How to Invest with Spectre of Rising Interest Rates on Horizon (+2K Views)

With the global economy growing, with federal deficits exploding, and with central banks printing money like there’s no tomorrow, there can be little doubt that rising markets will also bring rising interest rates. Who gets hurt when interest rates rise? The answer is all borrowers with debts coming due because they must pay more to roll them over and all lenders who have extended medium- or long-term credit at fixed rates because they suffer an immediate loss in the market value of their loans. Words: 928

In further edited excerpts from his original article* Martin Weiss (www.moneyandmarkets.com) goes on to say:

Ironically, despite the high probability of rising interest rates, three government reports reveal that nearly all U.S. financial sectors are exposed to the severe losses that higher rates can bring:

Report #1:
The Federal Deposit Insurance Corporation (FDIC) report concludes that with interest rates at record lows, they have nowhere to go but up.

More banks are now taking on higher levels of interest rate risk, leaving them overly exposed to rate rises at precisely the wrong time. They’re stuffing their portfolios with long-term mortgages, which invariably fall in value when interest rates rise and they’re relying too heavily on short-term financing, which will inevitably be more expensive when rates rise.

For nearly 20 percent of U.S. banks, long-term assets now make up more than HALF of their total assets — nearly double the level of 2006. This means that over 1,500 U.S. banks could suffer losses in half or more of their portfolio when rates go up i.e. over 1,500 banks are making the classic mistake of borrowing short and lending long. That’s what helped kill hundreds of institutions in the 1970s and 1980s … and that’s what could happen this time as well. There were almost 150 bank failures in 2009 and the FDIC is bracing itself for many more failures in 2010.

Report #2
The Comptroller of the Currency (OCC) report states that:
1. credit derivatives which were a key factor in Wall Street’s nuclear meltdown in 2008 have been reduced.

Unfortunately, they fail to recognize that credit derivatives were the bugaboo of the LAST crisis, which was all about credit defaults, but in the NEXT crisis, triggered by rising interest rates, the banks’ big nemesis is likely to be interest rate derivatives — those tied to bond yields, mortgage rates, and a variety of other rates.

2. U.S. banks hold $172.5 TRILLION in interest rate derivatives.

Unfortunately, they fail to mention that this is a new record represents over THIRTEEN times (84.5%) the amount they hold in credit derivatives.

Report #3
The Federal Reserve Board reports that:
a) credit unions and government agencies and government-sponsored enterprises (GSEs), such as Fannie Mae and Freddie Mac have major holdings in home mortgages.

Unfortunately, they do not mention that these mortgages are vulnerable due to their huge stakes in assets that automatically fall in market value when interest rates rise. Their combined percentage in assets potentially vulnerable to higher interest rates: 50.4 percent of assets.

b) life insurance companies — providers of life, health, and annuity policies — are major holders of corporate bonds: $1.9 trillion worth! Plus, they hold $332.9 billion in mortgages and another $50 billion in municipal bonds. Combined, that’s 55.7 percent of their assets in likely interest-sensitive investments.

c) property and casualty insurers — which cover your home, car, or business — are among the largest holders of municipal bonds: $394.1 billion. Plus, they have $272.6 in corporate bonds and another $112.3 billion issued by government agencies and GSEs. Combined total potentially vulnerable to rising interest rates: 58.4 percent.

Not all of these assets are locked into medium- or long-term rates. Some may be short term and, therefore, not hurt by higher rates. But the overwhelming bulk of the assets ARE vulnerable and, unlike credit defaults, which strike just a certain percentage of bonds and mortgages, the rising tide of interest rates impacts nearly ALL fixed-rate bonds and mortgages, driving down their market value across the board.

Here’s the bottom line for you.

1. When you’re choosing a vehicle to save your money:
– avoid long-term bonds like the plague. On the surface, their yields may look more attractive than the miserable short-term rates now available but buying them at this stage is like making a pact with the devil: you get your wish of higher yield at first only to lose your principal later, wiping out any yield advantage many times over.

2. When you’re choosing a mortgage or loan:
– avoid the variable-rate variety at all costs. The consequences could be ugly.

3. When you invest in the stock market:
a) carefully sidestep the shares in sectors directly impacted by rising interest rates — like banks, insurance companies, and other financial institutions that have their heads stuck in the sand about interest rate risk.

b) buy only the sectors that are insulated from rising interest rates or, better yet, that surge for some of the same reasons that rates rise, e.g. gold, natural resources, and emerging markets, which rise with inflation, a falling dollar, and growing demand for credit worldwide.

c) for good measure, buy interest rate hedges — such as specialized ETFs designed to profit from surging rates and sinking bond prices.

*http://www.moneyandmarkets.com/three-government-reports-reveal-new-looming-risk-5-36955

– The above article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered.
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