INVESTORS SHOULD LEARN FROM 1994´S RATE SPIKES / THE FINANCIAL TIEMS MARKET ANALYSIS ( VERY HIGHLY RECOMMENDED READING )

Investors should learn from 1994’s rate spikes

By Gillian Tett

Published: March 10 2011 19:56

In recent months, staff at the Federal Deposit Insurance Corporation have been quietly trying to assess what damage a sudden jump in US interest rates might inflict on the financial system.


But the body that insures deposits in banks faces a challenge: although it is clear that US banks and investment groups are loaded with bonds, it is very unclear how far these entities are hedged against any rate rise.


“It is frustrating for economists – we just don’t have the granular data. Nobody does,” says Rich Brown, FDIC chief economist, who laments that “interest rate risk has been a bit of a blind spot [recently] for some institutions, partly because there has been such a fixation on credit risk”.


This is potentially worrying, given the wider macro-economic climate. In recent days, the bond market has been shaken by news that Pimco has quietly sold all of its holdings of US Treasury bonds due to fears that yields will jump when the Federal Reserve ends quantitative easing. Such gloom is not shared widely; on the contrary, plenty of other investors expect yields to remain low because they think inflation pressures are relatively contained, the economic outlook uncertain and geopolitical worries remain rife.


But even if Bill Gross of Pimco turns out to be wrong, his call suggests risk of an upward swing in US rates is a possibility that needs to be reckoned with. That raises a crucial question: are investors and institutions sufficiently braced for this possibility – or, as Mr Brown fears, still too distracted by credit risk that any such rise could potentially cause damage?


In theory, history ought to have left US financiers well prepared. After all, in 1994 the US bond markets suffered one major shock, when Alan Greenspan, the US Federal Reserve chairman, unexpectedly doubled short-term interest rates to 6 per cent in a year. That caused long-term rates to leap from 6 to 8 per cent, partly because the structure of the US mortgage market created a so-called “convexity” problem (essentially when rates rise, the duration of fixed-rate mortgages typically lengthens, and in 1994 portfolio managers tried to hedge that by selling long-term Treasuries, fuelling panic). The swing also caused big losses for many investors and banks, because these had previously been so confident that Greenspan would keep rates low that they had not hedged their exposures. Worse still, many investors were exposed to highly leveraged bets on interest rate derivatives; Orange County alone lost some $1.5bn from this. But though this panic occurred just 17 years ago – or within the career of many financiers – it is far from clear that the right lessons have all been learnt. In Europe, the Bank of England recently devoted a special section in its latest Financial Stability Review to asking whether there could be a repeat of the 1994 shock. And some continental European regulators are now quietly discussing the issue, partly because European institutions were hurt back in 1994.


However, in the US, public analysis has been minimal. In January 2010, Donald Kohn, then Fed vice-chairman, gave a speech warning that “many banks, thrifts and credit unions may be exposed to an eventual increase in short-term interest rates”.


Late last year, Sheila Bair, head of the FDIC, declared that “bankers and regulators should place heightened scrutiny on the interest-rate exposures on the balance sheets of financial institutions, and ensure that these institutions can withstand interest rate increases of as much as 500 basis points over a two- to three-year period”. But Ms Bair’s forceful comments were striking because they are so rare; the Fed has largely been silent.


Fed officials say this is because any replay of 1994 now looks exceedingly unlikely. After all, the argument goes, since 1994 the US central bank has learnt that it is unwise to shock the markets; hence Ben Bernanke’s current determination to keep signalling his policy stance. Moreover, investors are now wiser about interest-rate derivatives, and the US mortgage market is less vulnerable to convexity risk; or so, the argument goes.


But none of these points is bulletproof. After all, the proportion of fixed-rate mortgages has recently risen, which may have increased convexity, and the use of interest-rate derivatives is rife. Meanwhile, the Fed will soon face challenges as it tries to exit quantitative easing – the risk of policy surprises cannot be ruled out.


And then, of course, there is all that interest-rate exposure, which is of an unknown size. Maybe this time, banks and investors will be savvier at hedging; but there again, the Fed’s recent actions might have bred complacency. Either way, the one thing that is clear is that it is time for regulators and investors alike to think hard about that interest rate risk, not just credit risk. If not, the risk managers and regulators may end up, once again, fighting yesterday’s war.


Copyright The Financial Times Limited 2011.