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Jamie Dimon's $5 billion bet against bonds

June 3, 2013: 5:00 AM ET

Most of the big banks say they will make money from rising rates. They can't all be right.

Jamie Dimon

Sitting pretty: Dimon says his bank will make $5 billion if rates rise

FORTUNE -- Interest rates have been rising lately. And a lot of people are nervous about what will happen when the Federal Reserve stops buying bonds in the next year or so. Warren Buffett is watching. One group of people not among the rate worrywarts: Bank CEOs. Nearly every bank executive seems to be predicting his bank will make money, in some cases a lot more and seemingly overnight, when rates rise.

"Something like 20 of the 25 biggest banks in the nation will tell you they will make money when interest rates rise," says Glenn Schorr, a top bank analyst at Nomura. "But when you listen to regulators you still hear fear."

For the time being, bank investors seem to be siding with the CEOs. Shares of the big four banks, Bank of America (BAC), Citigroup (C), JPMorgan Chase (JPM), and Wells Fargo (WFC), have all been rising lately despite the recent rise in rates.

The problem is that's not the way things have played out before. Rising interest rates, particularly sharp increases, have generally been bad news for banks' bottom lines. That's what happened in 1994 when the rates jumped 3%.

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But bank analysts say it could be different this time around. We are starting at a much lower point on interest rates than we did nearly two decades ago. Recently, the extreme low interest rates have been a negative for banks, pushing down their net interest margins, which is the difference between what a bank pays for funding and what it gets back in interest when it makes a loan. The analysts say rising rates will significantly improve the banks' lending profits, especially since the big banks have vastly more deposits, on which the banks pay close to nothing to savers, than they did two decades ago.

What's more, pretty much everyone has expected rates to go up for a while now. Bank CEOs have regularly said in the last year that they have moved their bond investments into debt that will come due in shorter periods of time. The shorter it is until a bond matures, the less you lose when interest rates rise.

The boldest of these predictions, perhaps not surprisingly, comes from JPMorgan's brash CEO Jamie Dimon. In April, in his annual letter to shareholders, Dimon predicted that his bank would make $5 billion over the following 12 months if interest rates were to suddenly rise 3%.

It's very hard to see how. A spokesman for JPMorgan declined to comment. The analysts I talked to said they were basically taking Dimon at his word. They hadn't done the math themselves and said it would be very hard to figure out.

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One answer could be that Dimon and JPMorgan Chase have taken a very big bet that interest rates would rise. Indeed, in his letter to shareholders Dimon says the bank "is currently positioned" to make money when rates rise and that that positioning "costs us a certain amount of current income." That could mean that JPMorgan has bought a large amount of interest rate swaps, a type of derivative contract that pays out when rates rise, on which the bank could be paying a regular insurance type premium.

But a large London Whale-like trade against interest rates seems unlikely from the bank right now. What's more, according to its 10-Q, JPMorgan holds fewer interest rate derivatives than it did a year ago. And it's hard to see how JPMorgan is giving up income. The bank made $21 billion last year, far more than any of its rivals.

The other possibility is that Dimon is talking about how much more money the bank would make off its lending portfolio. Indeed, in its most recent 10-K, JPMorgan included a chart that said a 1% increase in interest rates would boost the bank's lending profits by $2.1 billion, which would more than clear Dimon's bar for a 3% increase.

But it's not clear that JPMorgan would actually get that much boost. A recent report from Nomura found that lending profits don't rise nearly as much when just long-term rates rise, and short-term borrowing rates remain low, which is what has been happening lately. That's probably because those loans take the longest to reprice. Indeed, JPMorgan says that if just long-term rates were to rise, the bank would only get a $778 million boost from a 1% increase in interest rates. Triple that and you get $2.3 billion, well short of Dimon's prediction.

And that number doesn't take into effect how much JPMorgan could lose in its bond portfolio, which is hundreds of billions of dollars. Even a 1% increase in rates could cost the bank a few billion. Clearly, Dimon included the statement in his annual letter because he is getting questioned about what would happen if interest rates rise from worried investors. If he really wants those questions to go away, he has more explaining to do.

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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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