is that the crackpots over at the American Enterprise Institute want to double down on the problem by decrying the current bubble” in fixed-rate mortgages. By their reckoning, ARMs and balloon mortgages will make us al safer.
GOP politicians consider these clowns to be “experts.”
http://www.aei.org/article/new-bubble-may-be-building-in-30-year-mortgages/
http://heartland.org/policy-documents/research-commentary-future-30-year-fixed-rate-mortgag
http://urbanland.uli.org/Articles/2011/June/Sichelman30yr
reminds me of bill black’s anecdote about in the buildup to the s&l crisis everyone was completely concerned about interest rate risk and ignored credit risk. fast forward to today…
If interest rates were to go up sharply it is not just U.S. banks that would go bust, the U.S. will go bust. Even as the U.S. is running annual deficits in the neighborhood of $1.5 trillion and the national debt has exploded, annual interest expense has barely gone up because ZIRP has short term rates at zero, 5 year rates under 1% and 10 year rates under 2%. From 2001 to 2009, the national debt doubled but annual interest expense was about flat as the average rate on the debt dropped from a little over 6% to a little over 3%. I haven’t done the numbers more recently but would guess the average rate paid on the portfolio of outstanding government debt is 2.5% or less.
With $15 trillion or so in government debt outstanding, every 1% rise in the interest rate translates into $150 billion added to the annual deficit. And a very high percentage of the debt is financed short term, around 60% of it 2 years and under the last time I looked. So it wouldn’t take that long for a spike in interest rates to have a major impact on the fiscal deficit.
So what have the banks got to lose by betting on a continuation of ZIRP? The Fed is clearly going to do everything within its power to keep interest rates as low as it can for the foreseeable future.
The U.S. is a sovereign currency issuer. It is impossible for it to “go bust”.
That’s merely a matter of semantics. Of course a country that can issue its own currency can’t technically default on its debt, but for all practical purposes printing massive amounts of money and destroying purchasing power (like the Weimar Republic did) is effectively a default.
Yves, I find the juxtaposition of this issue – bank interest rate risk and the very next story of a fund manager’s revolt over exec pay totally disorienting. So, if exec pay is tied to company performance, how could such risk not affect the exec’s pay and result in a less risky path? Of course, I see that that path is being paved by the Fed, not the banks themselves, but let’s be honest here – the Street owns the Fed, so why not encourage the Fed to be a tad tighter to reduce interest rate risk. Or is ZIRP absolutely necessary to prevent a balance sheet disaster. Are you suggesting that U.S. finance has fallen into a trap of its own making?
“… the banks also own a lot of duration …” Still trying to get my head around that one.
* * *
Consider the weasels, they toil not nor spin, or words to that effect. Also, too, Matthew 18:23 and following. Though I’m not sure I agree with the moral of the story.
I wish I were a trader, so that I could understand that, but I’m not, and I can’t. How do the banks’ holdings compare with the 50,000 years from the Triassic Era that I bought yesterday on Ebay?
Going back over the post from the beginning with a spreadsheet maybe I will find enlightenment, or googling around.
Indeed, it’s scary due amongst other thing due to the awful amount of unfunded liabilities in the interest rate swaps monster market.
A sudden increase of more than 100bps could make all the dealers and swap writers equity position go underwater and the leveraged paper mountain collapse again with all the naked writing based on absurd risk models. MF Global’s everywhere, and I doubt there is willingness to print money to save them this time.
But because the CB’s are effectively controlled by the banks when it comes to policy and operations (CB’s are reactive rather than proactive, reactive to bank needs), rates will never be hiked in the foreseeable future. The fat tail risk here is what if inflation goes wild, what then can CB’s do or will do? Let banks go bust and all the creditors with them or let us all eat inflation? Such rise in inflation could only come from supply shocks given the bad shape of labour and income stagnation, but the risk is there.
swaps have a hideous side to them. They seem to provide “cheap” exposure, but once you decide to terminate them the entire present value of the exposure gets monetized(e.g. present valued)
If nothing else, Bernanke won’t raise rates until far too late just to keep his perfect either/or record of utter incompetence/enabler of looting intact, of course.
However, there is something else. Not only won’t he raise rates, he’s likely to attempt to “lower” them further in an attempt to force savers to spend, as per Krugman and other elite status quo “liberal” economists via “negative interest rates” after Obama is re-elected in a landslide that is also the lowest turnout ever (look for Reps to abandon Romney and pour all their efforts into Congress – and just maybe hold the House, which would be ideal for elite looters).
http://www.nytimes.com/2012/04/29/magazine/chairman-bernanke-should-listen-to-professor-bernanke.html?_r=1&ref=magazine
So Japan and zombieland it is, though Japan had the US and China for export markets (surpluses) through those years, while the US has much-weakened partners for years ahead.
Unless, perhaps, the Fed cannot actually control rates under ALL circumstances. What happens when raising rates is not an option and for some reason the $ suddenly needs defending – a steady, relentless pressure as opposed to a short, quick spike?