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The looming disaster the Fed's stress tests miss

November 19, 2012: 5:00 AM ET

Banks could lose tens of billions of dollars if the bond market turns south.

Federal Reserve

FORTUNE -- In the past year or so, banks, looking for safety and some yield, have stashed an increasing amount of their cash in the bond market, much of it in U.S. Treasuries. If rates were to rise quickly, that could cause huge losses at the banks, and potentially a credit crunch that would rival the financial crisis. Sounds scary, right? Want to know something even scarier? The Federal Reserve seems unaware this is even a possibility.

The Fed recently released its criteria for the latest round of bank stress test. The tests are a new annual regimen implemented in the wake of the financial crisis. In part, they're supposed to protect us from having another one.

The testing process will start in a month or so, but the results won't be made public until late winter or early spring. When complete, the tests are supposed to judge whether the nation's largest banks have the resources to survive even in the most extreme economic conditions.

There are three scenarios. One envisions inflation picking up. Another contains a rise in the unemployment rate to 12%, and a drop in the stock market of 50%. None of the scenarios, though, test what would happen to banks if interest rates rose anywhere near a level that historically could be considered high.

One of the Fed's tests includes a 4% long-term interest rate. That's high compared to the 1.6% were are at now, but it's far lower than average if you take a view that is longer than say 2008. In the 1970s and early 1980s, long-term interest rates were routinely above 10%.

MORE: Sheila Bair: The one thing banking regulators should do now

Those weren't great decades for banks. But the problem is much worse now, because banks -- the big ones in particular -- have diverted more and more of their cash away from lending and into the bond market. What's more, relatively high returns on bonds for the past few decades have left prices at high levels. The result is that a march back up in rates, which would cause bond prices to fall, could be devastating for the banks' portfolios.

How much? It's hard to tell. Individually, banks don't have to detail in their financial statements how much they have in bonds. They do give a figure for how much interest rate risk they are taking on, and that figure at most banks has been going up. But that generally only includes the bank's trading businesses, and not the bonds the banks have characterized as long-term investments, which make up the bulk of their holdings. Collectively, banks and Wall Street firms own nearly $415 billion in Treasury bonds, up from just $20 billion in 2007.

"The banks are wide open," says Christopher Whalen, who is a senior managing director of Tangent Capital Partners. "The whole industry has a lot of interest rate risk."

Bank executives argue that they have moved some of their portfolios into short-term bonds, to minimize the damage of higher rates. What's more, they say, if rates were to go up that would be good for business in general even if their bond portfolios were to suffer.

But it would take time for the banks to benefit from being able to charge higher interest rates. The bond losses, however, would be immediate.

And it's not clear all of the banks' businesses would be more profitable if rates were higher. Higher interest rates could very painful for borrowers who decided to stick with their variable rate mortgage, or were not able to refinance out of it. For that group, higher interest rates could lead to more foreclosures. And banks are currently benefiting from a lot of refinance activity. If rates go up, that business would surely go away.

MORE: Where the stress tests failed

Of course, with the economy still very weak, and the U.S. seen as the safe haven, it's unlikely we would have a rush out of the U.S. bond market that would cause interest rates to turn up sharply anytime soon. But isn't the possibility of 12% unemployment, something that has never happened in my lifetime, quite lower than the possibility of 5% long-term interest rates, which was the norm just 5 years ago? Yes, high unemployment seems more likely these days than high interest rates. But that's just what we have come to expect.

There's a reality television show that's become a staple of summer programing these days called Big Brother. The show's tagline is expect the unexpected. The Fed might want to consider adopting it.

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About This Author
Stephen Gandel
Stephen Gandel

Stephen Gandel has covered Wall Street and investing for over 15 years. He joins Fortune from sister publication TIME, where he was a senior business writer and lead blogger for The Curious Capitalist. He has also held positions at Money and Crain's New York Business. Stephen is a four-time winner of the Henry R. Luce Award. His work has also been recognized by the National Association of Real Estate Editors, the New York State Society of CPA and the Association of Area Business Publications. He is a graduate of Washington University, and lives in Brooklyn with his wife and two children.

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