America’s oldest lender may inspire a new beat

July 8, 2013

By Martin Hutchinson and Antony Currie
The authors are Reuters Breakingviews columnists. The opinions expressed are their own.

America’s onetime oldest lender might provide the beat for a new generation. First Pennsylvania needed a bailout from the Federal Deposit Insurance Corp in 1980 after rising rates whacked its portfolio of U.S. Treasuries. It’s easier to hedge such risks now, though not perfectly. And financial institutions these days mark securities they own to market prices. Complacency could cause bank history to rhyme.

First Penn’s failure was an extreme case. From 1976, it bought $1 billion of long-term Treasuries – about one-eighth of its assets when the FDIC stepped in – and funded them with deposits. In late 1979, short-term rates shot up to 15 percent and First Penn’s funding costs to around 15.5 percent, about twice the interest received on its U.S. government bond holdings.

That left the bank founded just a few years after America declared its independence running at a loss, sitting on $328 million of problem loans, a theoretical Treasuries hit of $300 million – and just $312 million of capital. The FDIC’s $500 million of aid and $1 billion deposit guarantee kept the bank afloat. First Penn recovered, repaid the FDIC and in 1990 was bought by CoreStates Financial, a franchise now subsumed into Wells Fargo.

Unlike First Penn, lenders today must book any losses on long-term securities investments, although for accounting purposes it shows up as a hit to capital not the bottom line. So by all rights, they ought to be more mindful of the risks. Swaps and options also provide a way to hedge exposures not available 33 years ago. And short-term rates shouldn’t budge at all for some time.

Even so, hedges can’t cover everything and also have a way of going wrong. U.S. banks are heavily exposed to rate-sensitive securities, holding $1.85 trillion of Treasury and agency bonds plus another $141 billion of non-agency mortgage debt, according to the Federal Reserve. Real estate investment trusts, meanwhile, owned $450 billion of home loans at year-end, according to Capital IQ, funding most of them with short-term repos. Ultra-low interest rates also probably induced some banks and REITs to buy longer-dated paper for extra yield.

The real lesson from First Penn is that even owning what are supposed to be the safest securities on the planet is no shield against being destroyed by interest-rate risk. That’s the refrain the whole industry should be humming to itself.

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