By Michael Kling
Banks could be walloped by a bursting bond bubble, cautions Federal Reserve Governor Jeremy Stein.
Banks, Stein warned in a recent speech in St. Louis, may be especially as risk from loses because they typically hold a high portion of long-term bonds, which suffer the most when interest rates rise.
Many experts worry that bond investors will suffer substantial losses when interest rates rise from their historic low, prompting bond values to drop. The current long-running period of low rates may indeed be encouraging firms to assume greater risks of long-term bonds, or bonds with greater duration, as they hunt for yield, Stein noted.
“Putting it all together, my reading of the evidence is that we are seeing a fairly significant pattern of reaching-for-yield behavior emerging in corporate credit,” Stein said.
Even if investors are taking greater risks, that doesn’t necessarily mean a bond bubble poses danger to the entire financial system, he said. The key question is how much of the asset — whatever it might be — is financed by short-term claims held by investors who might dump them at the first signs of trouble, leading to market wide fire sales of illiquid assets.
So far, there seems to be only modest short-term leverage behind corporate credit, indicating little systemic threat. Still, getting a handle on the financial data is challenging for regulators, he cautioned. Banks may be searching for yield and taking on greater risks in less observable parts of their business.
Unlike inflation and unemployment, emerging bubbles are difficult to measure, Stein said.
“Waiting for decisive proof of market overheating may amount to an implicit policy of inaction on this dimension.”
How much risk banks have in long-term bonds is open to debate.
JPMorgan Chase CEO Jamie Dimon testified to Congress that the average duration of bonds in JPMorgan’s portfolio was just three years. But Fortune magazine reported that it had almost $200 billion in bonds — almost 56 percent of its portfolio — that won’t mature for 10 years or more, indicating an average duration of at least 10 years.
The bank’s security filings used the date the bonds are due. Dimon used projections for when the bonds will be paid off, or the effective duration, Fortune noted.
Most of JPMorgan’s long-term bonds are backed by mortgages, which the bank thinks will last an average of three years as homeowners sell their homes or refinance, according to Fortune. However, refinances will probably drop when rates rise.
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