Rising rates are a problem for high yield borrowers that now find their calls going unreturned, investment grade borrowers who see their outstanding paper fall in value – leading to aggrieved investors – and project managers scrambling to revise their discount rate calculations. According to Fitch, rising rates could affect not only the terms but the availability of bank financing.
Banks are sitting on mountains of unrealized gains, especially on mortgage bonds, which have happily boosted capital just when new regulations and more intrusive regulators are calling for fatter cushions. Those gains are now at risk, meaning some banks could be forced to pump up their capital by either issuing equity (not a realistic scenario for most banks) or cutting back their risk.
It may be that appetite for bank loans from spread investors that see it as a convenient way to pick up margin while shortening duration will continue for a while. In fact, the bond meltdown has moved duration shortening from a priority to a panic.
But supply may be nonetheless crimped as these investors pair duration shortening with credit risk aversion. Also, banks in this environment may not want to risk having “hung” loans of the type that nearly sank them during the financial crisis.
Unrealized profit deterioration’s effect on capital isn’t the only worry for banks, Fitch says. Their net interest margin models may be way off. It’s impossible to say, since they have never been tested in the reversal of such a persistently low rate environment. According to Fitch:
“The vast majority of Fitch-rated banks have disclosed that they are asset-sensitive, meaning net interest income (NII) rises along with interest rates, as assets reprice faster than liabilities. While we believe that most income simulation models are likely directionally sound, the magnitude of NII changes could be vastly different than modeled outcomes, depending on how depositors and borrowers actually behave as rates rise. This is particularly relevant given the unprecedented length of time during which rates have remained at historically low levels.”
If the models fail, it is likely to crimp access to credit. It all depends on how the Fed manages expectations and if it can put the brakes on the growing risk aversion in the markets.