Sat Aug 7, 2004
By Richard Leong
NEW YORK (Reuters) - U.S. banks could be hurt by their vast holding of mortgages and related securities if interest rates rise rapidly, according to analysts and bank regulators.
The Office of the Comptroller of the Currency (OCC), one of the federal bank regulators, cautioned that a small but growing number of banks that have accumulated trillions of dollars of mortgage securities through "carry" trades are vulnerable if rates rise quickly.
Carry trades have been immensely profitable for banks and other investors by borrowing at low short-term rates and putting money into longer-dated investments like mortgage securities.
Some economists are not as worried about the direct impact of rising interest rates on banks' enormous mortgage holdings as about the ripple effect on banks if rising interest costs crimp the ability of homeowners to keep up on their mortgages.
They are concerned that the default level for adjustable rate-mortgages, which have exploded in popularity over the past few years, would jump with swiftly rising interest rates.
In the worst-case scenario, if enough mortgages go bad due to a housing slowdown, they could destabilize the banking system and the rest of the economy, according to Paul Kasriel, chief economist at The Northern Trust Co. in Chicago.
"If something goes wrong in the housing market, something could go wrong in the banking system," Kasriel said.
Although the OCC does not envision an imminent emergency for the banking system on rising rates, it signaled banks to monitor their mortgage holdings, which are at historically high levels.
"This is not indicative of a larger systemic risk," said Kathryn Dick, OCC's Deputy Comptroller for Risk Evaluation. "It's pro-active supervision," she said of OCC's bulletin to banks dated July 1.
BANKS' HUGE GROWTH IN MORTGAGES
During the past four years, the U.S. banking industry has thrived through its exponential growth in the mortgage sector, fueled by rock-bottom interest rates and the housing boom.
Banks have lent trillions to consumers to buy homes and to refinance their higher-rate mortgages, and engaged in carry trades locking in solid returns of 4 percent to 5 percent on their mortgage investments.
U.S. commercial banks held $2.3 trillion in mortgages at the end of the first quarter, or 24 percent of all mortgage debt outstanding, according to the latest Federal Reserve data.
The volume of mortgage-related assets in the banking system grew to 27 percent of total assets at the end of 2003 from 10 percent of total assets in 1987, the OCC said.
When interest rates rise, values of mortgage loans and securities held by banks decline because of longer maturities and a slowdown in mortgage refinancing.
Consequently, these mortgage assets will not bring in enough cash flow because there is not enough money to pay back the loans banks took out to buy these assets.
The OCC said banks may actually get a brief lift in earnings in response to the Fed raising short-term U.S. rates, but higher rates will eventually erode the long-term values and economic values of mortgage assets.
"Just because earnings rise over the near term does not mean there isn't an interest rate risk problem," OCC's Dick said in a statement at the time of the bulletin.
The OCC rang a pre-emptive warning so banks could avoid the squeeze caused by the prior rate increase cycle in 1994 by the Federal Reserve, according to OCC's Dick.
At the moment, most analysts and Fed Chairman Alan Greenspan say the mortgage market has adjusted for the recent rate rise and the extended duration of mortgage assets, or their price sensitivity to rate changes.
More Financial News