REGULATORS TO BANKS : TIME TO STOP CARRYING ON / BARRON´S ( VERY HIGHLY RECOMMENDED READING )

FRIDAY, JANUARY 8, 2010

UP AND DOWN WALL STREET

Regulators to Banks: Time to Stop Carrying On

By RANDALL W. FORSYTH

The Fed and other regulators warn banks about the risk of rising rates. What's up?

THE FEDERAL RESERVE AND OTHER BANKING REGULATORS, which have been widely excoriated for having failed to foresee the consequences of risky mortgage lending, Thursday took the unusual step of warning banks and other depository institutions of the risks posed by possible rises in interest rates from their current historically low levels.

In an "advisory", the major regulators told banks buying long-term assets funded with short-term liabilities they are endangering those earnings and their capital if interest rates rise.

Many banks are resorting to the so-called carry trade to generate profits to offset losses on loans and securities portfolios. With the Fed pegging the cost of overnight money at near zero, and the spreads between short- and longer-term interest rates at near-record levels, the carry trade provides assured profit margins.

But if short-term rates rise, banks' cost of funds will increase while the prices of their securities are certain to tumble. That's been the risk banks and other interest-rate players have faced since time immemorial.

That the Fed and other regulators found it necessary to remind banks of this just now is, indeed, interesting. The obvious inference is that the monetary authorities are planning to raise the federal-funds rate target from the current rock-bottom 0-0.25% range.

That doesn't mean such a move is imminent. While a few second-tier Fed officials have made noises that rate hikes ought to come sooner rather than later, Ben Bernanke, the central bank's chairman, and his No. 2, Donald Kohn in speeches earlier this week gave no indication of reversing the central bank's intention to maintain extraordinarily low rates "for an extended period."

But, having failed completely to anticipate and to warn about the housing bubble and its inevitable bursting, the Fed and other regulators now apparently are taking the opposite tack: an excess of caution about the impact of the eventual lifting of interest rates, even if it is unlikely to come to pass any time soon. (The fed-funds futures market is pricing in an increase to a 0.5% rate target by the August meeting and 1% by December, hardly a radical tightening campaign.)

What's happened is that credit risks of the past cycle have morphed into interest-rate risk, observes George Goncalves, interest rate strategist at Cantor Fitzgerald.

Banks previously generated profits by giving mortgage loans without regard to the borrower's ability to repay -- what the late economist Hyman Minsky termed "Ponzi finance" -- because of their confidence of being able to offload or hedge that risk.

Banks may be similarly overly confident that the "extended period" over which the Fed says it plans to maintain extraordinarily low rates will continue as long or even beyond the current consensus forecast. Thus, they may not have properly hedged for the eventual, indeed inevitable, increase in short-term rates from their current, near-nil level.

By contrast, these regulators -- which also include the Federal Deposit Insurance Corp., the National Credit Union Administration, the Comptroller of the Currency, the Office of Thrift Supervision and the Federal Financial Examination Council State Liaison Committee -- no doubt are concerned that a lack of preparedness for rate hikes could precipitate losses similar to what was seen in 1994.

Then, the Fed under Alan Greenspan decisively lifted the fed-funds target from what then was a shockingly low 3% to 6%, resulting in massive losses, especially in mortgage-backed securities and derivative investments dependent upon low short rates. The culmination was the bankruptcy of Orange County, Calif., whose Treasurer speculated in derivatives that blew up when rates rose.

Perhaps mindful of that episode, beginning in 2004 the Greenspan Fed raised rates from a low of 1% at a glacial pace over the next couple of years. During that period, subprime and other feckless lending boomed. The rest, as they say, is history.

Bernanke et. al. now are trying to avoid repeating either episode -- losses from bad interest-rate bets resulting from quick, decisive tightening as in 1994, or moving too slowly and inflating an asset bubble, as happened a decade later.
Losses resulting from interest-rate risks now would hit banks' profits and balance sheets hard. That would further impair their ability to provide credit, the lack of which currently is hampering the economy, as Fed Vice Chairman Kohn observed earlier this week.

But allowing interest-rate speculation in the carry trade to get out of hand would further hurt the already battered reputation of the central bank and other regulators. In a page one piece in Wednesday's New York Times, the headline posed the question: "Fed Missed This Bubble. Will It See a New One?"

In his speech to the American Economics Association earlier this week, Bernanke argued that the housing bubble and bust was the result of a lack of adequate regulatory oversight, not too-easy monetary policy. Now, the regulators are trying to show they're vigilant cops on the credit beat.

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