Federal Deposit Insurance Corp. Chairman Sheila Bair on Monday warned that the so-called bond bubble could pose a threat to financial institutions that are unprepared for rising interest rates.
"Private and public borrowers should avoid over-reliance on short-term funding that could leave them vulnerable to higher debt-service costs if rates rise, or even liquidity problems if financial markets should balk at rolling over large volumes of private debt," Bair said in prepared remarks to the Risk Management Association in Baltimore.
Bair said that many investors appear content to hold safe, low-yield Treasurys in an uncertain economic environment. But regulators should place heightened scrutiny on the interest-rate exposure of financial institutions," and ensure that these institutions can withstand interest-rate increases of as much as 500 basis points over a two- to three-year period," she added.
I am not in the bond bubble crowd. The current egregiously low bond yields are the result of Federal Reserve manipulation, not speculative activity by investors. Will bond yields rise? Sure, when the Federal Reserve decides to stop supporting the market. Until then, you can expect a prolonged period of low rates because no one wants (or has the money) to fight the Fed.
However, Ms, Bair makes a good point regarding the risks of short term funding (repo, wholesale funding, etc). This type of funding works great until it doesn't as Lehman and Bear Stearns demonstrated. But with a complete government guarantee, financial institutions have little incentive to change their habits. Worse case scenario you get free money from the Fed as an emergency loan. If you are financial institution, why would you tinker with this great situation?
The last sentence of Ms. Bair's quote assumes we have a rational Fed Chairman. We obviously don't so it is unlikely the Fed would ever raise rates that aggressively. Most forecasters expect 0% interest rates through 2012 if not later. If the banks have any problems with rising rates, don't worry the taxpayer protection team will be there for a new bailout. God Bless America!
Black Swan Insights
No Bond Bubble--- Just Another Fed Machination