The U.S. economy has experienced an extraordinary period of low interest rates since the financial crisis, spurred by the Federal Reserve’s aggressive rate cuts intended to stimulate the economy. The Fed quickly brought the effective federal funds rate down from 5% to near 0%, where it remains today.
Common sense says that rates cannot stay this low forever, so that leads to the questions:
- When will interest rates start to rise again?
- By how much will they go up?
- What should your bank be doing to prepare?
Fed minutes released in February indicated that short-term interest rates may begin increasing as soon as 2015, sooner than the previous Fed position that rates would stay low until at least 2016. The Fed also plans to accelerate tapering of its bond-buying program (Quantitative Easing) this year with the goal of eliminating QE by the end of 2014.
As for the magnitude and speed at which rates will rise, considering the long-term historical average of the 10-year U.S. Treasury note provides a good indicator. Its 75-year average interest rate is 6.2%, so a reversion to the mean would require a rise of 600-800 basis points in a relatively short period of time.
Lastly, and most importantly, this leaves what your bank should be doing to prepare for rising interest rates.
1. Evaluate your risk
Now is the time for all community banks to assess their current interest rate position and protect the bank from the potentially negative effects of rising rates. Rising rates will impact both borrowers’ ability to service debt and income property values.
The first area to look at is the length of terms your bank is offering on fixed-rate loans, especially income property and owner-occupied real estate loans. To stay competitive in a tight market, some community banks have been offering borrowers long-term fixed rate loans, including five-to-seven-year balloon mortgages. Such mortgages might be appropriate in a stable interest rate environment, but they can be extremely risky in the current environment.
For example, suppose interest rates rise just 300 basis points within the next two years. If you are currently offering five-year balloon mortgages at 4%, the bank will be underwater when rates go up. Worse yet, when the balloon matures, you may not be able to refinance it at a higher rate without creating a non-performing loan or a troubled debt restructure (if you refinance at a below-market rate).
2. Perform stress testing
The next step is to stress test both individual loans and your entire portfolio for rising interest rates. Higher rates could have a significant impact on borrowers’ cash flow and their ability to service debt.
For example, at the individual loan level, adding several hundred basis points to the interest rate of a $500,000 note could add upwards of $13,000 in interest expense for a borrower. Evaluating this increase gives you a good idea of their ability to generate sufficient cash flow to service the debt going forward.
This will also give you an opportunity to be proactive with customers and start talking about steps to minimize the impact of rising rates, before they get into trouble.
3. Make a plan now
While no one know exactly when interest rates will rise and by how much, it is safe to say it will happen. Therefore, prudent community banks will start planning now for the potential impact of rising rates on individual credits and their commercial loan portfolio as a whole.
Contact us today if you have any questions about rising interest rates 417-881-0145.