Sheila Bair’s Warning

Sheila Bair is the head of the overwhelmed FDIC. She talked to Bloomberg TV today, and is warning banks to plan for the inevitable increase in interest rates.

On the surface, you might think banks could only benefit from increasing interest rates, but the games Bernanke and Tim Geithner are playing are perverting the laws of supply and demand and increasing the damage when the dam breaks.

The game everyone has been playing is the Fed and Treasury are flooding banks with almost “free” money (less than 1/4% interest). The idea is this will cause a surge in lending and business activity and break the back of the recession. It isn’t working.

What the banks are doing is borrowing the money from the Fed at short term rates (90 days) and using the money to buy 2-10 year treasury notes, which are paying 0.4-2.5%. Guaranteed profit, risk-free and not having to deal with those annoying business people and people expecting to earn interest on their life savings sitting in CDs. The technical term for this is uncovered interest rate maturity arbitrage.

The problem is all perpetual motion machines and ponzi schemes eventually fail. When interest rates start to go up, longer term bonds lose more than just their short term interest. If you bought a 2.5% 10 year note, and the rates go to 3.5%, your note loses roughly 10% of its value overnight (1% x 10 years). At the end of 90 days, the Fed wants its money back. If it stops offering “free” money, you will have to pay higher rates, which could mean increasing acquiring more deposits (savings accounts, CDs) which will mean paying higher rates. The interest you’re getting on the 10 year treasury note will no longer cover what it costing, but you can’t trade it away early without taking the 10% loss.

A bank aware of this risk for the remaining 9 3/4 years could prearrange to sell the 10 year note after 90 days or buy insurance to protect it from interest rate changes for the next 10 years. There are two problems with that – the cost of buying that protection will exceed their risk free profit (there is no free lunch) and the just passed FinReg bill now prohibits banks from engaging in trading of financial derivatives (like treasury note futures or interest rate swaps).