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How banks could get blown away by bond bubble

February 11, 2013: 10:44 AM ET

A Federal Reserve governor is publicly raising concerns about a bond bubble, and he thinks banks could take a big hit.

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On bubble watch: Fed gov Jeremy Stein

FORTUNE -- Bank chief executives have spent the past few months telling investors not to worry about rising interest rates. Most have said their banks are not taking risks in the bond market and are protected from losses.

One Federal Reserve governor doesn't agree. On Thursday, governor Jeremy Stein became the latest high profile person to publicly worry about what a bond bubble could do to the financial sector and the economy. In a speech at a symposium in St. Louis, Stein talked about how or if the Fed should respond.

Stein sees some areas of concern. He thinks the high-yield bond market might be due for a pull back, and that some mortgage finance companies could be overstretched. But Stein says at least for now a drop in bond prices won't do too much harm to the overall economy.

MORE: Goldman braces for bond market blow up

One exception: Banks. Stein says historically banks have tended to put their money in longer-term bonds, which have higher yields, when interest rates are low. And he sees some of that behavior today. The problem is longer-term bonds tend to lose the most when interest rates rise.

Determining how much of a hit banks could take from a drop in bond prices isn't easy. Banks aren't required to disclose their bonds holdings. Most give clues, but not in any consistent way. What's more, higher interest rates would boost banks' lending profits, offsetting some of the losses in their bond portfolios.

Still, it appears, at least initially, banks stand to lose more from higher rates than they will gain. According to FDIC data, banks earned on average just 3.86% on all their loans and leases. That was the lowest that figure has been since the FDIC began collecting the data back in 1984, but given that 10-year Treasury bonds are yielding around 2%, still high enough to substantiate Stein's claim that banks are "reaching for yield."

Last summer, JPMorgan Chase CEO Jamie Dimon, in an effort to reassure Congress about the safety of his bank's investments in the wake of the London Whale trading loss, testified that the average duration of the the bonds in JPMorgan's portfolio was three years. Look at JPMorgan's books, however, and you might come away with a very different number.

MORE: We're stashing more cash in the bank

In its third quarter securities filing, the last time the bank has updated investors on the matter, JPMorgan (JPM) said that it held nearly $200 billion in bonds that won't mature for 10 years or more, or nearly 56% of its overall portfolio. That would suggest JPMorgan's average duration is at least 10 years, perhaps more, and potentially a cause for concern.

The rub is the difference between the date the bonds come due, which is what JPMorgan's books are going by, and the so-called effective duration, which is a bank's guess as to when its bonds are likely to be paid off. The later figure is the one Dimon quoted Congress.

Most of JPMorgan's longer dated bonds are backed by mortgages. And while most people get 30-year home loans, they tend to repay earlier, because of a sale or refinance. So it does makes sense to count those loans as something less than 30 years. How much less? JPMorgan puts the average life of a mortgage at three years. Borrowers were turning over their home loans frequently in the middle of the last decade. And there has been a lot of refinancing recently. But if rates turn up, it's likely more and more people will end up hanging onto their mortgage longer than usual, particularly if they got it recently.

Bank of America (BAC) prefers investors focus on effective duration. In its most recent 10-Q, B of A told investors that it held $33 billion, or just 11% of its overall debt portfolio, in bonds that won't get paid back for at least a decade or more, down significantly from the quarter before.

MORE: Go long on the economy, hedge on stocks

Take a look the numbers B of A reported to the FDIC, which requires banks report durations based on the date on the bonds, and not best guesses, and you get a very different picture. By those numbers, B of A appears to have around 90% of its portfolio, or $266 billion, in bonds that won't come due for 10 years or more.

If that is right, a 1% rise in interest rates could cause B of A to lose nearly $30 billion, or five times what JPMorgan lost on the recent London Whale debacle. That's not enough to blow away the bank should the bond bubble burst - it has nearly $250 billion in capital - but it's certainly enough to sting, a lot.

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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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