Testing for the coming stress

Two days ago the US Federal Reserve gave instructions to US banks to run stress tests, based on a scenario whereby short term interest rates would increase by as much as 400bp. It could easily be interpreted as if interest rates were just around the corner. It is probably not, but it is certainly a not-so-subtle hint that the banks ought to begin remodelling their balance sheets.

Over the past year, the banks have been busy recapitalising themselves by borrowing at zero cost from the central bank and investing the money in government bonds. It has given the banks a nice yield pickup of some 300bp and has helped the finance ministries to place some of the huge new issues, stemming from the effort to save the very same banks. At the same time, the banks have been more than stingy with giving out loans to companies and individuals.

Positioning the banks in this way gives a wonderfully discreet way of giving them a hefty economic support: the 300 bp in yield pickup is of course paid for by the taxpayers.

But there is a downside, and a significant one. If the short term yields increase by 200bp and the government bond yields increase by 100bp, the value of the bond holdings will drop like a stone. Since the government bond market is highly transparent, it is not possible to hide the lower value of the bond portfolio. The result is that the banks would be hit badly, not by the higher short term interest rates, but by their bond holdings.

For those of us old enough to remember the Savings and Loan Crisis in the early 1990's, this is exactly what happened when Fed increased the interest rates. Then-chairman Greenspan had otherwise issued an extraordinarily clear statement that interest rates would go up some three months before the event. The banks had just not believed it would happen.

The current situation in some respects bears comparison with the aftermath of the S&L cleanup. This time there is the added complication that many banks still have a significant exposure to collateralised mortgage securities. A significant part of those loan packages are based on variable rate mortgages, and mortgages with an initial interest-only period. Mortgage lenders with such structures will be hit badly once the short term interest rates begin to increase, and that may lead to an increase in loan delinquencies.

In other words, the banks have positioned themselves for a maximum use of the low interest rates to bolster their profits and their capital. They may not have positioned themselves optimally for what will happen within 18 months from now.

I have argued that it would be a while until short term interest rates would begin to hit the economy. But given the way many banks have positioned themselves, they will be hit by the slightest increase in the short term interest rates.

It again seems that the drive to maximising profits from a given situation implies that some obvious risks are being ignored. Sounds eerily familiar, doesn't it?