Fed Printing – It’s All About The Banks

In an investment environment where companies must show compounding earnings each successive quarter, without the Fed and Helicopter Ben printing money the banks would be is serious trouble.  Here’s why:

In the past 5 years banks have made money in the following ways:

1)  Borrow short, lend long.  As long as the banks’ cost of credit is virtually zero, they make money on the spread.  In 2008, 30 year mortgages were initiated at 5-6% interest, now they are initiating at 3-4%. Each successive quarter, banks are earning less on performing mortgages but the spread is still positive and they are making up the difference on mortgage origination fees.

2)  Proprietary trading.  Since 2008, the stock market has more than doubled and been quite volatile to boot.  The Dodd-Frank legislation provisions regarding proprietary trading have not yet hindered banks from making large profits buying, holding, and also trading volatility.   Derivatives have, for the most part, worked in their favor.

3)  Holding treasuries and other credit instruments.  As long as credit yields are trending downward, banks make money on the credit instruments they hold on their books (the market value of existing obligations go up as yields go down).

4) Releasing loan loss reserves.  As long as the economy looks like it’s improving, banks are permitted to take into income a portion of the allowance for bad debts they accrued in 2008.  (This has been a huge contributor to bank earnings over the past 5 years.)

5) Mergers, acquisitions, and IPOs.  When the economy is stable, banks make huge fees structuring and underwriting deals.  While this revenue is nowhere near what was made in the heyday of the 80s and 90s, it is still a factor in the overall profitability of a bank.

Without Central Bank intervention, most (if not all) of the above would not just lessen but reverse!  Let’s see how:

1) Borrow short, lend long.  Without Central Bank intervention, interest rates would find their true, risk adjusted value.  People who locked in 3-4% loans for long periods of time would count themselves lucky, while banks would take a hit on the spread.  Indeed, even with Central Bank intervention, banks will not make as much in this category as they have historically, due to the lower zero bound, where interest rates simply cannot go any lower.  From here on out, without Central Bank intervention, the risk of yield curve inversion is quite high.  Also, when interest rates begin to creep up, refinancing dries up and with it the fat origination fees the banks have gotten used to  (Just last week new mortgage applications were down 7% as interest rates have been trending sharply higher in the past month).

2)  Proprietary trading.  As JPM’s $5 billion derivatives “hiccup” proved, banks don’t do well on these type of investments when the worm turns (especially if it turns quickly and they are on the wrong side of the trade).  The “new normal” cited by Bill Gross of PIMCO, is death to a bank’s prop trading profits.  There must be volatility, preferably to the upside, for banks to continue to make as much money as they have in the past.  Without the hopium provided by Central Bank intervention, the risk is to the downside.

3)  Holding treasuries and other credit instruments.  Interest rates must be held down or the credit instruments the banks hold will go down in value.  While the banks no longer have to mark these instrument to market, they have counted on price appreciation to accrete earnings.  (As a corollary, banks don’t lend as readily when interest rates are rising.  If they do, it’s at variable rather than fixed rates.  This in turn hurts the recovery as both the cost and availability of credit goes down.)

4) Releasing loan loss reserves.  Without Central Bank intervention, all hope for growth in the economy and new jobs (justification for releasing reserves) would evaporate.  Not only would banks not be able to release additional loan losses as profit, but they would very probably have to initiate an increase to their loan loss reserves, which would be a drag on profits.

5)  Mergers, Acquisitions and IPOs.  Fees would dry up virtually overnight.  Nobody does deals when the economy isn’t growing.

 

In short, it’s really all about the banks.  The Fed has to keep the banks liquid and profitable at any cost.  So far, just the promise of future easing has kept the hounds at bay.  Soon, however, it will require real infusions of liquidity to keep interest rates moving downward and the stock markets moving upwards.  Without it the banks are, in a word, screwed.

 

1 comment to Fed Printing – It’s All About The Banks

  • jerry thielmann

    I still havnt gotten the hat I ordered and paid for on July 25, 2012.

    Not a good way to do business.

    order#201207251534214841

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