Three Government Reports Reveal New Looming Risk

Never before have I seen a broader range of investment opportunities as those opening up early in January!

But if you’re among those throwing caution to the wind … or if you’re slashing your keep-safe holdings to practically zero, then take a long, hard look at the …

Ubiquitous, Unprecedented Exposure
To the Risk of Rising Interest Rates

With the global economy growing, with federal deficits exploding, and with central banks printing money like there’s no tomorrow, there can be little doubt that rising markets will also bring rising interest rates.

Even if the Fed continues to hold down short-term rates, there are too many rates that the Fed cannot control — long-term bond yields, mortgage rates, and countless other rates that are driven primarily by free market forces.

So you must ask: “Who gets hurt when interest rates rise?” The answer:

• All borrowers with debts coming due; they must pay more to roll them over.

• All lenders who have extended medium- or long-term credit at fixed rates; they suffer an immediate loss in the market value of their loans.

Yet, ironically, despite the high probability of rising interest rates, three just-released government reports reveal that nearly all U.S. financial sectors are exposed to the severe losses that that higher rates can bring:

Government Report #1

Source: Federal Deposit Insurance Corporation (FDIC)

Title: “Nowhere to Go but Up: Managing Interest Rate Risk in a Low-Rate Environment”

Link: Click here for the report with my annotations and key sections highlighted.

The FDIC’s primary conclusions:

1. With interest rates at record lows, they have nowhere to go but up.

2. More banks are now taking on higher levels of interest rate risk, leaving them overly exposed to rate rises at precisely the wrong time. They’re stuffing their portfolios with long-term mortgages, which invariably fall in value when interest rates rise. And they’re relying too heavily on short-term financing, which will inevitably be more expensive when rates rise.

3. For nearly 20 percent of U.S. banks, long-term assets now make up more than HALF of their total assets — nearly double the level of 2006. This means that over 1,500 U.S. banks could suffer losses in half or more of their portfolio when rates go up.

The big picture: Banks are making the classic mistake of borrowing short and lending long.

That’s what helped kill hundreds of institutions in the 1970s and 1980s … and that’s what could happen this time as well.

Meanwhile, even before this new crisis hits, the debt crisis that has supposedly passed is still taking a huge toll:

The FDIC just announced on Friday that seven MORE banks have just failed — Citizens State Bank of New Baltimore, MI … First Federal Bank of California of Santa Monica, CA … Imperial Capital Bank of La Jolla, CA … Independent Bankers’ Bank of Springfield, IL … New South Federal Savings Bank of Irondale, AL … Peoples First Community Bank of Panama City, FL … and RockBridge Commercial Bank of Atlanta, GA.

Total bank failures so far this year: 140! And the FDIC is bracing itself for many more failures next year.

Government Report #2

Source: Comptroller of the Currency (OCC)

Title: OCC’s Quarterly Report on Bank Trading and Derivatives Activities, Third Quarter 2009

Key facts:

Fact #1. Credit derivatives — mostly bets on the failure of large companies — were the primary cause of the AIG collapse and a key factor in Wall Street’s nuclear meltdown last year. So in this report, the OCC seems proud to announce that U.S. banks have reduced their holdings in these radioactive credit derivatives — from a peak of $15.9 trillion at the end of last year to $13 trillion on 9/30/09.

Problem: The banks are fighting the last war! Yes, credit derivatives were the bugaboo of the LAST crisis, which was all about credit defaults.

But in the NEXT crisis, triggered by rising interest rates, the banks’ big nemesis is likely to be interest rate derivatives — those tied to bond yields, mortgage rates, and a variety of other rates.

Fact #2. U.S. banks now hold $172.5 TRILLION in interest rate derivatives, a new record. That’s over THIRTEEN times the amount they hold in credit derivatives.

Fact #3. Among all derivatives held by U.S. banks (now at a record $204.3 trillion), interest rate derivatives represent 84.5 percent of the total! Specifically:

• JPMorgan Chase holds $79 trillion in derivatives, with 80.8 percent of those tied to interest rate changes.

• Bank of America has $40.1 trillion, with an even larger share — 89.2 percent — tied to interest rates.

• Goldman Sachs has $42 trillion in derivatives; and among the top 10 U.S. derivatives players, it has the single largest share — 94.3 percent — in the interest rate sector.

Government Report #3

Source: Federal Reserve Board

Title: Flow of Funds Accounts of the United States, Third Quarter 2009

Key facts:

Banks aren’t the only ones vulnerable to higher interest rates. This just-issued report shows that several other major financial sectors are also vulnerable, due to their huge stakes in assets that automatically fall in market value when interest rates rise. Specifically …

• Credit unions are loaded up with $318.4 billion in home mortgages, plus $103.9 billion in government agencies and government-sponsored enterprises (GSEs), such as Fannie Mae and Freddie Mac. Their combined percentage in assets potentially vulnerable to higher interest rates: 50.4 percent of assets.

• Life insurance companies — providers of life, health, and annuity policies — are among the largest holders of corporate bonds: $1.9 trillion worth! Plus, they hold $332.9 billion in mortgages and another $50 billion in municipal bonds. Combined, that’s 55.7 percent of their assets in likely interest-sensitive investments.

• Property and casualty insurers — which cover your home, car, or business — are among the largest holders of municipal bonds: $394.1 billion. Plus, they have $272.6 in corporate bonds and another $112.3 billion issued by government agencies and GSEs. Combined total potentially vulnerable to rising interest rates: 58.4 percent.

Not all of these assets are locked into medium- or long-term rates. Some may be short term and, therefore, not hurt by higher rates. But the overwhelming bulk of the assets ARE vulnerable!

And unlike credit defaults, which strike just a certain percentage of bonds and mortgages, the rising tide of interest rates impacts nearly ALL fixed-rate bonds and mortgages, driving down their market value across the board.

Here’s the Bottom Line for You …

• When you’re choosing a vehicle to save your money, avoid long-term bonds like the plague. On the surface, their yields may look more attractive than the miserable short-term rates now available. But buying them at this stage is like making a pact with the devil: You get your wish of higher yield at first only to lose your principal later, wiping out any yield advantage many times over.

• When you’re choosing a mortgage or loan, avoid the variable-rate variety at all costs. The consequences could be ugly.

• And when you invest in the stock market …

First, carefully sidestep the shares in sectors directly impacted by rising interest rates — like banks, insurance companies, and other financial institutions that have their heads stuck in the sand about interest rate risk.

Second, buy only the sectors that are insulated from rising interest rates … or — better yet — that surge for some of the same reasons that rates rise. Example: Gold, natural resources, and emerging markets, which rise with inflation, a falling dollar, and growing demand for credit worldwide.

Third, for good measure, buy interest rate hedges — such as specialized ETFs designed to profit from surging rates and sinking bond prices.

Good luck and God bless!

Martin

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