Fed’s Jeremy Stein Warns of Banks and Bubble Risk

“FORTUNE — Bank chief executives have spent the past few months telling investors not to worry about rising interest rates. Most have said their banks are not taking risks in the bond market and are protected from losses.

One Federal Reserve governor doesn’t agree. On Thursday, governor Jeremy Stein became the latest high profile person to publicly worry about what a bond bubble could do to the financial sector and the economy. In a speech at a symposium in St. Louis, Stein talked about how or if the Fed should respond.

Stein sees some areas of concern. He thinks the high-yield bond market might be due for a pull back, and that some mortgage finance companies could be overstretched. But Stein says at least for now a drop in bond prices won’t do too much harm to the overall economy.

One exception: Banks. Stein says historically banks have tended to put their money in longer-term bonds, which have higher yields, when interest rates are low. And he sees some of that behavior today. The problem is longer-term bonds tend to lose the most when interest rates rise.

Determining how much of a hit banks could take from a drop in bond prices isn’t easy. Banks aren’t required to disclose their bonds holdings. Most give clues, but not in any consistent way. What’s more, higher interest rates would boost banks’ lending profits, offsetting some of the losses in their bond portfolios.

Still, it appears, at least initially, banks stand to lose more from higher rates than they will gain. According to FDIC data, banks earned on average just 3.86% on all their loans and leases. That was the lowest that figure has been since the FDIC began collecting the data back in 1984, but given that 10-year Treasury bonds are yielding around 2%, still high enough to substantiate Stein’s claim that banks are “reaching for yield.”

Last summer, JPMorgan Chase CEO Jamie Dimon, in an effort to reassure Congress about the safety of his bank’s investments in the wake of the London Whale trading loss, testified that the average duration of the the bonds in JPMorgan’s portfolio was three years. Look at JPMorgan’s books, however, and you might come away with a very different number….”

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