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Printing - It's 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 don't have to worry about the spreads they get on the loans they make.  In 2008, 30 year mortgages were initiated at 5-6% interest, now they are initiating at 3-4%.  Banks are earning less on performing mortgages but the spread is still positive and they have also been making a killing on refinancing fees.

2)  Proprietary trading.  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 the volatility. 

3)  Holding treasuries and other credit instruments.  As long as yields are going down, 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 made in 2008.  This has been a huge contributor to bank earnings over the past 5 years.

5) Mergers, acquisitions, and IPOs.  While the economy is improving, 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 make less 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 cannot get 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 refinancing 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 their 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 variable rather than fixed.  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 in the short run would fade.  Not only would banks not be able to release additional loan losses as profit, but they could very probably have to increase 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. 

 

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.

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