Bank Rate Bomb Will Destroy the Smallest and Weakest

NEW YORK (TheStreet) -- U.S. community banks are not prepared for the possibility of a quick spike in rates when the ballooning federal deficit comes home to roost within the next few years.

While all banks will suffer in a Greek-like interest rate environment, smaller banks and thrifts are least prepared for the economic doomsday scenario.

Frank A. Mayer -- a partner in the Financial Services Practice Group of Pepper Hamilton LLP, in the firm's Philadelphia office -- says that bank regulators "within the last 18 months have been issuing a great deal of supervisory guidance on managing interest rate risk," since there's nowhere to go but up, "from an interest rate risk point of view."

"This is particularly important for thrifts," -- which have transitioned from being supervised by the Office of Thrift Supervision to the Office of the Comptroller of the currency, as required under the Dodd-Frank Wall Street Reform and Consumer Protection Act -- since many thrifts "have never run an interest rate risk model, lacking the expertise," according to Mayer.

The U.S. national debt of over $15 trillion is a topic frequently avoided by people looking to manage stress, but the debt represents a dire threat to smaller banks over the next several years.

Despite a debt roughly matching the annual gross domestic product -- similar to Greece's debt load -- the Federal Reserve has had a relatively easy time keeping short-term interest rates near zero, and the market rate for 10-year U.S. Treasury paper was just 1.92%, as of Wednesday morning, falling from roughly 3.50% two years earlier, and 4.55% at the end of February 2007.

So the "deficit without tears" -- in the words of French economist Jacques Rueff -- goes on, as the rest of the world continues to use the U.S. dollar as a reserve currency and international investors continue to put their excess liquidity into U.S. Treasuries.

So what does the obscene national debt mean to U.S. banks in the current environment, and what does it mean going forward, when rates eventually rise, as the economy continues to strengthen?

Mayer says that "interest rate risk stress testing is very important going forward," and that banks and thrifts may need to stress tests for scenarios of rate hikes of as much as 400 basis points in a year.

Federal bank regulators are worried over the effect of the U.S. federal deficit and debt on the banks and thrifts they supervise, and are "trying to get the word out, that if institutions are not properly managing IRR or stress testing, they can be required to augment their capital."

While the Federal Reserve Open Market Committee said in its statement on Jan. 25 that it had decided to "keep the target range for the federal funds rate at 0 to 1/4 percent" and that economic conditions were "likely to warrant exceptionally low levels for the federal funds rate at least through late 2014," the meeting minutes for Jan. 24 and Jan. 25 show that some six committee members (out of 17) "anticipated that the target rate would need to be increased to around 1½ to 2¾ percent at the end of 2014."

Moving out to 2015 and 2016, the target rate expectations for the committee were "in a range from 3¾ to 4½ percent, reflecting participants' judgments about the longer-run equilibrium level of the real federal funds rate and the Committee's inflation objective of 2 percent."

So depending on the strength of the continued economic expansion and the lag time of the Fed's economic data, U.S. banks could be faced with a rate spike of 400 basis points over a relatively short period, squeezing net interest margins in a very painful way for liability-sensitive institutions.

Kevin L. Petrasic -- a partner in the Global Banking and Payment Systems practice of Paul Hastings in the firm's Washington, D.C. office -- says the battles in Congress over raising the U.S. debt ceiling last August and in November "had a negative effect on the stock market, and certainly on bank stock prices," but over the long term, "the national debt is a grave concern from its impact on the stability of the economy" and the "significant uncertainty for the environment for financial institutions."

So the current situation -- historically low rates with an unprecedented national debt -- can't go on forever, and banks need to plan for a possible fast rise in interest rates.

Banks also need to worry about the effect on the market values of their government bond investments falling, as interest rates rise. As of Dec. 30, Bank of America (BAC) has $39.6 billion in U.S. Treasury securities on its balance sheet, marked at fair value, according to the company's Federal Reserve filing. The company also had another $3.3 billion in in U.S. government agency and sponsored agency obligations. All of this paper acts as a "carry trade" for BofA, meaning that the bank is essentially gets paid to hold the paper and do nothing. If interest rates rise, the carry trade falls apart.

Following years of regulatory orders requiring banks to raise capital, clean up their credit administration and improve their liquidity contingency planning, we can expect to see a new wave of orders requiring enhanced interest rate risk management, along with capital raises for some banks.

This leads, inevitably, to more industry consolidation, as small banks stress out. Even at this stage of the recovery, with the Federal Deposit Insurance Corp. reporting on Tuesday that U.S. banks earned an aggregate $119.5 billion, 19% of the nation's roughly 7,400 lost money during the fourth quarter.

The threat from a net interest margin squeeze from the inevitable rise in short-term rates, and the consequent regulatory action, will just be another reason for many banks -- which have already seen declining margins, reduced fee revenue from the August 2010 clampdown on overdraft services, the Durbin Rule's limit on debit card interchanges fees and now the Consumer Financial Protection Bureau's investigation of overdraft fees -- to combine with larger and stronger institutions.

In his speech at the Economic Club of Minnesota on Wednesday, Federal Reserve Chairman Ben Bernanke addressed the "difficult tradeoffs currently faced by fiscal policymakers," caught between the need to trim and eventually eliminate the annual federal budget deficit, and the need to continue current policies to spur the economic recovery.

But Bernanke took an ominous long-term tone, saying that "without significant policy changes to address the increasing fiscal burdens that will be associated with the aging of the population and the ongoing rise in health-care costs, the finances of the federal government will spiral out of control in coming decades, risking severe economic and financial damage."

"Acting now to put in place a credible plan for reducing future deficits over the long term, while being attentive to the implications of fiscal choices for the recovery in the near term, can help serve both objectives," of fiscal sanity and economic growth, Bernanke said.

-- Written by Philip van Doorn in Jupiter, Fla.