Are Bankers Swimming Naked?

Editor's note: A previous version of this article misstated several net income figures in the table. The Fool regrets the error.

It's a shame this went underreported: Last week, five financial regulators (including the Fed and the FDIC) issued banks with a joint advisory regarding "sound practices for managing interest rate risk." Although the warning is couched in broad, highfalutin' terms, regulators' message to bankers is clear: Don't fall asleep at the wheel, lulled by the stream of easy profits in the "current environment of historically low short-term interest rates." Bankers should remain vigilant -- and their shareholders even moreso.

Banks are printing money right now. They're borrowing at near zero short-term rates in order to fund portfolios of higher-yielding assets, then pocketing the difference in yield. Unfortunately, bankers have a highly underdeveloped sense of long-term survival, generally preferring to grab profits in the here and now without sufficient regard for risk in the there and then.

At zero, rates are in a one-way street
Unfortunately, short-term rates won't stay at zero forever, and they don't have anywhere to go but up. That will raise bankers' borrowing cost and (potentially) hammer the value of the securities they own. My colleague Morgan Housel has described this risk in some detail with regard to Goldman Sachs (NYSE: GS), which just capped one of the most profitable years in its history. (JPMorgan Chase (NYSE: JPM) and Wells Fargo (NYSE: WFC) also earned massive profits in 2009 -- see the table below).

Source: Capital IQ, a division of Standard & Poor's.

Don't forget the bond massacre of 1994
While I think the market is correct in anticipating no increase in rates before the second half of the year, I think it may be underestimating the magnitude of the hikes once they occur. The Fed surely wants to avoid a repeat of the bond rout of 1994 – that year, institutions and investors suffered losses on U.S. bonds of more than $600 billion ($876 billion in today's dollars) due to an unanticipated series of rate hikes. With this advisory, the Fed has given banks fair warning regarding this risk; we'll (soon) find out which bankers were swimming naked once the interest rate tide goes out.

You don't need to speculate on interest rates to take advantage of Wall Street's myopia; Anand Chokkavelu explains why you should buy these stocks before Wall Street catches on.