Yves Smith — The Hidden Bank Time Bomb: Interest Rate Risk

At the Atlantic Economy Summit in Washington last month, Sheila Bair fielded a question about the just-released results of the latest bankstress 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.

Read the rest at Naked Capitalism
The Hidden Bank Time Bomb: Interest Rate Risk

by Yves Smith