Health of the Banking System

After falling steadily from mid-October through early February, the banking sector has been on a tear in recent weeks. As with the broader market, the sector’s rally faces a test when first-quarter earnings kick off this week, featuring reports from Bank of America and JP Morgan.”You’ll see improving health [but] the system still has some underlying issues,” says Kenneth Posner, author of Stalking the Black Swan  and the former head of Morgan Stanley’s financial services research group.

With unemployment stubbornly high, more bad consumer loans are an obvious risk facing the sector. CreditSights, for one, estimates Bank of America JPMorgan and Wells Fargo may have to set aside an additional $30 billion to cover possible losses on home-equity loans, Bloomberg reports.

The biggest issue facing the banks now is interest rate risk, Posner says: “Rising interest rates would be a double whammy for banks.”

First, banks have generated huge profits in the past year thanks largely to the spread between the Fed’s zero interest rate policy and yields on “risk-free” Treasury bonds in the 3% to 4% range. Should the Fed further raise its discount rate – the rate it charges banks to borrow – that would cut into bank profits.

Second, “much of commercial real estate on the books of banks is performing today, but just barely,” Posner says. “If a rise in interest rates pushed up borrowing costs [for commercial developers] and you didn’t see a sudden jump in lease rates, that would make commercial real estate much worse.”

Ben Bernanke presumably knows this, which is why the Fed has pledged (repeatedly) to keeping rates low for an “extended period.”

While forecasting they will stay “lower longer than expected,” interest rates are a “relative game,” Posner notes. “It’s not just what’s happening here but the rest of the world will effect our interest rates.”

Case in point: the yield on the 30-year approached its highest level since October 2007 intraday Monday in reaction to the latest bailout plan for Greece, which prompted funds to flow out of the relative safety of Treasuries.