December 20, 2010

What goes through the mind of a Rüppell’s Griffon Vulture? Last August, a seven year old vulture named “Gandalf” was performing as part of the World of Wings bird display in the Scottish town of Cumbernauld, North Lanarkshire, when she unexpectedly caught a thermal and took off, soaring high into the sky and away from captivity. These vultures are not your everyday birds, and handlers quickly realized they had a problem on their hands.

It turns out that these large, majestic birds (up to 4ft tall, with a 10ft wingspan) are the highest recognized flyers on the planet, and have soared to well over 35,000 feet in their native skies in Africa. Air traffic controllers were quickly alerted, and issued a warning to local pilots that a large vulture, capable of soaring to commercial flight altitudes, was on the loose and posed a risk to aviation in the vicinity of Glasgow International Airport.

After a brief taste of freedom and a little weary from her trip, Gandalf was spotted and recaptured without incident 4 days later. Crisis averted. But on that day when she slipped the surly bonds of earth, no one really knew how high she would climb, nor how long she would stay aloft. Even though she had never escaped before, the staff knew her capabilities and took serious the potential for her rapid ascent to altitude and the risks imposed therein. So, with our own recent experience, we too can now appreciate what the World of Wings went through. From our own perch overlooking the economic recovery, we have also witnessed a rapid rise, but in interest rates, posing their own set of risks to banks, borrowers, and businesses that are unprepared for these new heights.

The rise in interest rates since the Nov 2-3 Fed meeting is something of a mystery. The Fed announced its QE2 asset purchase plan, intending to drive longer term interest rates down, and instead they’ve crept up and up. World reaction to QE2 has been mixed, but the market reaction is undeniable: five, seven, and ten year U.S. Treasury rates were up more than 100 basis points in the last six weeks, before a modest pull back, and corresponding swap rates were up a similar amount in the same period. The yield curve is now the steepest it has been since March, with the difference between 2yr and 10yr treasuries now at 275 basis points.

It’s been nearly one year since the various banking regulators issued a joint statement and held a symposium to warn financial institutions that exceptionally low interest rates would eventually end, and that reliance on investing longer term while funding with shorter dated financing would pose a risk to those banks in time. You can imagine the regulators were warning that the Fed would eventually raise rates, not that market participants could raise rates by simply requiring greater yield, and yet we are in the same position with an elevated rate environment today.

So, whether you believe the regulators cried wolf back in January 2010, or gave the public the longest advance warning in the history of interest rate risk management, the ball is nonetheless squarely in your court. What to do, now that you have seen the capabilities of this large, majestic market, soaring overhead a bit higher than expected? How high will it climb, and do you risk a mid-air collision which results in a crash? When will it come down, if it comes back down? Will short rates follow, and if so, when? If you have variable rate borrowings, or fixed income assets, you have interest rate risk that may look a bit more real to you today than it did 6 weeks ago. Even the Federal Reserve has interest rate risk, and incredibly had a near 9 billion dollars of unrealized losses on its 1 trillion dollar treasury and agency portfolio, when rates rose 20 basis points on a single day last week.

You don’t need to have Fed-sized interest rate risk, though, to know that your own margins could compress or your debt service could balloon when rates rise. As you know, we are view neutral but believe you should know what your risks are and be comfortable with those risks. If you are just now thinking about what to do, it may finally be time to explore interest rate protection products to fit your needs. The vast majority of clients are best served with either a pay-fixed interest rate swap or a purchased interest rate cap, to fix or limit their debt service. You may also consider more complex products if the situation dictates. Regardless of the situation, Chatham Financial stands ready to help you navigate the elevated rate environment.

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