Rising Rates? Beware of Big Banks

08/29/2013 9:00 am EST

Focus: STRATEGIES

Michael Burnick

Editor, Real Wealth Report

It appears financial stocks have caught a cold, and could be a victim of rising interest rates, says Mike Burnick in Money and Markets.

Until now, financials have been top gainers, up 23.8% this year, and an engine for the stock market's rally. A slump in bank stocks could be a red flag for a drop in the broader market.

If you take them at face value, many pundits will tell you that rising interest rates are good for financial stocks, because higher lending rates enable banks to fatten their profit margins. But don't fall for such a simplistic argument.

Today's mega-banks earn most of their income from more speculative sources, like trading, and capital markets, which can become volatile in an unstable interest-rate environment.

The reality is that traditional commercial and consumer lending is no longer the big money maker that it used to be for banks. Since the 2008 financial crisis, households and businesses have been deleveraging—paying down debt—and demand for loans has been limp.

In recent years, the big banks have fattened their profits mainly from capital-markets businesses: Mergers and acquisitions, stock and bond offerings, and other types of trading. Rising interest rates also make the cost of capital go up for businesses, which can result in less deal making, lowering financing fees for the banks.

Another, even bigger risk to banks' bottom line is an end to the gravy-train of easy-money trading opportunities sponsored by the Federal Reserve.

For the past several years, big banks have padded their profits by playing the carry trade, pocketing the spread between borrowing from the Fed at ultra-low short-term rates and reinvesting the proceeds in longer-term Treasury and mortgage-backed securities.

It was an easy way for the banks to book extra trading profits—as long as rates remained low and stable. But with longer-term interest rates now on the rise, many of the biggest US banks face a multibillion-dollar hit to their capital.

Yields on 10-year US Treasury notes surged to within a whisker of 3% early this week, up from 1.6% in May. That was the highest level in almost two years. The corresponding sell-off in bond markets has been brutal.

Thanks to the easy-money carry trade in recent years, big banks, including JPMorgan Chase (JPM), Bank of America (BAC), Wells Fargo (WFC) and Citigroup (C) are now holding bloated portfolios of available-for-sale securities, mainly long-term Treasury and mortgage-backed bonds.

These portfolios have taken huge paper losses during the bond market sell-off, and the pain may not be over if interest rates continue to surge.

To put this into context, analysts estimate that the big-four US banks, listed above, would collectively take a $36.1 billion pre-tax hit to their capital from only a one percentage point rise in longer-term bond yields.

Most at risk are the money-center banks that are primary dealers with the Federal Reserve. Those include not only the big four, but also Goldman Sachs (GS) and even foreign banks like Barclays (BCS) and UBS (UBS).

The same firms that have feasted on the Fed's ultra-low interest-rate policy now face the greatest risk, as rates rise again.

Eventually, higher interest rates should enable banks to earn more interest income from traditional lending. But that takes time. Meanwhile, with loan demand still soft and banks sitting on large securities portfolios, the pain could be prolonged.

Bank of America, for example, has a $315 billion securities portfolio, 90% of which is invested in longer-term Treasury and mortgage-backed bonds.

If yields keep rising, the value of those securities will continue to decline. In June, the bank's chief financial officer admitted it will take two and a half to three years to earn enough extra interest income to offset the decline in capital from a one percentage-point increase in rates.

Today, investors are focusing more on the potential upside for banks if faster economic growth follows higher interest rates. They should be paying more attention to the dark side of rising rates: Growing capital losses from their bloated bond holdings.

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